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"The mark of a well educated person is not necessarily in knowing all the answers, but in knowing where to find them."

           —— Douglas Everett.

Here you will find relatively brief articles and papers, each of which focuses on a fairly narrow topic.  For more broad coverage of investing issues, see our Reading Room for Books.

We've listed herein a mix of good articles from the popular press (intended for lay people) and highly technical academic papers.  Hopefully, these materials will elucidate more than they confuse.  We've included links for the vast majority of the entries.  Note that some of the papers are quite lengthy and may take a fair amount of time to download.

Unfortunately, some papers aren't freely available on the Internet at this time (to the best of our knowledge).  You may be able to find them at large public libraries.  You almost certainly will be able to locate them at most business school libraries.  For those papers which aren't freely available online, we've tried to include brief summaries.

Articles written in a fashion such that laypeople can probably understand them are colored blue — most people should be able to comprehend them.  Technical articles and papers intended for professionals/academics are colored red.

If you have questions or comments about any of the materials referenced here, contact us — we love talking about this stuff!

bulletAsset Allocation
bulletBid-Ask Spreads
bulletBonds
bulletBroker/Dealers
bulletCapital Asset Pricing Model (CAPM)
bulletCharitable Giving
bulletClosed-End Funds
bulletCollege Planning
bulletCommodity Futures
bulletCurrency Hedging
bulletData Mining
bulletDefined Benefit Pension Plans
bulletDefined Contribution Pension Plans
bulletDimensional Fund Advisors (DFA)
bulletDiversification
bullet Diversification of Concentrated Positions
bulletDividends
bulletDollar Cost Averaging
bulletEfficient Market Hypothesis
bulletEmerging Markets
bulletEndowment Fund Management
bulletEquity Premium
bulletEstate Planning
bulletExchange Traded Funds
bulletFama/French Three-Factor Model
bulletForeign Investing
bulletFrontier Markets
bulletHedge Funds
bulletHigh-Yield Bonds (Junk Bonds)
bulletIlliquidity Premium
bulletIndex Weighting
bulletInflation-Indexed Bonds (TIPS and I-Bonds)
bulletInvestor Psychology/Behavioral Finance
bulletLife Insurance
bulletLong Term Care Insurance
bulletMarket Timing
bulletModern Portfolio Theory
bulletModern Portfolio Theory using Downside Risk
bulletMomentum Investing
bulletMortgage Refinancing
bulletMutual Fund Fees
bulletMutual Fund Persistence
bulletPassive vs. Active Management
bulletPension Fund Management
bulletPerformance Evaluation
bulletPerformance Measurement
bulletPortfolio Insurance
bulletPrivate Equity
bulletProfitability Investing
bulletPrudent Investor Rule
bulletReal Estate Investment Trusts (REITs)
bulletRebalancing
bulletRetirement Investing
bulletReversion to the Mean
bulletRisk Measures
bulletSocial Security Retirement Benefits
bulletSurvivorship Bias
bulletSynthetic/Enhanced Indexing
bulletTax Loss Harvesting
bulletTax Managed Investing
bulletVariable Annuities
bulletMiscellaneous Other

Asset Allocation

Asset allocation refers to the division of one's investment portfolio across the various asset classes.  At the highest level, this refers to a split between stocks and bonds.  Many more finely defined sub-asset allocations are also common.  Also, see Modern Portfolio Theory, Rebalancing and Tax-Managed Investing.

bulletIan Ayres and Barry J. Nalebuff, "Diversification Across Time," Yale Law & Economics Research Paper No. 413, Oct 4, 2010.  This outstanding paper discusses the idea of spreading one's stock exposure more evenly across their lifetime, which should then reduce the riskiness surrounding the ending wealth.  Here's an excellent website where the authors discuss this idea.  Here's the outstanding book where they elaborate in depth on this idea.

bulletIan Ayres and Barry J. Nalebuff, "Mortgage Your Retirement -- A Commentary by Ian Ayres and Barry Nalebuff," Forbes, November 14, 2005.  This outstanding article covers the same ground as the "Diversification Across Time" paper above, but at a level which is more readable for the layperson.

bulletGary P. Brinson, L. Randolph Hood, and Gilbert P. Beebower, "Determinants of Portfolio Performance," Financial Analysts Journal, July/August 1986, pp. 39-44.  This was the paper which revolutionized portfolio construction by emphasizing the importance of asset allocation.  It found that, on average, 93.6% of the total return variation of the pension funds studied over time was due solely to asset allocation.  Further, it found that active management resulted in an annual reduction of 1.1 percentage points in total returns.

bulletGary P. Brinson, Brian D. Singer, and Gilbert P. Beebower, "Determinants of Portfolio Performance II: An Update," Financial Analysts Journal, May/June 1991, pp. 40-48.  "Clearly, the contribution of active management [which was found to be somewhat negative] is not statistically different from zero."  An update of their previous work, with similar conclusions.

bulletJohn C. Bogle, "The Riddle of Performance Attribution: Who's in Charge Here — Asset Allocation or Cost?," a speech presented before the Financial Analysts Seminar Sponsored by the Association for Investment Management and Research At Northwestern University, Evanston, Illinois July 20, 1997.  Vanguard's founder concludes that, while asset allocation is very important, controlling costs is also very important.

bulletNatalie Chieffe, "Asset Allocation, Rebalancing, and Returns," Journal of Investing, Winter 1999, pp. 43-48.  "The results of this research show that market conditions tend not to provide reliable information on which to base the rebalancing decision [i.e., tactical asset allocation decisions].  Much of the advice presented to investors during periods of unusual market activity should be ignored.  It is more important to rebalance the retirement portfolio on the basis of a change in risk aversion, rather than on the conditions in the financial markets."  Basically, this paper supports the idea of strategic, not tactical, asset allocation.

bulletJohn H. Cochrane, "Portfolio Advice for a multifactor world," Economic Perspectives, XXIII (3) Third quarter 1999 (Federal Reserve Bank of Chicago), pp. 59-78 (296kb).  Also here.  Pragmatic advice on asset allocation.

bulletWolfgang Drobetz and Friederike Köhler, "The Contribution of Asset Allocation Policy to Portfolio Performance,"  WWZ/Department of Finance Working Paper No 2/02 (115kb).  "... active management not only failed to add value above the policy benchmarks [but] it destroyed a significant portion of investors' value."  This paper concludes that asset allocation accounts for about 134 percent of the level of portfolio performance (implying that active management accounts for about minus 25%).

bulletEugene F. Fama and G. William Schwert, "Asset Returns and Inflation," Journal of Financial Economics, November 1978, pp. 115-146 (1.49mb).  For a smaller file version, see here (749kb).  This paper studies the relative efficacy of various asset classes as inflation hedges.  It finds that treasury bonds are a complete hedge against expected inflation.  It also finds that private residential real estate is a complete hedge against both expected and unexpected inflation.

bulletRoger C. Gibson, "A Timely Reminder: The recent market tumult offers a perfect opportunity to remember the advantages of a diversified, balanced portfolio," Financial Planning, October 2001.  An excerpt from Mr. Gibson's outstanding book, Asset Allocation: Balancing Financial Risk (McGraw-Hill, 2000).

bulletRoger C. Gibson, "The Rewards of Multiple-Asset-Class Investing" Journal of Financial Planning, July 2004, pp. 58-71.  Also here.  Another outstanding version of his timeless message, reprinted from its original appearance in this Journal in March 1999.

bulletSherman Hannah and Peng Chen, "Subjective and Objective Risk Tolerance: Implications for Optimal Portfolios," Financial Counseling and Planning Journal, Vol 8 No 1 1997, pp. 17-26.  "For a typical investor under the age of 50, a retirement savings portfolio should be 100% in stocks."  This paper attempts to make suggestions primarily based on need and ability to bear risk ("objective risk"), but not very much on willingness to bear risk ("subjective risk").  In general, we do not agree with the 100% stock asset allocation recommendation except in cases where there is a very high willingness and ability to tolerate risk.

bulletSteven Horan, "After-Tax Valuation of Tax-Sheltered Assets," Financial Services Review, 11 2002, pp. 253-275.  This study builds on Reichenstein and Sibley papers below.

bulletSteven Horan, "An alternative approach to after-tax valuations," Financial Services Review, 16 2007, pp. 167-182.  This study builds on Reichenstein and Sibley papers below.

bulletJeffrey T. Hoernemann, Dean A. Junkans, and Carmen M. Zarate, "Strategic Asset Allocation and Other Determinants of Portfolio Returns," Journal of Wealth Management, Winter 2005, pp. 26-38.  This study reviews and revises the Brinson studies above.  This study concludes that strategic asset allocation only explains about 77.5% of the variability of portfolio returns, not 90+% as suggested by Brinson et. al.

bulletKwok Ho, Moshe Arye Milevsky, and Chris Robinson, "Asset Allocation, Life Expectancy, and Shortfall," Financial Services Review, 3(2) 1994, pp. 109-126.  Also here.  This study suggests that, in order to minimize shortfall risk, it may be appropriate for investors to maintain 100% stock allocations well into their retirements (i.e., as late as age 75 for men and 80 for women).  In general, we do not agree that most retirees should use such a high stock allocation unless they have a very high willingness and ability to tolerate risk.

bulletRoger G. Ibbotson and Paul D. Kaplan, "Does Asset Allocation Policy Explain 40, 90, or 100% of Performance?," Ibbotson Associates (97kb).  Also here.  The full article appeared in Financial Analysts Journal, January/February 2000 (244kb).  An analysis of criticisms of the two "Determinants of Portfolio Performance" papers.

bulletScott L. Lummer and Mark W. Riepe, "The Role of Asset Allocation in Portfolio Management," Ibbotson Associates (40kb).  Also here.  This paper also appeared in Global Asset Allocation: Techniques for Optimizing Portfolio Management (John Wiley & Sons, 1994).

bulletDavid Nawrocki, "The Problems with Monte Carlo Simulation," Journal of Financial Planning, November 2001, pp. 92-106.  Also here.  Also here.  This excellent article puts Monte Carlo simulations into perspective.  Consumers are increasingly being led to believe that use of a Monte Carlo simulator accurately projects the probability of meeting their financial goals.  The article correctly exposes this fraud.  We believe that Monte Carlo simulators may be useful in educating clients about the nature of risk and return tradeoffs, but they certainly shouldn't be counted on to determine one's asset allocation.  The principal problem with them is that the entire analysis depends solely on the validity of the data inputs as predictors of the future.  Unfortunately, there is only one thing we know for certain about those inputs, whatever they might be: they are wrong.  We don't know how wrong they are or whether they overstate or understate the future, but we are 100% certain that they are wrong.  Good bibliography at the end and good sidebar by John Kingston.

bulletJohn Nuttall, "The Importance of Asset Allocation."  A harsh, but very valid, critique of the "Determinants of Portfolio Performance" papers.

bulletAndré F. Perold and William F. Sharpe, "Dynamic Strategies for Asset Allocation," Financial Analysts Journal, January/February 1988, pp. 16-27.  This paper studies three dynamic asset allocation strategies: Buy-and-hold, portfolio insurance (both constant proportion and options-based), and constant-mix.  The paper concludes that each might be most appropriate in certain market conditions or for certain clients.  We believe that the constant-mix strategy is most appropriate for most individual investors in that it controls the amount of risk in the portfolio.  Controlling risk not only controls expected return, but it tends to preclude investors from allowing well-documented psychological phenomena to influence them to do things which are adverse to their financial well-being.

bulletJames M. Poterba, "Valuing Assets in Retirement Saving Accounts," National Tax Journal, June 2004, pp. 489-512.  This paper builds on the Reichenstein and Sibley papers below.

bulletWilliam Reichenstein, "Calculating Asset Allocation," Journal of Wealth Management, Fall 2000 (54kb).  A similar article, "Rethinking the Family's Asset Allocation," appeared in Journal of Financial Planning, May 2001, pp. 102-109.  Another similar paper, "Asset Allocation and Asset Location Decisions Revisited," appeared in the Journal of Wealth Management, Summer 2001.  Yet another similar paper, "Calculating the family's asset mix," appeared in the Financial Services Review, Volume 7 Number 3 1998 (1.49mb). Another similar paper, "Implications of principal, risk, and returns sharing across savings vehicles," appeared in the Financial Services Review, Volume 16(2007), pp. 1-19.  Another similar paper, "Calculating After-Tax Asset Allocation is Key to Determining Risk, Returns, and Asset Location," appeared in the Journal of Financial Planning, July 2007.  This paper suggests that asset allocation should be calculated on the basis of post-tax values of your portfolio.  For example, $100,000 in a Roth IRA is worth much more than $100,000 in a 401(k) due to eventual tax effects.

bulletWilliam Reichenstein, "10 Lessons You Should Learn from Recent Market History," AAII Journal, February 2003.  Here are the ten lessons referred to in the title:
bulletMixing bonds and stocks moderates portfolio risk;
bulletPortfolio risk rises disproportionately slowly as stocks are added to the portfolio;
bulletAn all-bonds portfolio is not the lowest-risk portfolio;
bulletPortfolio returns rise disproportionately quickly as stocks are added to the portfolio;
bulletAn often-overlooked risk for the long-run investor is the risk of having a too-conservative portfolio;
bulletBy rebalancing once a year, you maintain a stable risk exposure;
bulletA balanced portfolio avoids market timing;
bulletDue to rebalancing, if an asset class becomes overvalued, you will be selling it as it rises; and, if an asset class becomes undervalued, you will be buying it as it falls;
bulletRebalancing provides a discipline that helps investors overcome inertia;
bulletA fixed-weight strategy takes little time and it can save time at tax time.

bulletL. Jacobo Rodriguez, "Core Equity: An Integrated Portfolio Solution," Institute for Fiduciary Education, 2005.  This paper describes a somewhat novel approach to designing a portfolio.  Rather than developing your asset allocation and then implementing it with several highly specialized funds, you would instead build all (or most) of the allocation preferences into a single fund.  DFA has done this with their "Core Equity" funds, of which they have five.  The idea is that you'd combine one or more of those funds together, with other Core Equity funds or other funds, to get the overall portfolio factor exposure that you desire.

bulletPaul A. Samuelson, "The Long-Term Case for Equities: and how it can be oversold," Journal of Portfolio Management, Fall 1994, pp. 15-24.  This paper, written by a Nobel prize winner, warns against market timing, warns against active management, and generally supports the prudence of strategic asset allocation.

bulletPaul A. Samuelson, "Asset allocation could be dangerous to your health: Pitfalls in across-time diversification," Journal of Portfolio Management, Spring 1990, pp. 5-8.  This paper, written by a Nobel prize winner, warns against tactical asset allocation (and is consistent with the prudence of strategic asset allocation).

bulletMike Sibley, "On the Valuation of Tax-Advantaged Retirement Accounts," Financial Services Review, 11 (2002), pp. 233-251 (726kb).  An excellent discussion of how to get an after-tax valuation for a retirement account.  Due to the assumption made that the taxable equivalent investment is perfectly tax inefficient, the equations' applicability is limited only to valuing bond investments.

bulletSteve Strongin and Melanie Petsch, "Protecting A Portfolio Against Inflation Risk," Investment Policy, July/August 1997, pp. 63-82 (439kb).  An excellent discussion of how to hedge against various types of inflation risk.  It suggests that international diversification, inflation-indexed bonds, and commodities are the best hedges against inflation.

bulletRonald J. Surz, Dale Stevens, and Mark Wimer, , "The Importance of Investment Policy," Journal of Investing, Winter 1999, pp. 80-85.  "We find that, on average, policy [a.k.a., asset allocation] explains approximately 100% of investment returns. If a manager succeeds in adding value, this can drop to as low as 85% when risk is not incorporated, and even to 75% on a risk-adjusted basis. If the manager fails to add value, policy can explain as much as 135% of return unadjusted for risk, or 165% risk-adjusted; the difference between these percentages and 100% is explained by manager value reduced through market timing, selection, and/or costs.  In other words, if a manager neither adds nor reduces value, policy explains 100% of performance."

bulletRonald J. Surz, Dale Stevens, and Mark Wimer, "The Importance of Investment Policy: A Simple Answer to A Contentious Question," PPCA.  "We find that, on average, policy [a.k.a., asset allocation] explains approximately 100% of investment returns. If a manager succeeds in adding value, this can decrease to as low as 85% when risk is not incorporated, and even further to 75% on a risk-adjusted basis. On the other hand, if the manager fails to add value, policy can explain as much as 135% of return unadjusted for risk, or 165% risk-adjusted ..."

bulletRonald J. Surz, Dale Stevens, and Mark Wimer, "Investment Policy Explains All," Journal of Performance Measurement, Summer 1999, pp. 43-47 (22kb)  This paper also appeared in Journal of Investing, Winter 1999, pp. 80-86.  Another critique of the two Determinants of Portfolio Performance papers.

bulletYesim Tokat, "The Asset Allocation Debate: Provocative Questions, Enduring Realities," Investment Research and Counseling /ANALYSIS, April 2005.  A summary of the issues.  "Unless there is a strong belief in the ability to select active managers who will deliver higher risk-adjusted net returns, investors’ focus should be on the asset allocation choice and its implementation using broadly diversified, low-cost portfolios with limited market-timing."

bulletYesim Tokat, Nelson Wicas, and Francis M. Kinniry, "The Asset Allocation Debate: A Review and Reconciliation," Journal of Financial Planning, October 2006, pp. 52-63.  A summary of the issues.  "Unless there is a strong belief in the ability to select active managers who will deliver higher risk-adjusted net returns, investors’ focus should be on the asset allocation choice and its implementation using broadly diversified, low-cost portfolios with limited market-timing."

bulletR. Douglas Van Eaton and James A. Conover, “Equity Allocations and the Investment Horizon: A Total Portfolio Approach,” Financial Services Review, 11(2) Summer 2002, pp. 117-133 (1.65mb).  This article provides support for the idea that an investor's equity exposure should be somewhat proportional to their time horizon (actually it should be somewhat proportional to the ratio of existing assets to future savings).

Bid-Ask Spreads

All securities bought or sold on exchanges have a bid-ask spread.  This is the difference between the security's selling price and its buying price.  The difference covers the costs and profits of the market maker.  Whenever you buy or sell a security on an exchange, you implicitly incur one-half of the bid-ask spread as a transaction cost.  Also, see Illiquidity Premium.

bulletKidwell, Blackwell, Peterson, and Whidbee, "Financial Institutions, Markets, and Money," John Wiley & Sons.  This slide presentation summarizes Chapter 10 of the referenced book.  The highlight as it applies to this topic:  In general, bid-ask spreads:

bulletare proportionately higher for low-priced stocks due to fixed costs of operations.
bulletare higher for trades of a few shares.
bulletare higher for a large block trade; a liquidity service is performed.
bulletare narrower with more frequent trading, where the costs of providing liquidity are less.
bulletare wider with traders with insider information, where the dealer may have to incur the cost of price discovery, or buying high, selling low!

bulletJinbaek Kim, "A Study on the Bid-Ask Spread," U.C. Berkeley Working Paper.  The appendices here are outstanding.  They summarize the important existing research on the bid-ask spread.

bulletRichard Roll, "A Simple Implicit Measure of the Bid-Ask Spread in an Efficient Market," Journal of Finance, September 1984, pp. 1127-1139(342kb).  This paper suggests a simple formula for the effective Bid-Ask spread in an efficient market.

bulletHans Stoll, "Inferring the Components of the Bid-Ask Spread: Theory and Empirical Tests," Journal of Finance, March 1989, pp. 115-134.  See here for a good discussion of this paper.  This paper finds that serial return covariances are strongly negatively correlated with the square of the bid-ask spread.  Further, the paper finds that the bid-ask spread can be broken down empirically into the following components:
 
bulletAdverse Information Costs: 43%.
bulletInventory Holding Costs: 10%.
bulletOrder Processing Costs: 47%.

bullet "Empirical Market Microstructure Research."  A good summary of the important existing research on the bid-ask spread.

Bonds

Fixed income assets (e.g., bonds) are often added to a portfolio to lessen its volatility.  Another benefit from including bonds in a (otherwise all equity) portfolio is the improved risk/return characteristics resulting from the less than perfect correlation of bonds with equities and other assets.  Also, see Inflation-Indexed Bonds and High-Yield Bonds (Junk Bonds).

bulletDavid A. Plecha, "Fixed Income," Dimensional Fund Advisors.  Details the rationale behind DFA's fixed income strategies.  An excellent, very readable article.

bulletVance Anthony, Martha Mahan Haines, and Murat Aydogyu, "Report on Transactions in Municipal Securities," United States Securities and Exchange Commission, July 1 2004 (2.3mb).  This excellent study quantifies the extent of typical bid-ask spreads for individual municipal bonds (they're big).  The bid-ask spread is effectively a transaction cost.  Effectively, any time you buy or sell a municipal bond, you pay one-half of the bid-ask spread as a transaction cost, perhaps in addition to a brokerage commission.  For a good discussion of this study, see the Zweig article below.

bulletManoj V. Athavale and Terry L. Zivney, "Now is Always the Best Time to Buy Bonds," Journal of Financial Planning, August 2005, pp. 56-61.  This outstanding paper suggests that it makes sense to buy bonds when you need them, even if that happens to be in a rising interest rate environment.  "... financial planners would better serve their clients by helping them define their investment time frame and helping them understand the role of bonds in their portfolio, and discouraging speculation on the direction and magnitude of interest rate changes."

bulletThomas J. Berger, "Global Bonds and Emerging Debt: Worth Considering or Worth Forgetting?," Institute for Fiduciary Education, October 1 1999 (140kb).  This paper points out the diversification benefits of investing a portion of your fixed income portfolio overseas.

bulletDonald G. Bennyhoff, "Municipal Bond Funds and Individual Bonds," The Vanguard Group, July 2004.  Also here.  This paper looks at the pros and cons of using muni bond funds vs. using individual bonds.

bulletChristopher R. Blake, Edwin J. Elton, Martin J. Gruber, "The Performance of Bond Mutual Funds," Journal of Business, July 1993, pp. 371-403.  This study concludes, "Overall and for subcategories of bond funds, we found that bond funds underperformed relevant indexes.  ... this underperformance was approximately equal to the average management fees ..."  "... on average, a percentage point increase in expense leads to a percentage point decrease in returns ..."  This paper strongly supports the prudence of a strategy of selecting bond funds by cost (i.e., choosing no-load funds with the lowest expense ratios).

bulletJames L. Davis, "The Information in the Term Structure: An Update," Dimensional Fund Advisors, October 2000.  Details the empirical support for DFA's "variable maturity" strategy.

bulletDale L. Domian and William Reichenstein, "Performance and Persistence in Money Market Fund Returns," Financial Services Review, 1997 Vol 6, pp. 169-183.  This paper confirms strong persistence in money market mutual funds due principally to the almost perfect negative correlation of expenses and performance.  The paper strongly supports the prudence of a strategy of selecting money market funds by cost (i.e., choosing no-load funds with the lowest expense ratios).

bulletDale L. Domian, Terry S. Maness, and William Reichenstein, "Rewards to Extending Maturity: Implications for investors," Journal of Portfolio Management, Spring 1998, pp. 77-92.  This paper confirms that short term bonds offer superior risk-adjusted returns to those offered by longer term bonds.  "The average term premium appears to rise very sharply as maturity lengthens through about one year, continues to rise through about three years, remains essentially flat from. about three through fifteen years, and falls thereafter."  "The greatest reward to risk is realized for extending maturity through the shortest end of the bond market. In fact, most of the average reward to extending maturity probably occurs by the time maturity reaches one year."

bulletDale L. Domian and William Reichenstein, "Predicting Municipal Bond Fund Returns," Journal of Investing, Fall 2002, pp. 53-65.  This paper confirms persistence in municipal bond mutual funds due principally to the almost perfect negative correlation of expenses and performance.  The paper strongly supports the prudence of a strategy of selecting municipal bond funds by cost (i.e., choosing no-load funds with the lowest expense ratios).

bulletScott J. Donaldson, "Taxable Bond Investing: Bond Funds or Individual Bonds," Vanguard Investment Counseling & Research/ANALYSIS, March 2005 (662kb).  Also here.  An excellent paper which compares and contrasts the pros and cons of buying individual bonds vs. using low-cost bond mutual funds.

bulletAmy K. Edwards, Lawrence E. Harris, and Michael S. Piwowar, "Corporate Bond Market Transaction Costs and Transparency," Journal of Finance, June 2007, pp. 1421-1451.  "Our results show that corporate bonds are expensive for retail investors to trade.  Effective spreads in corporate bonds average 1.24% of the price of representative retail-sized trades ($20,000). ... Corporate bond transaction costs are much lower for institutional-sized transactions."  This paper confirms the prudence of using bond funds instead of individual bonds -- due to the much higher transaction costs associated with retail-size trades.
 
bulletEdwin J. Elton, Martin J. Gruber, Deepak Agrawal, and Christopher Mann, "Explaining the Rate Spread on Corporate Bonds," Journal of Finance, February 2001, pp. 247-278 (219kb).  This paper studies the factors which influence the difference between returns on corporate bonds and government bonds.  They found that the possibility of default for corporates explains about 18% of the difference.  They also found that the tax-exempt treatment of government bonds at the state and local level explains about 36% of the difference.  Of the remaining effects, about 85% is explained by factors which are commonly used to explain common stock returns.

bulletCheol S. Eun and Bruce G. Resnick, "International Diversification of Investment Portfolios: U.S. and Japanese Perspectives," Management Science, January 1994, pp. 140-161.  "For U.S. investors, the international bond diversification with exchange risk hedging offers a superior risk-return trade-off than the international stock diversification, with or without hedging."  This paper supports the prudence of hedging the currency risk on foreign bond investments.
 
bulletEugene F. Fama, "Update of the Research Underlying Dimensional's Bond Strategies," Dimensional Fund Advisors, September 2003.  Updates the empirical support for DFA's "variable maturity" strategy.

bulletEugene F. Fama and Robert R. Bliss, "The Information in Long-Maturity Forward Rates," American Economic Review, September 1987, pp. 680-692.  This paper suggests that long forward interest rates have significant power in predicting future spot interest rates.  "The 1-year forward rate calculated from the prices of 4- and 5-year bonds explains 48 percent of the variance of the change in the 1-year interest rate 4 years ahead."  In other words, the market is fairly efficient at anticipating future interest rates.

bulletRoberto C. Gutierrez, Jr., "Book-to-Market, Equity, Size, and the Segmentation of the Stock and Bond Markets," Texas A&M Working Paper, April 11 2001 (85kb).  This paper suggests that book-to-market ratio and market capitalization have explanatory power for the cross section of corporate bond returns, just as they do for stocks.

bulletEric E. Haas, "Corporate Bond Fund or Individual Treasuries: Which is Better?," Altruist Financial Advisors LLC Working Paper, May 4 2005.  This paper quantitatively answers the question, "Which is better for an individual investor: A bond fund or individual bonds?"  As you might imagine, the answer ultimately is, "It depends."  But basically, this paper suggests that, over the period studied (85-02), a short-term investment grade corporate bond fund would have outperformed, on a risk-adjusted basis, a portfolio of individual treasury bonds, if the difference in its fees were less than about 0.71 percentage points.  Since such funds are generally available (e.g., the Vanguard Short-Term Investment Grade Fund (VFSTX)), it seems prudent for most individual investors to go the bond fund route.

bulletDelroy Hunter and David P. Simon, "Benefits of International Bond Diversification," Journal of Fixed Income, March 2004, pp. 57-68 (1mb).  This paper finds that, during the period 1992 to 2002, there was benefit to diversifying a bond portfolio overseas, but only if you hedged the currency risk.

bulletAntti Ilmanen, "Does Duration Extension Enhance Long-Term Returns?," Journal of Fixed Income, September 1996, pp. 23-36.  "The main conclusion is that duration extension does increase expected returns at the front end of the [yield] curve ... and for durations longer than two years, no conclusive evidence exists of rising expected returns."

bulletAntti Ilmanen, Rory Byrne, Heinz Gunasekera, and Robert Minikin, "Which Risks Have Been Best Rewarded?: Duration, equity market, and short-dated credit risk," Journal of Portfolio Management, Winter 2004, pp. 53-57.  This outstanding paper looks at what return enhancing strategies are most "worthwhile" for bond investors: extending duration, changing from bonds to stocks, and decreasing credit quality.  It finds that the highest increase in risk adjusted returns comes from extending duration from treasury money market to the 1 to 3 year range, and from increasing credit risk from zero (Treasuries) to investment-grade corporates.  This paper supports a strategy of using short-term investment grade corporate bonds as the (non-inflation indexed) bond component in your portfolio.

bulletAlexander Kozhemiakin, "The Risk Premium of Corporate Bonds," Journal of Portfolio Management, Winter 2007, pp. 101-109.  "If investors are concerned primarily with generating the best risk-adjusted returns, the shape of the risk premium curve will promote investment-grade bonds.  ... This also implies that 1) ensuring proper diversification and 2) reducing transaction costs are of more importance in managing investment-grade portfolios than a detailed credit analysis of individual bonds."  This paper supports the idea that concentrating on investment grade bonds (i.e., rather than on lower-quality debt) seems prudent for most investors.

bulletHaim Levy and Zvi Lerman, "The Benefits of International Diversification in Bonds," Financial Analysts Journal, September/October 1988, pp. 56-64.  "There appears to be a very large potential for international diversification in stocks and bonds, even if we qualify the expectation of possible gains by recognizing the possible extra costs associated with holding foreign investments."

bulletBurton G. Malkiel, "Expectations, Bond Prices, and the Term Structure of Interest Rates," Quarterly Journal of Economics, May 1962, pp. 197-218.  This seminal paper laid out clearly some of the principal phenomena affecting bond pricing.

bulletCraig McCauley, "The Case for Global Fixed Income," Global Investor, October 1996, pp. 29-31.  "... presents a compelling case for US investors to substantially increase their exposures to international fixed income markets (on a fully hedged or unhedged basis), and to maintain a permanent exposure to this asset class."

bulletRobert C. Merton, "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, May 1974, pp. 449-470 (1.58mb).  This paper suggests that corporate bonds can be modeled as riskless bonds (i.e., Treasury bonds) plus a put (i.e., an option to sell the stock) that bondholders issue to the owners of the company’s stock.  As the company's prospects become better, the stock's price increases, which causes the value of the put to decrease (which is good for the bondholders who issue the virtual puts), which causes the value of the bond to increase, which causes the yield on the bond to decrease.  On a separate line of thought, as the company becomes riskier, the value of the put increases (which is bad for the bondholders who issue the virtual puts), which causes the value of the bond to decrease, which causes the yield on the bond to increase.  This is how high-yield bonds get to be high-yield bonds!

bulletFrederick S. Mishkin, "The Information in the Term Structure: Some Further Results," Journal of Applied Econometrics, Oct-Dec 1988, pp. 307-314.  "The term structure does help predict spot interest rate movements several months into the future."  This paper provides additional support for the prudence of DFA's "variable maturity" strategy.

bulletAlejandro Murguía and Dean T. Umemoto, "Analyzing Fixed-Income Securities and Strategies," Journal of Financial Planning, November 2005, pp. 80-90.  A good discussion of issues around investing in bonds.

bulletEugene A. Pilotte and Frederick Sterbenz, "Sharpe and Treynor Ratios on Treasury Bonds," Journal of Business, January 2006.  "Most striking is our finding that reward-to-risk ratios vary inversely with maturity and are incredibly high for short-term bills. Apparently investors would do much better engaging in highly leveraged investments in bills instead of purchasing long maturity bonds or common stocks."  This paper provides additional support for the prudence of keeping bond durations short.

bulletTom Potts and William Reichenstein, "Predictability of Fixed Income Fund Returns," Journal of Financial Planning, November 2004.  This paper finds that relative bond fund returns are somewhat predictable.  For funds with similar duration and credit worthiness, the difference in returns is likely to be similar to the difference in expense ratio.  The gross returns for Intermediate-Term bond funds were consistent (over five year periods, but less so for shorter periods) with the yield on five year treasuries at the beginning of the period.  The gross returns for Long-Term bond funds were consistent (over ten to twenty year periods, but less so for shorter periods) with the yield on twenty year treasuries at the beginning of the period.

bulletWilliam Reichenstein, "Bond Fund Returns and Expenses: A Study of Bond Market Efficiency," Journal of Investing, Winter 1999, pp. 8-16 (488kb).  This paper finds a strong persistence in bond fund performance.  It suggests this is due to the strong negative correlation between a bond fund's expenses and its performance.  In other words, this paper suggests that selecting bond funds by price (i.e., no-load funds with the lowest expense ratios) is an extremely prudent strategy.

bulletV. Vance Roley and Gordon H. Sellon, Jr., "Monetary Policy Actions and Long-Term Interest Rates," The Federal Reserve Bank of Kansas City Economic Review, Fourth Quarter 1995, pp. 73-89 (142kb).  This excellent paper describes, theoretically, how bond yields respond to changes in the Federal Funds Target rate and why.

bulletSandeep Singh and William H. Dresnack, "Market Knowledge in Managed Municipal Bond Portfolios," Financial Services Review, 6(3), pp. 185-196.  "This study provides further support in favor of indexing."  "When state income taxes are considered significant, for example, in states like New York and California, it is beneficial for the individual investor to buy into state-specific municipal bond funds."  The paper found that state-specific muni-bond funds were riskier than national funds, but they offered superior risk-adjusted after-tax returns.

bulletJason Zweig, "The dark side of the muni: Municipal bonds seem safe, but buying or selling them is fraught with peril.  Protect yourself," Money, August 20 2004.  This article discusses the high transaction costs of buying and selling municipal bonds, as well as market inefficiencies of the municipal bond market, at least from the perspective of an individual investor.  The study discusses the Anthony/Haines/Aydogyu study above.

Broker/Dealers

Broker/Dealers are involved with selling financial products and executing brokerage transactions (as opposed to providing objective advice as a fiduciary).  Sadly, the public is ill-informed about the conflicts of interest exhibited by Broker/Dealers and subsequently tend to accept sales-pitches masquerading as objective financial advice as such objective financial advice.

bulletDaylian M. Cain, George Lowenstein, and Don A. Moore, "The Dirt on Coming Clean: Perverse Effects of Disclosing Conflicts of Interest," Journal of Legal Studies, Vol 34 (2005), p 1.    This outstanding study shows that even if Broker/Dealers plainly disclose their inherent conflict of interest, the consumer might actually be worse off than if the disclosure didn't happen.  This study confirms the prudence of requiring fiduciaries to avoid, rather than merely disclosing, conflicts of interest.  "Conflicts of interest can lead experts to give biased advice. While disclosure has been proposed as a potential solution to this, we show that disclosure can have perverse effects, and might even increase bias. Disclosure may increase bias because advisors feel morally licensed and strategically encouraged to exaggerate their advice even further from the truth. As for those receiving the advice, proper use of the disclosure depends on understanding how the conflict of interest biased the advice and how that advice impacted them. Because people lack this understanding, disclosure can fail to solve the problems created by conflicts of interest."

bulletEric E. Haas, Comment to the SEC on Broker/Dealer exemption to the Advisers Act of 1940, August 23 2004.  A frank discussion of the principal issues surrounding the SEC's proposed exemption of Broker/Dealers from the requirements of the Investment Adviser's Act of 1940.

bulletEric E. Haas, Comment to the SEC on Broker/Dealer exemption to the Advisers Act of 1940, January 25 2005.  Another brief comment on the principal issues surrounding the SEC's proposed exemption of Broker/Dealers from the requirements of the Investment Adviser's Act of 1940.

bulletDuane R. Thompson, Letter to the SEC commenting on Broker/Dealer exemption to the Advisers Act of 1940, February 7 2005.  An excellent discussion of the issues surrounding the SEC's proposed exemption of Broker/Dealers from the requirements of the Investment Adviser's Act of 1940.

Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model was developed in the mid-60s by William Sharpe, John Lintner, and Jan Mossin (independently).  Some believe that its utility has largely been eclipsed by the introduction of the Fama/French Three-Factor Model.

bulletFrank Armstrong, "Capital Asset Pricing Model," Investor Solutions, 2002.  An excellent introduction to the CAPM.

bulletEugene F. Fama and Kenneth R. French, "The Capital Asset Pricing Model: Theory and Evidence," CRSP Working Paper 550, January 2004 (105kb).  Also here.  This excellent paper discusses some of the major problems with the CAPM.  "The problems are serious enough to invalidate most applications of the CAPM"  "... despite its seductive simplicity, the CAPM's empirical problems probably invalidate its use in applications."

bulletEugene F. Fama and Kenneth R. French, "Disagreement, Tastes, and Asset Prices," CRSP Working Paper 552, February 2004 (89kb).  Also here.  This paper discusses the implications of one of the assumptions of the CAPM that there is complete agreement among investors about probability distributions of future payoffs on assets.

bulletWilliam N. Goetzmann, "An Introduction to Investment Theory," Yale School of Management.  This is from a college course.  It is an excellent introduction to the CAPM.

bulletWilliam F. Sharpe, "Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk," Journal of Finance, September 1964, pp. 425-442 (1.17mb).  Also here.  This is the paper that basically defined the CAPM and won Dr. Sharpe the Nobel Prize.

Charitable Giving

Charitable Giving has several benefits.  First, of course, it is good for the soul.  But many don't realize how it can have enormously beneficial tax effects as well.  For example, if, instead of donating cash, you donate highly appreciated securities, you can avoid paying capital gains taxes on those securities (and the charity wouldn't have to pay them either).  This is in addition, of course, to the benefit of the tax-deduction you get for charitable gifts of any kind.

There are at least two means for implementing a long-term giving program: Donor-Advised Funds and Charitable Remainder Trusts.  Of the two, Donor-Advised Funds are the simplest to set up and administer.  The Vanguard Charitable Endowment Program and the Fidelity Charitable Gift Fund are generally the most preferred DAFs due to their exceptionally low fees.  Investors who want a bigger, better selection of investments to choose from might choose The American Endowment Foundation, which has a tiered fee scale.

Also, see Estate Planning.

bulletRoccy DeFrancesco, "Gifts That Keep Giving," Financial Planning, July 2004, pp. 89-92.  A good article which goes into detail about one way to use a Charitable Gift Annuity in conjunction with a Donor-Advised Fund and a Irrevocable Life Insurance Trust.

bulletElfrena Foord, "Philanthropy 101: Donor-Advised Funds," Journal of Financial Planning, November 2003, pp. 66-73.  A good article which compares Donor-Advised Funds to Private Foundations.

bulletLawrence C. Phillips and Thomas R. Robinson, "Charitable Remainder Trust: A Powerful Financial Planning Tool," Journal of Financial Planning, August 1997, pp. 70-76 (980kb).  A good primer on Charitable Remainder Trusts.

bulletEric Lee Smith, "Donor-Advised Funds: A Well Kept Secret," The CPA Journal, September 2001, pp. 62-63.  A good discussion of Donor-Advised Funds.

bulletEric Lee Smith, "An Introduction to Donor-Advised Funds," from The ePhilanthropy Foundation's Guide to Success Online, 2001.  This interesting article (a chapter from a book) is geared towards organizations who might be considering starting a Donor-Advised Fund.

Closed-End Funds

Closed End Funds are mutual funds which are bought and sold on exchanges (i.e., like you buy and sell stocks).  Interestingly, the share price, determined by the market, can dramatically differ from the share price determined by the current value of the securities a closed end fund holds (i.e., its NAV).  This gives an investor the opportunity to get exposure to securities at a deep discount.  Whether or not it is prudent to do so is a different story.  Before going out and buying discounted closed-end funds, be sure to read the Pontiff and Reichert/Timmons papers below.

bulletDominic Gasbarro, Richard D. Johnson, and J. Kenton Zumwalt, "Evidence on the Mean-Reverting Tendencies of Closed-End Fund Discounts," The Financial Review, May 2003, pp. 273-291.  This paper examines the "mean-reverting" tendency of closed-end funds.  Specifically, it examines the hypothesis that funds sold at a discount to NAV tend to have their discount narrow (i.e., the fund share price tends to increase towards NAV over time).  The truth of this hypothesis is important for investors who desire to engage in closed-end fund arbitrage.

bulletBurton G. Malkiel, "The Valuation of Closed-End Investment Company Shares," Journal of Finance, June 1977, pp. 847-859.  This paper suggested that it seemed possible to get significant abnormal positive returns through investing in deeply discounted closed-end funds.  Specifically, this paper found at least two reasons to consider deeply discounted closed-end funds:
bulletThe expected returns on a deeply discounted closed-end fund are much higher than the expected returns on a similar portfolio of the underlying securities.  Even if the discount doesn't narrow, you get all of the income from the underlying securities with a fraction of the up-front investment.
bulletFund discounts seem to narrow when the market falls and increase when the market rises.  This suggests that closed end funds might make good diversifiers, all else being equal.

bulletJeffrey Pontiff, "Excess Volatility and Closed-End Funds," The American Economic Review, March 2003, pp. 155-169.  This interesting paper finds that the prices of closed end funds are about 64 percent more volatile than the assets they hold.  This is yet another reason to think twice before attempting a closed end fund arbitrage strategy.

bulletCarolyn Reichert and J. Douglas Timmons, "Closed-End Investment Companies: Historic Returns and Investment Strategies," The Financial Review, May 2003, pp. 273-291.  Also here.  This interesting paper models the results of a simple investment strategy designed to take advantage of the presumed tendency of a closed-end fund (which is trading at a discount) to have its discount lessen over time.  Specifically, this paper analyzes a strategy of buying the closed-end funds with the greatest discount, holding them for one year, then replacing them with the funds which a year later are available at the greatest discount.  This paper's conclusion: "The results do not support the use of a simple mechanical strategy.  Even when marginally significant before-tax returns are available, transaction costs and taxes erode the benefits.  Excess returns are not possible for investors lacking the time or resources to actively trade in the marketplace.  Small investors following simple trading rules with a minimum of rebalancing are unlikely to earn the abnormal returns documented in earlier studies.  This should serve as a warning to investors lured by the promise of excess returns from CEIC [Closed-End Investment Company] funds selling at discounts.  It is important for small investors to be aware of the need for additional monitoring, more frequent trading, larger initial investments, or short selling if they want to use CEIC funds to outperform the market.  Investors wanting to avoid these complications should consider alternative investments."

bulletRex Thompson, "The information content of discounts and premiums on closed-end funds," Journal of Financial Economics, 6, pp. 151-186.  Thompson finds that a relatively simple trading rule (based on discounts for closed-end funds) earned statistically significant abnormal returns of about 4% per year over the period 1940-1971. In addition, the results are quite uniform throughout the period.

College Planning

There are several tax-advantaged means of saving for college.  For most people, 529 savings plans are the best choice.  If your state offers tax-deductions for contributions to your state's plan, you should consider (the direct purchased version of) that plan (i.e., don't buy it through a financial adviser).  Otherwise, you should consider one of the low cost alternatives: Colorado, Iowa, Michigan, Minnesota, Missouri, Nebraska, Nevada (Vanguard), New York, Ohio, Utah or Virginia (note that Nebraska's and New York's plans offer significantly greater investing flexibility than the others).  Utah's plan is definitely the least expensive of the bunch, followed closely by Ohio's and Virginia's.  Note that West Virginia's SMART529 Select plan, while not being among the lowest cost plans, has the best investment choices and may be the best value, especially for very young beneficiaries (for information on what makes a "good" investing choice, see here).  For information on all 529 plans, see SavingforCollege.com.  Note that, if you choose another state's plan, it may be necessary to transfer it back to your state's plan immediately before college in order to avoid taxation of withdrawals by your state.

bulletKeith R. Davenport, Douglas Fore, and Jennifer Ma, "Miracle Growth?  Everyone touts the benefits of 529 college savings plans.  But compared to the alternatives, are they really that extraordinary?," Investment Advisor, September 2001, pp. 58-66.

bulletRamon P. DeGennaro, "Asset Allocation and Section 529 Plans," Federal Reserve Bank of Atlanta Working Paper 2003-1 (70kb).  Also here.  A good discussion of these issues.

bulletSusan M. Dynarski, "Who Benefits from the Education Savings Incentives?  Income, Educational Expectations, and the Value of the 529 and Coverdell," NBER Working paper W10470, May 2004.  Also here and here.  This excellent paper finds that the advantages of the 529 and Coverdell ESA rise sharply with income.  While they still make sense for low income people, 529 and Coverdell plans are a dramatically better "deal" for high-income savers.  Also, see the discussion of this paper here.

bulletSusan M. Dynarski, "Tax Policy and Education Policy: Collision or Coordination?  A case study of 529 and Coverdell Savings Vehicles," NBER Working paper W10357, March 2004 (434kb).  Also here and here. 

bulletJennifer Ma and Douglas Fore, "Saving for College: A Comparison of Section 529 Plans with Other Options: An Update," TIAA-CREF Institute research dialogue, January 2002, pp. 1-20.  An excellent comparison of 529 plans to other savings vehicles.

bulletJennifer Ma, "The Impact of the 2003 Tax Law on College Savings Option," TIAA-CREF Institute, July 31 2003.  This note studies the impact of the 2003 tax law on college savings.  It finds that Coverdell ESAs and 529 plans still tend to be the optimal choice for most investors.

bulletBarry Marks and William Reichenstein, "Tax Strategies for Financing Higher Education," Journal of Financial Planning, May 2000.  The authors survey the various means of saving for college education.  Note that this article preceded the vast tax law changes enacted in 2001.

bulletMark C. Neath, "Section 529 Prepaid Tuition Plans: A Low Risk Investment with Surprising Applications," Journal of Financial Planning, April 2002, pp. 92-98.  "In short, Section 529 plans promise to become an important tool for financial planners, not only for college savings, but for a wide range of asset protection, estate planning and other financial planning goals."

bulletLynn O'Shaughnessy, "Avoiding Fee Pitfalls as College Savings Climb," New York Times, July 13 2003.  Also here.  A discussion of 529 plans, emphasizing the importance of fees when choosing a plan.

bulletJohn J. Spitzer and Sandeep Singh, "The Fallacy of Cookie Cutter Asset Allocation: Some Evidence from 'New York's College Savings Program'," Financial Services Review, Volume 10(4) 2001.  This study was done before 529 plan qualified withdrawals were made tax-free, which somewhat affects the conclusions, but it is an interesting analysis nonetheless (especially since the current tax-free status may go away after 2010).

bullet"IRS Publication 970: Tax Benefits for Education," United States Internal Revenue Service.
 
bullet TIAA-CREF Brochure on College Savings options, TIAA-CREF.  An excellent overview and comparison of the major options.

Commodity Futures

Commodities refers to real assets such as energy, agriculture, livestock, industrial metals, and precious metals.  The below papers make a compelling case for the diversification benefits of collateralized commodities index futures contracts (i.e., they have a very low correlation with other asset classes).  Unfortunately, there are few practical means for retail investors to prudently expose themselves to this asset class.  We currently recommend the DFA Commodity Strategy Portfolio (DCMSX) as the preferred means of implementing this asset class.  If you don't have access to DFA funds (Altruist clients do), you might consider the PowerShares DB Commodity Index Tracking Fund (DBC). 

In general, we would recommend only a fairly small fraction of any portfolio be allocated to this asset class.  Further, since futures contracts (and derivatives thereof) tend to be quite tax-inefficient, these investments are generally best held in tax-exempt accounts.

bulletErnest M. Ankrim and Chris R. Hensel, "Commodities in Asset Allocation: A Real Asset Alternative to Real Estate?," Financial Analysts Journal, May/June 1993, pp. 20-29.  "These allocations demonstrate that ... collateralized commodities offer attractive diversification benefits."  "... unconstrained portfolio allocations call for placing between 4% and 8% of the portfolio in this asset class ..."

bulletMark J. P. Anson, "Maximizing Utility with Commodity Futures Diversification," Journal of Portfolio Management, Summer 1999, pp. 86-94.  "This research demonstrates that commodity futures, when considered in their proper portfolio context, are a valuable asset class for risk-averse investors.  Because of their excellent diversification potential over long periods of time, commodity futures are found to have greater utility, the more risk-averse the investor."

bulletFrank Armstrong, "Commodities As An Asset Class," Investor Solutions, July 15 2004.  An outstanding primer on this asset class.

bulletGary Baierl, "Investing in Global Hard Assets: A Diversification Tool for Portfolios," Ibbotson Associates, April 7 1999 (117 kb).

bulletZvi Bodie and Victor I. Rosansky, "Risk and Return in Commodity Futures," Financial Analysts Journal, May/June 1980, pp. 27-38.  This paper studied the period 1950 to 1976.  During that time, it found that commodity futures had stock-like returns, but very low correlation with stock returns (which makes it a good diversifier for stocks).  It found that a portfolio consisting of 60% stocks and 40% commodity futures would have had the same long term returns as an all-stock portfolio with one third the volatility.

bulletBurak Cerrahoglu and Barsendu Mukherjee, "The Benefits of Commodity Investment," Center for International Securities and Derivatives Markets, March 2003 (253 kb).  "Adding a commodity component to a diversified portfolio has been demonstrated to result in enhanced risk-adjusted performance."

bulletAdam De Chiara and Daniel M. Raab, "The benefits of real asset portfolio diversification," Euromoney International Commodities Review 2002 (187kb).  Also here.  A good article that lays out the case for use of commodities as an asset class.

bulletKenneth A. Froot, "Hedging Portfolios with Real Assets," Journal of Portfolio Management, Summer 1995, pp. 60-77.  "It appears that commodity hedges are, at least for stocks, more potent hedges than even CPI-linked bonds [e.g., TIPS].  The reason appears to be a negative correlation between stock (and to some extent bond) returns and commodity prices (even when holding inflation fixed)."

bulletGeorgi Georgiev, "Benefits of commodity investment," Journal of Alternative Investments, Summer 2001, pp. 40-48 (247kb).  "Adding a commodity component to a diversified portfolio of assets has been demonstrated to result in enhanced risk-adjusted performance."

bulletGary B. Gorton and K. Geert Rouwenhorst, "Facts and Fantasies about Commodity Futures," NBER Working Paper 10595, June 2004 (704kb).  Also here.  Here's a good discussion of this paper.  "Fully-collateralized commodity futures have historically offered the same return and Sharpe ratio as equities. While the risk premium on commodity futures is essentially the same as equities, commodity futures returns are negatively correlated with equity returns and bond returns. The negative correlation between commodity futures and the other asset classes is due, in significant part, to different behavior over the business cycle. In addition, commodity futures are positively correlated with inflation, unexpected inflation, and changes in expected inflation."

bulletGary B. Gorton, Fumio Hayashi, and K. Geert Rouwenhorst, "The Fundamentals of Commodity Futures Returns", Yale ICF Working Paper 07-08 and NBER Working Paper W13249, June 2007 (940kb).  Also here and here.  This paper examines the source of risk premiums for commodities futures and distinguishes it from the theory of normal "backwardation."

bulletRobert J. Greer, "The Nature of Commodity Index Returns," Journal of Alternative Investments, Summer 2000, pp. 45-52 (261kb).  An excellent paper examining the nature of Commodities as an asset class.  The author concludes that commodities have returns similar to those of equities, that commodities are negatively correlated with stocks and bonds, and that commodities are positively correlated with inflation.

bulletRobert J. Greer, "Robert Greer Discusses the Benefits of Commodity Investing," PIMCO, March 2004.  A good interview discussing the PIMCO CommodityRealReturn Strategy Fund (PCRIX).

bulletThomas M. Idzorek, "Strategic Asset Allocation and Commodities," Ibbotson Associates, March 27 2006.  Also here.  This study found that including collateralized commodities futures in a strategic asset allocation had a strong tendency to increase risk adjusted returns both using historical data and conservative forecasted simulations.

bulletPaul D. Kaplan and Scott L. Lummer, "GSCI Collateralized Futures as a Hedging and Diversification Tool for Institutional Investors: An Update," Ibbotson Associates, Dec 1997 (159kb).  Also here.  This paper also appeared in the Journal of Investing, Winter 1998, pp. 11-17.  GSCI is the Goldman Sachs Commodity Index.

bulletChristopher A. Moth and John Kirk, "Real Return Fund: The Case for a Real Asset Class," Institute for Fiduciary Education, July 1 2000 (171kb).

bulletGregory Taggart, "The Case for Commodities," Bloomberg Wealth Manager, October 2003, pp. 58-66.  A good overview of the subject matter.  Intended for relatively unsophisticated readers.

bullet"PIMCO CommodityRealReturn Strategy Fund: Accessing the Diversification and Inflation-Hedging Potential of Commodities," PIMCO Advisors, 2003.  A two-page sales brochure for this mutual fund: previously our preferred means of exposure to commodity futures.

bullet"The Economic Purpose of Futures Markets," Commodity Futures Trading Commission, April 5 2004.  A good primer on how futures work, in general.

bullet"The Benefits of Commodity Investment 2005 Update," Center for International Securities and Derivatives Markets, June 2005.  "Adding a commodity component to a diversified portfolio of assets has been demonstrated to result in enhanced risk-adjusted performance. We believe that this research would place the use of investable commodity indices as a central part of the institutional investors’ asset allocation decision."

bullet"An Investor's Guide to Commodities," Deutsche Bank, April 2005.  A good discussion of the issues.

bullet"The Case for Commodities as an Asset Class," Goldman, Sachs, & Co., June 2004 (3mb).  A good discussion of the issues.  This is an easy-to-follow Powerpoint presentation.

Currency Hedging

When investing in foreign investments, an investor subjects herself to currency risk (i.e., the changes in the value of the investment due solely to changes in the exchange rate between the investor's native currency and that of the country where the investment is domiciled).  Some investors choose to hedge (i.e., eliminate) this risk by buying currency futures for the investment's currency.  Also, see Foreign Investing.

bullet Fischer Black, "Universal Hedging: Optimizing Currency Risk and Reward in International Equity Portfolios," Financial Analysts Journal, July/August 1989, pp. 16-22.  This paper also appeared in the January/February 1995 edition, pp. 161-167.  This paper argues that partial hedging of currency risk is optimal for equity portfolios.  It derives the optimal hedging ratio.
 
bullet Anthony Golowenko, "How Much to Hedge in a Volatile World?," State Street Global Advisors, March 14 2003.  This article summarizes most of the relevant research on this issue.

Data Mining

Data Mining (a.k.a., "Data Snooping") refers to the practice of searching through data looking for patterns.  Of course, there isn't anything wrong with that, in general.  However, many make the mistake of finding apparent patterns in the sample (which may be due to chance) and inappropriately extrapolating them from the sample to the data universe.  That's a fancy way of saying that if you find a pattern in past financial data, it may be that the pattern existed solely due to chance, even if it strongly appears otherwise.

bullet Grant McQueen and Steven Thorley, "Mining Fool's Gold," Financial Analysts Journal, March/April 1999 pp. 61-72.  This paper tests several strategies advocated by The Motley Fool.  After proving the imprudence thereof, they go farther to discuss the larger topic of data mining how to detect it and how to avoid it.  An excellent article.  Here's a summary of their guidance:

bulletThe more variables involved, the more likely the strategy worked just by chance.
bulletRules that are built on other rules (which didn't stand the test of time) are guilty of intergenerational mining.
bulletA plausible and reasonable theory why the strategy works is far more important than simply knowing that it did work.  When judging plausibility, the competitive nature of investing must be kept in mind.  Theories or explanations based on the idea that market participants are dumb, lazy, or myopic are not to be trusted.
bulletSuccessful strategies should stand up to out-of-sample testing.
bulletNever be impressed by unadjusted returns.  Many trading rules that yield high nominal returns come at a price, often in the form of increased risk, higher transaction costs, and/or higher taxes.  You need to correct for these in order to do a fair comparison with alternative strategies.
bulletAny popular investment strategy or rule tends to fall victim to its own success.

bullet Ryan Sullivan, Allan Timmermann, and Halbert White, "Dangers of Data-Driven Inference: The Case of Calendar Effects in Stock Returns," UCSD Working Paper, June 1998.  This paper debunks several previously observed "calendar" effects on the stock market as examples of data snooping bias.

bullet "Data Mining," Investor Home, 1999.  An outstanding summary of the subject matter.

Defined Benefit Pension Plans

This section addresses issues related to use of Defined Benefit Pension Plans.  Also, see Retirement Investing, Defined Contribution Pension Plan Design, and Pension Fund Management.

bulletTara Siegel Bernard, " Pensions Still Work Well For Some Businesses," The Wall Street Journal Startup Journal, May 11 2006.  Discusses benefits of Defined Benefit Plans.

bulletBill Bischoff, "The Solo Defined-Benefit Plan," SmartMoney.com, August 11 2005.  Discusses benefits of Defined Benefit Plans.

bulletSusan Garland, "Now the Self-Employed Can Sock Away More," BusinessWeek, July 30 2001.  Discusses benefits of Defined Benefit Plans.

bulletDorothy Hinchcliff, "Dusting Off Defined Benefit Plans: Some clients and advisors now can contribute $100,000 plus to these plans," Financial Advisor, July 2004, pp. 83-84, 108.  This good article describes how defined benefit plans might benefit certain high-income small business owners with few if any employees.

bulletKen Johnston, Shawn Forbes, and John Hatem, "Choosing Between Defined Benefit and Defined Contribution Plans," Journal of Financial Planning, August 2001.  Discusses differences between the two plan types.

bulletAvrum D. Lank, "Self-employed savings help," Milwaukee Journal Sentinel, December 14 2002.  Discusses benefits of defined benefit plans and solo 401(k)s.

bulletEric L. Reiner, "New Allure for Defined Benefit Plans," Financial Advisor, August 2003.  Discusses benefits of defined benefit plans.

bulletMelanie Waddell, "Planning Your Own Retirement," Investment Advisor, February 2004.  Discusses the OnePersonPlus product and defined benefit plans in general.

bullet"Choosing a Retirement Plan: Defined Benefit Plan," Internal Revenue Service.  A good discussion of Pros and Cons of defined benefit plans.

bullet Personal Defined Benefit PlanCharles Schwab.  This describes an off-the-shelf defined benefit plan for very small businesses.  Very low costs!
 
bulletOnePersonPlus. Dedicated Defined Benefit Services LLC (formerly Metavante Corp).  This describes an off-the-shelf defined benefit plan for very small businesses.

Defined Contribution Pension Plan Design

This section addresses issues related to design of defined contribution pension plans (e.g., 401(k), 403(b), etc.).  Also, see Retirement Investing and Pension Fund Management.

bulletSchlomo Benartzi and Richard H. Thaler, "Naive Diversification Strategies in Defined Contributions Pension Plans," American Economics Review, March 2001, pp. 79-98 (217kb).  This paper finds that defined contributions pension plan participants tend to split their investments evenly among all investment choices.  Thus, if most of the choices are bond funds, people would tend to mostly invest in bond funds.  This finding should be an important consideration for fiduciaries as they choose a plan's investment options.

bulletJames J. Choi, David Laibson, and Brigitte C. Madrian, "Plan Design and 401(k) Savings Outcomes," National Tax Journal Forum on Pensions, 2004 (476kb).  This paper surveys the impact of 401(k) plan design on four different 401(k) plan savings outcomes.

bulletJoe Faucher, "Excessive 401(k) Plan Fees and Costs: The Coming Storm in ERISA Litigation?," Reish Luftman Reicher & Cohen, February 2005.  A good article discussing the importance of controlling fees in Defined Contribution Plans.

bulletBrooks Hamilton and Scott Burns, "Reinventing Retirement Income in America," National Center for Policy Analysis Report no. 248, December 2001 (196kb).  This report, while suggesting some legislative changes, also makes some recommendations which are implementable now.

bulletMatthew D. Hutcheson, "Uncovering and Understanding Hidden Fees in Qualified Retirement Plans," February 1 2007.  An excellent discussion of the issue.

bulletSheena S. Iyengar, Wei Jiang, and Gur Huberman, "How Much Choice is Too Much?: Contributions to 401(k) Retirement Plans," Pension Research Council Working Paper 2003-10, 2003 (193kb).  This paper concludes that contribution rates are higher for 401(k) plans with fewer than ten investment alternatives, than for those with more than ten.

bulletStephen J. Lansing, "The (K)oncept Plan - 2004 Model,"  401khelpcenter.com.  A good article which describes features desirable in a 401(k) plan.

bulletOlivia S. Mitchell and Stephen P. Utkus, "Lessons from Behavioral Finance for Retirement Plan Design," Pension Research Council Working Paper 2003-6, 2003 (357kb).  A good summary of the features of a prudent plan design.

bulletRichard H. Thaler and Schlomo Benartzi, "Save More TomorrowTM: Using Behavioral Economics to Increase Employee Savings," Journal of Political Economy, 112:1 2004, pp. 164-187 (128kb).  This paper details a prescriptive savings program which encourages saving.  The idea is that people commit in advance to allocating a portion of their future salary increases towards retirement savings.

bulletStephen P. Utkus and Jean A. Young, "Lessons from Behavioral Finance and the Autopilot 401(k) Plan," Vanguard Center for Retirement Research, April 29 2004.  A slightly more recent version of the Mitchell/Utkus paper above.

bullet"401(k) Plan Sponsors Under Attack: The U.S. Retirement Crisis brings Criticism - and lawsuits - to the Plan Sponsor's Doorstep" Dalbar, July 2003.  This article points out how important it is for a 401(k) plan fiduciary to carefully execute his/her duties.

bullet Pension Research Council Working Paper Library.  Many good papers on this topic.

bullet ERISA 404(c) Rules, US Department of Labor, October 13 1992.  This sets out the rules a plan must meet in order to meet the 404(c) safe harbor (i.e., if you follow these rules, a plan sponsor is supposedly immune from liability "... for any loss, or by reason of any breach, which results ....").

Dimensional Fund Advisors (DFA)

Many of our recommended mutual funds come from DFA.  However, you may never have heard of them because they do no advertising to the public.  Here are some good articles on DFA.

bullet Shawn Tully, "How the REALLY smart money INVESTS: Nobel Prize winners entrust their nest eggs to DFA, where investing is a science, not a spectator sport," Fortune, July 6 1998, p. 148.  Also here.  An excellent article.  Perhaps the best introduction to DFA in the popular press.

bullet Robert Barker, "So You Think Stock Picking Is a Fool's Game," Business Week, November 18 2002.  An extremely brief basic introduction to DFA.

bullet Raymond Fazzi, "Going their own way," Financial Advisor, March 2001.

bullet Beverly Goodman, "The Best Fund Family You've Never Heard of and Why It Doesn't Want Your Money," TheStreet.com, August 26 2002.

bullet Seth Lubove, "'Investment Porn' Panned by DFA Funds Preaching Fama's Gospel," Bloomberg.com, March 27 2007.

bullet Dagen McDowell, "Dear Dagen: What's a Good Substitute for the Exclusive DFA Funds," TheStreet.com, July 8 1999.

bullet Timothy Middleton, "DFA funds hard to buy, easy to own," CNBC Money Central, June 4 2002.

bullet Lynn O'Shaughnessy, "Brain Trust: With a host of noted academics minding the store, Dimensional Fund Advisors has attracted a loyal following among fee-only advisors," Bloomberg Wealth Manager, November 2002, pp. 52-59 (120kb).  Also here.

bullet Joanna L. Ossinger, "The Dimensions of a Pioneering Strategy," The Wall Street Journal, November 6 2006, p. R.1.

bullet Tom Petruno, "Dimensional's 'Passive' Course Pays Off," Los Angeles Times, December 30 2005.
 
bullet Eric J. Savitz, "Ditching the Monkey," Barron's, January 9 2006.

bullet Barbara Mlotek Whelehan, "Taking a Market's Measure," Mutual Funds, August 2001.

bullet Scott Woolley, "The Index Insurgents," Forbes, October 30, 2006.

bullet "The Science of Investing," Dimensional Fund Advisors, 2010.  DFA's brochure.

bullet Dimensional Fund Advisors web site.

bullet Donald B. Keim, "An Analysis of Mutual Fund Design: The Case of Investing in Small-Cap Stocks," Wharton School of the University of Pennsylvania, 1998 (1.1mb).  This paper also appeared in Journal of Financial Economics, February 1999, p. 173.  An interesting paper analyzing the design of the DFA US Micro Cap Portfolio (DFSCX).

Diversification

Diversification refers to the idea that your investments ought to be spread out amongst many investments.  On average, a diversified portfolio will have the same expected return (but less risk/volatility) as a less diversified portfolio with similar characteristics.  When put that way, it is easy to see why diversification is beneficial — why have a more risky portfolio if you can't expect higher returns in exchange for taking on that additional risk?  Also, see the section on Modern Portfolio Theory.

"Diversification is your buddy." — Merton Miller, winner of the Nobel Memorial Prize in Economic Sciences, 1990

bulletDaniel J. Burnside, Donald R. Chambers, and John S. Zdanowicz, "How Many Stocks Do You Need to be Diversified?," AAII Journal, July 2004.  An excellent article.

bulletJohn Y. Campbell, Martin Lettau, Burton G. Malkiel, and Yexiao Xu, "Have Individual Stocks Become More Volatile? An Empirical Investigation of Idiosyncratic Risk," Journal of Finance, February 2001, pp. 1-43 (1.95mb).  This paper finds that, while several decades earlier, it may have been true that adequate diversification could be had with 15-20 stocks, it is no longer true.  The paper finds that, while volatility of the stock market as a whole has remained relatively steady, the volatility of individual stocks has increased.  This implies that correlations between stocks have decreased, which is confirmed by the paper's empirical results.  Thus, the benefits of diversification have increased, along with the need to hold more stocks to achieve those benefits.  This confirms the prudence of holding highly diversified mutual funds instead of individual stocks.  Also, see the Picerno summary article below.

bulletJohn L. Evans and Stephen H. Archer, "Diversification and the Reduction of Dispersion: An Empirical Analysis," Journal of Finance, December 1968, pp. 761-767.  This paper largely covers the same ground as the Fisher/Lorie paper below, but this paper only analyzed the period 1958-1967.

bulletLawrence Fisher and James Lorie, "Some Studies of Variability of Returns on Investments in Common Stocks," Journal of Business, April 1970, pp. 99-134.  This is the paper usually cited by those who claim that a portfolio of 16 or so randomly selected stocks provides 90-plus percent of possible diversification benefit.  This may have been true in the 1926-1965 period studied, but as you can see from the Campbell/Lettau/Malkiel/Xu paper above and the Surz/Price paper below, it no longer appears to be true.

bulletZoran Ivković, Clemens Sialm, and Scott Weisbenner, "Portfolio Concentration and the Performance of Individual Investors," Journal of Financial and Quantitative Analysis, September 2008, pp. 613-656.  This paper finds that individual investors with very concentrated portfolios tend to have higher returns than investors with more diversified portfolios.  This counterintuitive observation seems to support undiversified portfolios.  However, while the undiversified portfolios had (arithmetic) average returns that were 10% higher than diversified portfolios, they also had 50% more risk/volatility!  The risk-adjusted returns of undiversified portfolios were dramatically smaller than those of more diversified portfolios.  So this paper actually supports the prudence of diversification.  The higher arithmetic returns of an undiversified portfolio are likely to turn into lower geometric returns due to the increased risk/volatility (and geometric returns are what investors actually realize).

bulletHenry A. Latané and William E. Young, "Test of Portfolio Building Rules," Journal of Finance, September 1969, pp. 595-612.  "Diversification pays ... This advantage of diversification results entirely from the reduction of variance and hence increases in the geometric mean return.  It is not necessary to appeal to risk aversion on the part of investors to justify diversification."

bulletRichard W. McEnally and Calvin M. Boardman, "Aspects of Corporate Bond Portfolio Diversification," Journal of Financial Research, Spring 1979, pp. 27-36.  This paper analyzes how many individual corporate bonds are necessary in order to obtain diversification benefits.  Its conclusion is that, for high-grade bonds, there is limited diversification benefit, but that "something in the neighborhood of eight to 16 issues ... appear adequate to eliminate diversifiable risk in bond portfolios."  Note that this paper is considering diversifying volatility risk, NOT credit risk.

bulletJames Picerno, "Quantity Control," Bloomberg Wealth Manager, July/August 2000.  A good summary of the Campbell/Lettau/Malkiel/Xu paper above.

bulletMeir Statman, "How much Diversification is Enough?," Santa Clara University Working Paper, September 2002 (308kb).  "Lack of diversification is costly.  Investors who hold only 4 stocks in their portfolios forego the equivalent of a 3.3% annual return relative to investors who hold the 3,444 stocks of the Vanguard Total Index Stock Market Index fund.  Why do investors forego the benefits of diversification?"

bulletMeir Statman and Jonathan Scheid, "Dispersion, correlation, and the benefits of diversification," Santa Clara University Working Paper, May 2004 (566kb).  "Correlation is the common measure of the benefits of diversification but it is deficient for two reasons. First, the benefits of diversification depend not only on correlations but on standard deviations as well. Dispersion combines both effects. Second, dispersion, unlike correlation, provides an intuitive measure of the benefits of diversification. It is best to set aside correlation when we assess the benefits of diversification and focus on dispersion."

bulletRonald J. Surz and Mitchell Price, "The Truth About Diversification by the Numbers," Journal of Investing, Winter 2000, pp. 93-95 (60kb).  This paper challenges the conventional wisdom that a randomly chosen portfolio of 15-20 stocks gives nearly all the diversification benefit of the market.  "Fifteen-stock portfolios, on average, achieve only 75%-80% of available diversification, not the 90%-plus typically believed.  Even 60-stock portfolios achieve less than 90% of full diversification."  This confirms the prudence of avoiding individual stocks in favor of highly diversified mutual funds.

Diversification of Concentrated Positions

For various reasons, many investors find themselves overconcentrated in a single stock (or very few stocks).  Most often, this is the stock of their employer.  What can such a person do to prudently diversify?  In addition to the articles listed here, see the articles on NUA by Bradley and by Herbers in the "Retirement Investing" section below.

bulletKimberly L. Allers, "Pay Yourself Forward," Fortune, November 11 2002.  A good discussion of costless collars and prepaid variable forwards.

bulletDonald G. Bennyhoff, "Investment Solutions and Alternatives for Addressing Concentrated Equity," Vanguard Investment Counseling & Research, April 25 2007.  An excellent, objective discussion of the issues surrounding the various options.  "... our research suggests that immediate liquidation is the best solution for the vast majority of investors."

bulletThomas J. Boczar, "Stock Concentration Risk Management After TRA ‘97," Trusts & Estates, March 1998.  This article discusses the some of the implications of the Taxpayer Relief Act of 1997, as it relates to diversification of concentrated positions.

bulletThomas J. Boczar, "New Moves for Concentrated Stock Positions," ABA Trust & Investments, July/August 2001.  This article discusses various diversification strategies for investors with concentrated positions established before 1984.

bulletThomas J. Boczar and Robert Gordon, "IRS Regs Neutralize Diversification Techniques," ABA Trust & Investments, September/October 2001, pp. 18-23.  This article discusses various diversification strategies for investors with concentrated positions established after 1984.

bulletThomas J. Boczar, "The Legal Duties of Fiduciaries to Manage Stock Concentration Risk," The Monitor, September/October 2006, pp. 22-26.  This article goes through the fiduciary duties surrounding the question of diversification of concentrated positions.

bulletShira J. Boss, "Another Twist for Exchange Fund Loophole," Forbes.com, March 20 2001.  A very basic discussion of Exchange Funds, which are a "loophole", for the moment, in the tax law, but only for the very wealthy.  Exchange funds allow you to exchange shares of highly appreciated stock (or even non-appreciated stocks) into a fund (which also holds the stock of other contributors) in exchange for shares of the (more diversified) fund.  You hold it for seven years, after which you can cash out your share of the fund's stock shares.  Effectively, this allows you to diversify your portfolio while delaying realization of capital gains.  The Eaton Vance Exchange fund (CAPEX) may be one of the more interesting options here.  Also, see the Gutner article below.

bulletRobert M. Dammon, Chester S. Spatt, Harold H. Zhang, "Diversification and Capital Gains Taxes with Multiple Risky Assets," Working Paper, August 1 2001 (2.33mb).  A good discussion of issues surrounding the question of whether to liquidate a highly appreciated asset in the presence of capital gains taxes.

bulletRobert M. Dammon, Chester S. Spatt, Harold H. Zhang, "Optimal Consumption and Investment with Capital Gains and Taxes," Review of Financial Studies, Fall 2001, pp. 583-616 (581kb).  A good discussion of issues surrounding the question of whether to liquidate a highly appreciated asset in the presence of capital gains taxes.

bulletMark Fichtenbaum, "Rev. Rul. 2002-66: Straddle Treatment Required for Collar Transactions," Derivatives Report, 2002.  A recent revenue ruling clarifies use of collars.

bulletRoberta Gamba, "Executive Compensation: An Analytical Approach to Diversification of Concentrated Positions," Journal of Wealth Management, Fall 2002, pp. 23-29.  This article discusses a computer program which assesses the benefits of diversification against the tax cost and opportunity cost of doing so.

bulletDaniel Grant and Michael J. Driver, "SEC Rule 10b5-1: Allowing Corporate Insiders More Opportunities to Sell Company Stock," Journal of Financial Planning, May 2001, pp. 58-60.  Discusses SEC Rule 10b5-1 under the Securities Exchange Act of 1934, which allows corporate insiders a safe haven when selling their company's stock.  The rule basically requires the insider to commit to a divestment schedule in advance.  If followed, this protects an investor from charges of "insider trading."  This rule elaborates on the more general rules precluding illegal insider trading, as specified by section 10(b) of the Securities Exchange Act of 1934.  See here for a more in-depth discussion of insider trading issues.

bulletToddi Gutner, "Exchange Funds: Time to Swap 'n' Save?," Business Week, August 9 1999.  A very basic discussion of Exchange Funds.  Also, see the Boss article above.

bulletMark A. Miller, "Hedging Strategies for Protecting Appreciation in Securities and Portfolios," Journal of Financial Planning, August 2002, pp. 64-76.  An outstanding article which suggests costless equity collars as a remedy for those who, for whatever reason, must hold imprudently large positions in a particular stock.  However, such an approach must be carefully implemented to avoid running afoul of IRS constructive sale and tax straddle rules.

bulletCliff Quisenberry and Scott Welch, "Increasing the Tax-Effectiveness of Concentrated Wealth Strategies," Journal of Wealth Management, Summer 2005, pp. 29-39.  A good discussion of increasing the tax efficiency of Variable Prepaid Forwards.

bulletJohn Schneider, "Persuading Clients to Diversify Successful Company Stock," Journal of Financial Planning, July 2001, pp. 80-85.  An interesting case study.

bulletDavid M. Stein, Andrew F. Siegel, Premkumar Narasimhan, and Charles E. Appeadu, "Diversification in the Presence of Taxes," Journal of Portfolio Management, Fall 2000, pp. 61-71.  This excellent paper analyzes the desirability of liquidating a concentrated stock position with significant unrealized capital gains.  "When  the initial asset has substantially more risk than the benchmark, our results recommend near complete diversification despite a high initial tax cost."  "... greater diversification is needed with greater initial asset volatility, with longer investment time horizon, with lower expected return of the initial asset, with higher cost basis, and with lower risk-free rate.  Less diversification is needed when the investor receives a step-up in basis at the horizon."

bulletDavid M. Stein, "Death, Taxes, and Diversification," Investment Advisor, May 2002, pp. 95-99.  A good discussion of the tradeoffs which must be considered around the question of whether or not to diversify a highly concentrated equity position.

bulletDavid M. Stein and Andrew F. Siegel, "The Diversification of Employee Stock Options," Working Paper, March 12 2002.  A good discussion of the decisions surrounding exercising employee stock options.

bulletDavid A. Twibell, "Understanding Exchange Funds," Financial Advisor, November 2004, pp. 97-98.  A good discussion of Exchange Funds.

bulletScott Welch, "Managing single-stock risk: Unlocking liquidity with high net worth clients," Journal of Financial Service Professionals, September 2000, pp. 78-85 (713kb).  An excellent discussion of major issues and alternatives surrounding the problem of concentrated portfolios.

bulletScott Welch, "Having Your Cake, and Hedging it, Too," Bloomberg Wealth Manager, April 2001, pp. 59-66 (194kb).  A discussion of Variable Prepaid Forward Contracts.

bullet"Remedies for Concentrated Portfolios," Neuberger Berman, 2002.  A good summary of the major issues and the major alternatives surrounding the problem of concentrated portfolios.

bullet"Equity Risk Management Strategies: Hedging and Diversifying a Concentrated Equity Portfolio," Lydian Wealth Management.  A good summary of the major issues and the major alternatives surrounding the problem of concentrated portfolios.

bullet"Prepaid Variable Forwards: Off the Hot Plate?," XXI Tailored Solutions: Perspectives for the Professional Investor, Spring 2003.  Discusses a recent IRS ruling that a prepaid variable forward did not constitute a constructive sale.

bullet"Hedging Low Basis Stock: Decision Tree," XXI Twenty First Securities, 2002.  A decision tree which helps walk an individual through their options in dealing with a highly appreciated security.  Also, links to various relevant articles.

Dividends

With the passage of the Jobs and Growth Tax Relief Reconciliation Act of 2003, certain stock dividends are temporarily (i.e., until the end of 2010) taxed at the same low rate as long-term capital gains.  Some see this as making dividend paying stocks preferred to non-dividend paying stocks.  In fact, nothing can be further from the truth.  Also see Tax-Managed Investing.

bulletMerton H. Miller, "Do Dividends Really Matter?," The University of Chicago Graduate School of Business, Selected Paper #57.  This paper validates the idea that whether or not any particular stock pays dividends is irrelevant to the investor (except that the dividend-paying stocks are less tax-efficient, which is generally an undesirable feature).  Written by a Nobel Prize winner.

bulletJohn H. Boyd and Ravi Jagannathan, "Ex-Dividend Price Behavior of Common Stocks," Federal Reserve Bank of Minneapolis Staff Report Number 173, June 1994.  Also in Review of Financial Studies, 7(4) 1994, pp. 711-741.  "In a variety of tests, marginal price drop [i.e., when a stock goes ex-dividend] is not significantly different from the dividend amount. Thus, over the last several decades, one-for-one marginal price drop has been an excellent (average) rule of thumb."

bulletJames A. Campbell and William Beranek, "Stock Price Behavior on Ex-Dividend Dates," Journal of Finance, December 1955, pp. 425-429.  This is the seminal work on ex-dividend stock price behavior.  It showed that there was a virtually immediate drop in the price of a share of stock upon going "ex-dividend."  The amount of the drop is almost exactly equal to the amount of the dividend (actually, it is about 90% the price of the dividend).  Thus, the fact that a particular stock paid a dividend doesn't magically (or by any other means) increase the shareholder's wealth.  In fact, due to tax effects, it may actually decrease the shareholder's wealth.

bulletHarry DeAngelo, Linda DeAngelo, and René M. Stulz, "Dividend Policy, Agency Costs, and Earned Equity," Marshall School of Business Working Paper, June 2004 (101kb).  This paper proposes a solution to the question, "Why do firms pay dividends?"  It suggests that successful firms pay dividends in order to avoid accumulating large amounts of cash which can't be usefully deployed.  Thus it is a means of eliminating the temptation that might otherwise exist to invest that cash in less attractive opportunities.  We reject this rationale.  We believe that the same effect could be achieved (in a more tax-efficient fashion) simply by using excess cash to buy back stock.

bulletJohn R. Graham, Roni Michaely, and Michael Roberts, "Do Price Discreteness and Transactions Costs Affect Stock Returns? Ex-day Evidence During the 1/16ths and Decimal Pricing Eras," Journal of Finance, December 2003, pp. 2613-2637 (215kb).  Here's the same paper.  This paper investigates several theories proposing to explain the fact that stock prices don't tend to fall quite as much as they "should" upon going ex-dividend (i.e, "the ex-dividend pricing anomaly").  It finds that the only such theory which holds up under testing is the tax hypothesis.  This theory posits that "the price drop is less than the dividend because high personal taxes on dividends (relative to capital gains) reduce the value of the dividend."  This argument was probably first enumerated by Elton and Gruber in 1970.
 
bulletGustavo Grullon, Roni Michaely, Schlomo Benartzi, and Richard H. Thaler, "Dividend Changes Do Not Signal Changes in Future Profitability," Journal of Business, September 2005.  This paper debunks the conventional wisdom that a company's increase (or decrease) of their dividend conveys some useful information about the company's expected future profitability.  "... we show that ... dividend changes contain no information about future earnings changes.  We also show that dividend changes are negatively correlated with future changes in profitability (return on assets)."  Apparently, not only do dividend increases NOT suggest good future profitability, but rather the opposite!
 
bulletCampbell Harvey, Reviews of Dividend papers.  An excellent review of many dividend-related papers.

 

Dollar Cost Averaging

Dollar Cost Averaging refers to a procedure whereby an equal amount is invested each period on an ongoing basis.  For the purpose of deploying a stream of cash-flows (e.g., the residue of your take-home pay after subtracting expenses), this basically just means investing what you have to invest when you have it available to invest.  There are few other good choices in such a situation.   However, for those who are making changes in their portfolios, this might mean spreading out the change over a period of time rather than making the change all at once.  The below articles address this aspect of Dollar Cost Averaging.  Also see Market Timing.

bulletPeter W. Bacon, Richard E. Williams, and M. Fall Ainina, "Does Dollar-Cost Averaging Work for Bonds?," Journal of Financial Planning, June 1997.  This article compares lump-sum investment in bonds vs. doing it gradually over time.  "Does dollar-cost averaging work for bonds? Based on historical evidence, the major conclusion of our study is that an investor is better off, in terms of return and risk-adjusted performance, investing the lump sum immediately."

bulletGeorge M. Constantinides, "A Note on the Suboptimality of Dollar-Cost Averaging as an Investment Policy," Journal of Financial and Quantitative Analysis, June 1979, pp. 443-450 (652kb).  An outstanding theoretical discussion of the issue.

bulletJohn G. Greenhut, "Mathematical Illusion: Why Dollar-Cost Averaging Does Not Work," Journal of Financial Planning, October 2006, pp. 76-83.  This article examines the oft-cited reason to use dollar-cost averaging that this causes the average price per share to be lower than the average share price.  "We found instead that the price variations that would be expected for fundamentally valued stocks is precisely the pattern that negates the advantage DCA commonly has been illustrated to hold. .... Whether DCA is practiced by investors should be based on their psychological makeup (for example, aversion to regret) and their outlook for stocks, not on an overly simplistic and misleading representation of how stock prices vary."

bulletJohn R. Knight and Lewis Mandell, "Nobody Gains from Dollar Cost Averaging: Analytical, Numerical, and Empirical Results," Financial Services Review, 2(1) 1993, pp. 51-61.  "Our results strongly imply that the additional cost and effort associated with Dollar Cost Averaging cannot be justified for any investor, regardless of degree of risk aversion.  With the possible exception of its promoters, nobody gains from Dollar Cost Averaging."

bulletKaryl B. Leggio and Donald Lien, "Does loss aversion explain dollar cost averaging?," Financial Services Review, 10 (2001), pp. 117-127.  Perhaps the premier reason that some advocate dollar cost averaging is its ability to avoid the regret that might come from investing a lump sum "at the worst possible time."  This paper concludes that even taking this into account, DCA results in sub-par performance when compared to lump sum investing.

bulletKaryl B. Leggio and Donald Lien, "Comparing Alternative Investment Strategies Using Risk-Adjusted Performance Measures," Journal of Financial Planning, January 2003, pp. 82-86.  This article also appeared as "An Empirical Examination of the Effectiveness of Dollar-Cost Averaging Using Downside Risk Performance Measures," Journal of Economics and Finance, Summer 2003, pp. 211-223.  This paper compares dollar cost averaging to lump sum investing using three different measures of risk-adjusted return: Sharpe Ratio, Sortino Ratio, and Upside Potential Ratio.  "...performance metrics that more accurately reflect investor risk and return such as the Sortino ratio and the UPR also fail to consistently support DCA as a preferred investing strategy."

bulletMichael S. Rozeff, "Lump-Sum Investing versus Dollar-Cost Averaging: Those who hesitate, lose," Journal of Portfolio Management, Winter 1994, pp. 45-50.  " ... any investor with funds to put to work in risky assets should not, as long as the expected risk premium is positive, hesitate to invest immediately.  To spread one's investment over time simply invites higher standard deviation of return without an increase in expected return."  "...dollar averaging, or spreading a risky investment out over time, is mean-variance inefficient compared with a lump-sum investment policy that simply makes a once-and-for-all lump-sum initial commitment."

bulletRichard E. Williams and Peter W. Bacon, "Lump Sum Beats Dollar Cost Averaging," Journal of Financial Planning, April 1993, pp. 64–67 (1.8mb).  Also in Journal of Financial Planning, June 2004, pp. 92-95.  This article compares lump-sum investment in the stock market vs. doing it gradually over time.  "... the odds strongly favor investing the lump sum immediately [as opposed to spreading it out over equal installments]."

Efficient Market Hypothesis


This is a large part of the theoretical argument for passive management and against persistence of mutual fund returns.  The developed world's equity and bond markets are quite efficient.  This means that there are many intelligent rational people trying to maximize their wealth and that relevant information about securities travels extremely quickly.  In other words, everybody else already knows everything you think you know about a particular security and they have already taken advantage of that information (and eliminated any opportunity that may have briefly existed to take advantage of that information) before you (and I) get a chance to.

"THE INFLUENCES  which determine  fluctuations on the Exchange are innumerable; past, present, and even discounted future events are [all] reflected in market price ... At a given instant, the market believes in neither a rise nor a fall of true prices." — Louis Bachelier, Theory of Speculation, 1900

bulletEugene F. Fama, "Random Walks in Stock Market Prices," Chicago School of Business Selected Paper Series, Paper #16 (102kb).  Also available here (102kb).  This paper also appeared in Financial Analysts Journal, September/October 1965, pp. 55-59.  Reprinted in Financial Analysts Journal, January/February 1995, pp. 75-80.  This paper is a non-technical version of Dr. Fama's doctoral dissertation below.  This is the seminal paper where Dr. Fama coined the term "Efficient Market."  "In an efficient market, competition among the many intelligent participants leads to a situation where, at any point in time, actual prices of individual securities already reflect the effects of information based both on events that have already occurred and on events which, as of now, the market expects to take place in the future. In other words, in an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value."

bulletEugene F. Fama, "The Behavior of Stock Market Prices," Journal of Business, January 1965, pp. 34-105 (8.52mb).  This paper is the technical version of Dr. Fama's doctoral dissertation summarized above.

bullet Ray Ball, "The Development, Accomplishments and Limitations of the Theory of Stock Market Efficiency," Managerial Finance, 20 (2,3) 1994, pp. 3-48.  A good summary of the research into stock market efficiency.  See here for an excellent discussion of this paper.

bullet Elroy Dimson and Massoud Mussavian, "A brief history of market efficiency," European Financial Management, March 1998, pp. 91-193 (60kb).  An excellent, highly readable history of the efficient market hypothesis.

bullet "The Efficient Market Hypothesis and Random Walk Theory," Investor Home, 1999.  An outstanding summary of the subject matter.

bullet Eugene F. Fama, "Market Efficiency, Long-Term Returns, and Behavioral Finance," Journal of Financial Economics, September 1998, pp. 283-306 (135kb).  This paper is also available here and here.

bullet Eugene F. Fama, "Efficient Capital Markets: A Review of Theory and Empirical Work," Journal of Finance, May, 1970, pp. 383-417 (4.4mb).  A comprehensive review of the literature on this topic.

bullet Eugene F. Fama, "Efficient Capital Markets: II," Journal of Finance, December 1991, pp. 1575-1617 (5.4mb).  Here's a good summary.  A (somewhat less comprehensive) review of the literature twenty years after his first review.

bullet Burton G. Malkiel, "The Efficient Market Hypothesis and its Critics", Journal of Economic Perspectives, 2003 17(1), pp. 59-82 (523kb).  "This survey examines the attacks on the efficient-market hypothesis and the relationship between predictability and efficiency.  I conclude that our stock markets are more efficient and less predictable than many recent academic papers would have us believe."
 
bullet Burton G. Malkiel, "Reflections on the Efficient Markets Hypothesis: 30 Years Later", The Financial Review, February 2005, pp. 1-9 (401kb).  "The evidence is overwhelming that active equity management is, in the words of Ellis (1998), a 'loser’s game.' Switching from security to security accomplishes nothing but to increase transactions costs and harm performance. Thus, even if markets are less than fully efficient, indexing is likely to produce higher rates of return than active portfolio management. Both individual and institutional investors will be well served to employ indexing ..."
 
bullet "Is That a $100 Bill Lying on the Ground?  Two Views of Market Efficiency," Wharton School of Business, 2002.  Highlights of a debate between two influential academics, Burton Malkiel and Richard Thaler.  You may need to register (for free) in order to view this.

bullet Martin Sewell, "Efficient Markets Hypothesis Bibliography,"  University College London.  An excellent bibliography of this topic.

Emerging Markets

Emerging markets refers to stock markets of economies which are developing (e.g., China, Russia, Argentina, Mexico, etc.).  Investing in emerging markets is often done with a small portion of one's portfolio in order to get the diversification benefits offered by this asset class.  Also, see Foreign Investing and Currency Hedging.  Also, see Frontier Markets.

bulletSteven L. Beach, "Why Emerging Market Equities Belong in a Diversified Investment Portfolio," Journal of Investing, Winter 2006, pp. 12-18.  "Historical evidence, including analysis of downside risk, provides ample proof that emerging market equities have provided returns sufficient to compensate for their risk. ... investing in a broad emerging-market index fund can provide significant return opportunities, without the country-specific risks. In summary, diversified investment portfolios should contain both developed international and emerging market equities."

bulletWilliam J. Bernstein, "Rebalancing Individual National Markets," Efficient Frontier, Spring 2000.  Discusses the benefits of an emerging markets fund equal-weighted across countries (i.e., like DFA's Emerging Markets funds used to be).

bulletDavid G. Booth, "Active Management's Failure to Deliver in Emerging Markets: A View from the New Economy," Institute for Fiduciary Education, July 1 2000 (156kb).  This article points out that, compared with passively managed funds, actively managed funds haven't faired particularly well in emerging markets.  This is contrary to the conventional wisdom, which suggests that less efficient markets are more amenable to active management.

bulletCampbell R. Harvey, "Predictable Risk and Returns in Emerging Markets," Review of Financial Studies, Fall 1995, pp. 773-816 (3.4mb).  "... inclusion of emerging market assets in a mean-variance efficient portfolio will reduce portfolio volatility and increase expected returns."

bulletAsani Sarkar and Kai li, "Should US Investors Hold Foreign Stocks?," SSRN abstract #319754, January 2002 (47kb).  This paper finds that, if short selling is not allowed, there is no diversification benefit for US investors to diversify in foreign developed markets.  However, diversification into Emerging Markets remains beneficial under this constraint.

bulletJ.D. Steinhilber, "Emerging Markets Rebounding," IndexFunds.com, September 10 2003.  Discusses the iShares MSCI Emerging Markets Index Fund ETF (EEM).

bulletYesim Tokat, "International Equity Investing: Investing in Emerging Markets," Investment Counseling & Research/ ANALYSIS, July 2004 (755kb).  A good discussion of issues surrounding investing in emerging markets.

bulletYesim Tokat and Nelson Wicas, "Investing in Emerging Markets," Journal of Wealth Management, Fall 2004, pp. 68-80.  A good discussion of issues surrounding investing in emerging markets.

bulletKaren Umland, "Emerging Markets: Managing Risks," Institute for Fiduciary Education, 2003 (313kb).  A good discussion of the risks associated with investing in emerging markets.

bullet"Emerging Markets iShares," ETFZone.com, June 1 2003.  Discusses the iShares MSCI Emerging Markets Index Fund ETF (EEM).

Endowment Fund Management

Also, see Pension Fund Management.

bulletBala Arshanapalli, Edmond D´Ouville, and William Nelson, "A New Endowment Distribution Plan: How to Insure Current Spending While Growing the Fund Corpus," Journal of Wealth Management, Spring 2004, pp. 24-28 (91kb).  An interesting idea.  They suggest that endowments ensure the current funding continues uninterrupted by splitting the endowment and buying a long-term commercial annuity with a portion, while investing the other portion in stocks for growth.

bulletJames P. Garland, "A Market Yield Spending Rule for Endowments and Trusts," Financial Analysts Journal, July/August 1989, pp. 50-60.  This paper proposes a rule for calculating how much to spend annually from an endowment.

bulletCatherine D. Gordon, "Investment Committees: Vanguard's View of Best Practices," The Vanguard Group, June 2004.  A good discussion of best practices in investment committees.

bulletRobert C. Merton, "Optimal Investment Strategies for University Endowment Funds," NBER Working Paper # 3820, August 1991 (1.1mb).  Also here and here. 

bulletMoshe A. Milevsky, "A New Perspective on Endowments," IFID Working Paper, March 10 2003.  An excellent article discussing spending policies for endowments.

Equity Premium

The "Equity Premium" refers to how much stock returns are higher than bond returns.  There are many good reasons to believe that the equity premium in the future will be much less than the equity premium in the recent past.  It is prudent to have realistic expectations of what stock returns are likely to be in the future.  Therefore, macroscopic estimates thereof are quite important for investors.

bulletWilliam Reichenstein, "The Investment Implications of Lower Stock Return Prospects," AAII Journal, October 2001, pp. 4-7.  An excellent, readable article with very pragmatic advice.

bulletWilliam Reichenstein, "What Do Past Stock Market Returns Tell Us About the Future?," Journal of Financial Planning, July 2002, pp. 72-83.  This may be the best summary of recent studies in this area.

bulletRobert D. Arnott and Ronald J. Ryan, "The Death of the Risk Premium," Journal of Portfolio Management, Summer 2001, pp. 61-74 (198kb).

bulletRobert D. Arnott and Peter L. Bernstein, "What Risk Premium is 'Normal'?," SSRN Abstract No. 296854 (573 kb).  This paper also appeared in Financial Analysts Journal, March/April 2002, pp. 64-85.

bulletClifford S. Asness, "Stocks versus Bonds: Explaining the Equity Risk Premium," Financial Analysts Journal, March/April 2000, pp. 96-113 (187kb).  This paper presents a model for long term stock dividend yield which suggests that the difference between stock yields and bond yields is driven by the long-run difference in volatility between stocks and bonds.

bulletPeter L. Bernstein, "What Rate of Return Can You Reasonably Expect ... or What Can the Long Run Tell Us about the Short Run?," Financial Analysts Journal, March/April 1997.  "A strange and unexpected conclusion emerges. Stocks are fundamentally less risky than bonds, not only because their returns have been consistently higher than those of bonds over the long run but also because less uncertainty surrounds the long-term return investors can expect on the basis of past history. Equity investors have at least some notion of what the long run has provided to owners of equities and at least a few hints as to whether stocks are high or low relative to their long-run performance. Investors in the bond market, even with 195 years of history to look back on, can make no statement at all about a basic return; they can make no judgments beyond the duration of the particular instrument they happen to be holding at any given moment."

bulletWilliam J. Bernstein, "What's Expected?  What's Cheap?," Efficient Frontier, Summer 2001.

bulletPeter Coy, "How Risky Is the Risk Premium?," Business Week, December 25 2000, p. 122.

bulletElroy Dimson, Paul Marsh, and Mike Staunton, "Risk and Return in the 20th and 21st Centuries," Business Strategy Review, Summer 2000, pp. 1-18.  This is basically a longer version of the short article below.

bulletElroy Dimson, Paul Marsh, and Mike Staunton, "New evidence puts risk premium in context," Corporate Finance, March 2003, pp. 8-10 (61kb). "Our work results in a set of forward-looking, geometric risk premia for the United States, United Kingdom, and for the world of around 2.5 to 4.0 per cent."  "... this corresponds to arithmetic mean risk premia of around 3.5 to 5.25 per cent."

bulletElroy Dimson, Paul Marsh, and Mike Staunton, "Global Evidence on the Equity Risk Premium," Journal of Applied Corporate Finance, Fall 2003, pp. 27-38 (210kb).

bulletEugene F. Fama and Kenneth R. French, "The Equity Premium," CRSP Working Paper No. 522, April 2001 (131kb).  This paper also appeared in Journal of Finance, April 2001, pp. 637-659.

bulletAmit Goyal and Ivo Welch, "A Comprehensive Look the the Empirical Performance of Equity Premium Prediction," National Bureau of Economic Research Working Paper No w10483, May 2004.  This paper tests whether various empirical means of predicting near-term equity premiums have been useful in the past.  "... we find that, for all practical purposes, the equity premium has not been predictable, and any belief about whether the stock market is now too high or too low has to be based on theoretical prior, not on the empirically [sic] variables we have explored."

bulletLacy H. Hunt and David M. Hoisington, "Estimating the Stock/Bond Risk Premium: An alternative approach," Journal of Portfolio Management, Winter 2003, pp. 28-34 (317).  This paper's findings are consistent with most others, forecasting an equity premium significantly below historical norms over the next one to two decades.

bulletRoger G. Ibbotson and Peng Chen, "The Supply of Stock Market Returns," Ibbotson Associates.  June 2001 (129 kb).

bulletAntti Ilmanen, "Expected Returns on Stocks and Bonds: Investors must moderate their expectations," Journal of Portfolio Management, Winter 2003 (2.3mb).  A survey of the issues affecting expected returns.

bulletRavi Jagannathan, Ellen R. McGrattan, and Anna Scherbina, "The Declining U.S. Equity Premium," Federal Reserve Bank of Minneapolis Quarterly Review, Fall 2000, pp. 3-19 (150kb).  A good discussion of this issue.

bulletMimi Lord, "Is Equity Risk Premium Still Thriving, or a Thing of the Past?," Journal of Financial Planning, April 2002, pp. 62-70.  Ms. Lord interviews Roger Ibbotson and Robert Arnott.

bulletEllen R. McGrattan and Edward C. Prescott, "Average Debt and Equity Returns: Puzzling?," Federal Reserve Bank of Minneapolis Research Dept Staff Report 313, January 2003 (232kb).  An interesting look at the "equity premium puzzle" (i.e., why have returns on equity in the US been so much higher than predicted?).  After correcting for taxes, regulatory constraints, and diversification costs, and focusing on long-term rather than short-term savings instruments, they find that there really is no equity premium puzzle.

bulletIvo Welch, "Views of Financial Economists on the Equity Premium and on Professional Controversies," Journal of Business, 2000, pp. 501-537 (794kb).

bulletIvo Welch, "The Equity Premium Consensus Forecast Revisited," Cowles Foundation Discussion Paper No. 1325, September 2001 (166kb).  An update to his earlier work, using a survey taken three years after the first.

bullet"Great Expectations," The Economist, July 15 2000, p. 76.  Explains the Fama/French paper's conclusions in layman's terms.

bullet"Equity Risk Premium Forum," November 8, 2001 (2mb).  The record of an outstanding discussion led by several preeminent academics.

bullet Bibliography on Equity Risk Premium, November 8 2001.  An excellent bibliography on this topic

Estate Planning

Estate planning is extremely important for wealthy individuals who wish to maximize the amount of assets passed on to heirs.  In general, it is important that estate planning be done by an expert — usually a lawyer who specializes in this area.  The below articles discuss investment aspects of estate planning.  Also, see Charitable Giving.

bulletRobert M. Dammon, Chester S. Spatt, and Harold H. Zhang, "Taxes, Estate Planning and Financial Theory: New Insights and Perspectives," Carnegie Mellon Working Paper, March 15 2004 (57kb).  A good discussion of some relevant investing issues pertaining to estate planning.

bulletRoccy DeFrancesco, "Gifts That Keep Giving," Financial Planning, July 2004, pp. 89-92.  A good article which goes into detail about one way to use a Charitable Gift Annuity in conjunction with a Donor-Advised Fund and a Irrevocable Life Insurance Trust.

bulletJay S. Goldenberg, "The Living Trust for Estate and Financial Planning," Journal of Financial Planning, Summer 1980, pp. 217-227 (619kb).  Also here.  A good primer on Revocable Living Trusts and trusts in general.

bulletLynn Hopewell, "Advantages of Revocable Trusts," Journal of Financial Planning, April 1994, pp. 87-91 (645kb).  A good primer on Revocable Living Trusts.

bulletLawrence C. Phillips and Thomas R. Robinson, "Charitable Remainder Trust: A Powerful Financial Planning Tool," Journal of Financial Planning, August 1997, pp. 70-76 (980kb).  A good primer on Charitable Remainder Trusts.

bulletGary Underwood, "Preserving the Legacy," Investment Advisor, May 2005, pp. 84-88.  A good summary of twelve estate planning techniques.

bullet Deferring Capital Gains Taxes With The Premier VI Private Annuity/Trust, National Association of Financial and Estate Planning.  Describes an approach using a Private Annuity Trust when you have a highly appreciated asset whose value you which to preserve for heirs.

bullet Estate Planning Basics, National Association of Financial and Estate Planning.  A good basic discussion of many estate planning issues.

bullet Estate Planning: An Overview, Legal Information Institute.  A great on-line bibliography on the topic, from a legal perspective.

Exchange Traded Funds

Exchange Traded Funds are similar to conventional index mutual funds, but they are purchased like a stock.  The largest selection of ETFs are the iShares offered by Barclay's Global Investors.

bulletWilliam J. Bernstein, "The ETF vs. Open-End Index-Fund Shootout," Efficient Frontier, Fall 2001.

bulletWilliam J. Bernstein, "It's the Execution, Stupid!," Efficient Frontier, Winter 2004.  This article finds that the best index funds have tended to outperform "equivalent" ETFs even without considering the costs of bid-ask spreads and commissions which apply to ETFs, but not index funds.

bulletWilfred L. Dellva, "Exchange-Traded Funds Not for Everyone," Journal of Financial Planning, April 2001, pp. 110-124.  Also here.  Also here.  An excellent paper which compares ETFs with the best index mutual funds.

bulletEdwin J. Elton, Martin J. Gruber, George Comer, and Kai Li, "Spiders: Where are the Bugs," Journal of Business, July 2002, pp. 453-472.  This paper analyzes the performance of one of the first Exchange Traded Funds, the S&P 500 SPDR.  It finds that this ETF underperforms similar low cost index mutual funds by 0.18 percentage points per year.  This underperformance is principally due to the fact that SPDRs (unlike most more modern ETFs) are required to hold dividends received from their underlying stocks in cash until distribution to shareholders.

bulletRobert Engle and Debojyoti Sarkar, "Pricing Exchange Traded Funds," NYU Stern Working Paper, May 2002 (172kb).  An interesting paper.

bulletGary L. Gastineau, "Exchange Traded Funds: An Introduction," Journal of Portfolio Management, Spring 2001, pp. 88-96.  An introduction to ETFs.

bulletEric E. Haas, "ETFs vs. Index Mutual Funds," Altruist Financial Advisors LLC, 2004.  Pros and cons of ETFs as compared with conventional index mutual funds.

bulletLeonard Kostovetsky, "Index Mutual Funds and Exchange-Traded Funds," Journal of Portfolio Management, Summer 2003, pp. 80-92.  A good comparison of ETFs with index funds.

bulletJames L. Novakoff, "Exchange Traded Funds: A White Paper," Indexfunds.com, February 24 2000.  A good history and overview of ETFs.

bulletJim Novakoff, "Diamonds in the Rough: The 10 Keys To Building Sound ETF-Based Portfolios," Journal of Indexes, Third Quarter 2002.

bulletScott Rasmussen, "Going Long with Baskets: A cost-comparison of exchange-traded funds," Stanford University Honors Thesis, December 9 2002 (1.38mb).  An interesting paper comparing ETFs to conventional index mutual funds.

bulletSteven Schoenfeld, J. Lisa Chen, and Binu George, "ETFs offer the World to Investors," A Guide to Exchange-Traded Funds, Fall 2001, pp. 111-118.  "Index based strategies are the most efficient way to gain international exposure, and should outperform the average actively managed fund."

bulletJohn Spence, "New Study Examines Domestic, International ETF Premiums and Discounts," Indexfunds.com, February 14 2002.  This article discusses a study which quantifies the bid-ask spreads and market premiums for ETFs.

bulletJohn Spence, "Joined at the Hip – Vanguard’s VIPERS and index funds," IndexUniverse.com, November 11 2003.  This excellent article discusses why Vanguard's ETFs may have a slight advantage over other ETFs.  You may have to register (for free) to view this article (also, see this article in the Journal of Indexes).

bulletJim Wiandt, "How ETFs Manage a Tax-Efficiency Edge over Traditional Mutual Funds," Indexfunds.com, September 28 2001.

bulletBrad Zigler, "ETFs finish in first place: Exchange-traded funds appear to be living up to their promise," Financial Planning, May 1 2002.

bullet"Another Look at ETF Premium/Discounts and Spreads," Indexfunds.com, April 3 2002.
 
bullet"ETF Liquidity Myth Dispelled," ETFZone.com, November 6 2003.  Good discussion of what drives bid-ask spreads of ETFs.

bulletETFZone.com.  An excellent web site with a great deal of information on ETFs.

bulletExchangetradedfunds.com.  A good place for quotes on ETFs.

Fama/French Three-Factor Model

These papers explore the intellectual underpinnings for the idea that tilting a stock portfolio towards small and value stocks will tend to result in higher long-term expected returns (at the expense of somewhat higher short-term volatility).

bulletEugene F. Fama and Kenneth R. French, "The Cross-Section of Expected Stock Returns," Journal of Finance, Vol XLVII No 2 June 1992, pp. 427-465 (3.82mb).  Also here.  Also here.  Also here (3.9mb).  Also here.  This is the seminal paper that first provided proof that exposure to market risk, market capitalization, and book to price ratio almost completely explained (variations in) the level of stock returns.

bulletEugene F. Fama and Kenneth R. French, "Common risk factors in the returns on stocks and bonds," Journal of Financial Economics, 33 1993, pp. 3-56 (4.82mb).  Also here.  This paper extends the three factor model, which explains variation in stock returns, to five factors, which also explain variation in bond returns (the additional factors, only applicable to bonds, are default risk and term risk (i.e., maturity/duration)).  Note that explanatory power for the two risk factors are only applicable to high-quality bonds.  Lower quality bonds are also affected by the equity factors.

bulletFrank Armstrong, "Fama French Three Factor Model," Investor Solutions, 2001.  An outstanding, very readable introduction to the three factor model.

bulletBala Arshanapalli, T. Daniel Coggin, John Doukas, and H. David Shea, "The Dimensions of International Equity Style," Journal of Investing, Spring 1998, pp. 15-30.  A look at 1975 to 1996 international returns data confirms that both the value effect and the small effect exist abroad.

bulletRolf W. Banz, "The Relationship Between Return and Market Value of Common Stocks," Journal of Financial Economics, 9 (1981), pp. 3-18.  "It is found that smaller firms have had higher risk adjusted returns , on average, than larger firms.  This 'size effect' has been in existence for at least forty years and is evidence that the capital asset pricing model is misspecified.  The size effect is not linear in the market value; the main effect occurs for very small firms while there is little difference in return between average sized and large firms."  This paper probably originated the idea of a size premium.

bulletChristopher B. Barry, Elizabeth Goldreyer, Larry Lockwood, Mauricio Rodriguez, "Size and Book-to-Market Effects: Evidence from Emerging Equity Markets," Emerging Markets Review, 3, pp. 1-30 (233kb).  This paper finds a value premium in emerging markets.  It finds much less evidence in support of a small premium.

bulletSanjoy Basu, "The Relationship Between Earnings' Yield, Market Value, and Return for NYSE Common Stocks," Journal of Financial Economics, 12 (1983), pp. 129-156.  "The results confirm that the common stock of high E/P firms earn, on average, higher risk-adjusted returns than the common stock of low E/P firms and that this effect is clearly significant ..."  This paper confirmed the existence of a value premium.

bulletSanjoy Basu, "Investment Performance of Common Stocks in Relation to their Price-Earnings Ratios: A Test of the Efficient Market Hypothesis," Journal of Finance, June 1977, pp. 663-682.  This paper finds that stocks with low price-earnings ratios (i.e., value stocks) have higher risk-adjusted returns than stocks with high price-earnings ratios (i.e., growth stocks).

bulletWilliam J. Bernstein, "The Cross-Section of Expected Stock Returns: A Tenth Anniversary Reflection," Efficient Frontier, Summer 2002.  A very readable retrospective ten years after the original Fama/French paper on the subject.

bulletCarlo Capaul, Ian Rowley, and William F. Sharpe, "International Value and Growth Stock Returns," Financial Analysts Journal, January/February 1993.  A look at 1981 to 1992 international returns data confirms that the value effect exists abroad.

bulletLouis K. C. Chan and Josef Lakonishok, "Value and Growth Investing: A Review and Update," Financial Analysts Journal, January/February 2004, pp. 71-86 (85kb).  "The evidence suggests that ... value investing generates superior returns.  Common measures of risk do not support the argument that the return differential is due to the higher riskiness of value stocks.  Instead, behavioral considerations and the agency costs of delegated investment management lie at the root of the value-growth spread."

bulletJohn Chisholm, "The Risks of Value: Examining the Risk Budget Impact of an International Value Style," Institute for Fiduciary Education, October 1999 (171kb).  Examines the value premium overseas.

bulletTruman A. Clark, "The Dimensions of Stock Returns: 2002 Update," Dimensional Fund Advisors, April 2002.

bulletJames L. Davis, Eugene F. Fama, and Kenneth R. French, "Characteristics, Covariances, and Average Returns: 1929-1997," February 1999, Center for Research in Security Prices Working Paper No. 471 (227kb).  This paper also appeared in Journal of Finance, February 2000 Vol 55, pp. 389-406.  This paper more than doubles the sample size of returns analyzed, with the same conclusions as the original Fama/French paper (the original paper only used data from 1962-1989).

bulletJames L. Davis, "Is There Still Value in the Book-to-Market Ratio?," Dimensional Fund Advisors, January 2001.  Addresses whether BTM ratio has been superceded by other measures of value, such as Price/Earnings ratio and others.  The bottom line is that BTM remains in several pragmatic ways the optimal measure of the "value-ness" of a stock.

bulletJames L. Davis, "Explaining Stock Returns: A Literature Survey," Dimensional Fund Advisors, December 2001.  An excellent survey of literature on this subject.

bulletElroy Dimson, Stefan Nagel, and Garrett Quigley, "Capturing the Value Premium in the U.K. 1955-2001," Financial Analysts Journal, November/December 2003, pp. 35-45.  Also here.  "... we find a strong value premium in the UK for the period 1955-2001.  The value premium exists within the small-cap as well as the large-cap universe."  "However, managers attempting to capture the value premium in the small-cap segment should pay particular attention to rebalancing-induced portfolio turnover and market illiquidity in small-value stocks.  Compared to the U.S., the U.K. market for small-cap stocks is relatively illiquid.  Trading costs are therefore an even more crucial determinant of overall performance.  This is likely to be the case in other non-U.S. markets as well."  This suggests that it is important to implement strategies that sacrifice tracking accuracy in favor of reducing trading needs and lowering trading costs.

bulletEugene F. Fama and Kenneth R. French, “Value vs. Growth: The International Evidence,” Journal of Finance, December 1998 Vol 53, pp. 1975-1999 (2.38mb).  This paper also was SSRN Working Paper 2358 (54kb).  This paper examines non-US markets for the "value premium" and finds it in nearly every other country studied.

bulletEugene F. Fama and Kenneth R. French, "Size and Book-to-Market Factors in Earnings and Returns," Journal of Finance, March 1995, pp. 131-155.  "The evidence presented here shows that size and BE/ME [book to market ratio] are related to profitability."  "Firms with high BE/ME (a low stock price relative to book value) tend to be persistently distressed."  This helps explain why small stocks and value stocks tend to be have higher returns — because they are "riskier" than larger and more "growthy" companies.

bulletEugene Fama, Jr., "Engineering Portfolios for Better Returns," Senior Consultant, May 1998.  Dr. Fama's son discusses the practical implications of the Fama/French Three-Factor model.

bulletSherman Hannah and Peng Chen, "Small Stocks vs. Large: It's How Long You Hold That Counts," Journal of American Association of Individual Investors, July 1999.  This paper concludes that small cap stocks have tended to outperform large cap stocks in the US for holding periods of greater than 15 years.

bulletBob Hansen, "Risk and Return: Professor Ken French on the Cross Section of Expected Returns," Tuck Today, Winter 2004, pp. 3-9.  An outstanding interview with Professor Ken French.

bulletGabriel Hawawini and Donald B. Keim, "The CrossSection of Common Stock Returns: A Review of the Evidence and Some New Findings," The Wharton School of the University of Pennsylvania, 1998 (560kb).  Also here.  This paper also appeared in Security Market Imperfections in World Wide Equity Markets, Eds. D.B. Keim and W.T. Ziemba (Prentice Hall, 2000).

bulletRoger G. Ibbotson and Mark W. Riepe, "Growth Vs. Value Investing: And the Winner Is...," Journal of Financial Planning, June 1997, pp. 64-71 (1,337kb).  Also here.

bulletJeffrey Jaffe, Donald B. Keim, and Randolph Westerfield, "Earnings Yields, Market Values, and Stock Returns," Journal of Finance, March 1989, pp. 135-148.  "Our research finds significant E/P and size effects when estimated across all months during the 1951-1986 period."

bulletJosef Lokonishok, Andrei Shleifer, and Robert W. Vishny, "Contrarian Investment, Extrapolation, and Risk," NBER Working Paper number W4360.  This paper also appeared in Journal of Finance, Vol XLIX No 5, December 1994, pp. 1541-1578.  Also here and here.

bulletRichard C. Marston, "White Paper on Value and Growth Investing," Lincoln Financial Group, Dec 2004.  An excellent basic discussion of the value premium.

bulletNicholas Molodovsky, "Recent Studies of P/E Ratios," Financial Analysts Journal, May-June 1967, pp. 101-108.  An excellent summary of the earliest academic studies which detected a value premium.

bulletS. Francis Nicholson, "Price Ratios in relation to Investment Results," Financial Analysts Journal, January-February 1968, pp. 105-109.  Nicholson, who might rightfully be called the "father of the value premium", concludes that stocks with low price-earnings ratios (i.e., value stocks) tend to have dramatically higher subsequent returns than stocks with high price-earnings ratios (i.e., growth stocks).  His explanation is similar to what Benjamin Graham might have offered that value stocks are, effectively, "on sale."

bulletMarc R. Reinganum, "Abnormal Returns in Small Firm Portfolios," Financial Analysts Journal, March/April 1981, pp. 52-56.  This paper was among the first to demonstrate the "small" premium.

bulletBarr Rosenberg, Kenneth Reid, and Ronald Lanstein, "Persuasive Evidence of Market Inefficiency," Journal of Portfolio Management, Spring 1985, pp. 9-17.  This paper demonstrated the efficacy of a strategy of investing in value stocks and shorting growth stocks.  In other words, it validated the existence of a value premium.

bullet"What Has Worked In Investing," Tweedy, Browne Company, 1992 (289kb).  An interesting pamphlet from a small value-oriented mutual fund company.

Foreign Investing

Investing internationally with a portion of one's portfolio is often recommended in order to achieve diversification benefits.  Also, see Emerging Markets and Currency Hedging.

bulletScott Aiello and Natalie Chieffe, "International Index Funds and the Investment Portfolio," Financial Services Review, 8 1999, pp. 27-35.  "This study urges caution for those investors who seek to maximize returns.  However, it does suggest that the diversification one can gain from international index funds is significant and important."  Basically, this study is consistent with the conclusions of Sinquefield (1996) below.  Internationally diversifying one's otherwise domestic equity portfolio yielded a reduction in risk/volatility, but also a reduction in returns during the period studied.

bulletMarianne Baxter and Urban J. Jermann, "The International Diversification Puzzle is Worse than you Think," American Economic Review, March 1997, pp. 170-180.  Appendix A of this paper is here.  Also NBER Working paper 5019, February 1995.  Also here.  This interesting paper looks at the degree of international diversification justified when taking into account an investor's "human capital."  This is the present value of a person's future earnings.  It finds that human capital is highly correlated with an investor's domestic market.  When you take that into account, the natural tendency to overweight one's own country in their portfolio becomes dramatically amplified.  In fact it suggests not only increasing foreign investment, but increasing it to the point of actually shorting domestic investments.  This paper, therefore, supports a significant investment overseas for most individual investors.

bulletMarianne Baxter, Urban J. Jermann, and Robert J. King, "Nontraded Goods, nontraded factors, and international non-diversification," Journal of International Economics, April 1998, pp. 211-229.  This paper's conclusions are consistent with those of the one above.

bulletEric Brandhorst, "International Diversification," State Street Global Advisors, July 15 2002.  "International diversification works. Over the past 30 years, portfolios comprising both U.S. and non-U.S. equities have experienced higher returns and lower levels of overall risk. Risk reduction was the dominant effect for those who invested internationally during the past decade."

bulletRobin Brooks and Marco Del Negro, "The Rise in Comovement across National Stock Markets: Market Integration or IT Bubble?," Federal Reserve Bank of Atlanta, September 2002 (301kb).  This study suggests that the recent trend of industry diversification becoming more important than country diversification in international investing appears to be a temporary phenomena related to the IT bubble of the late 1990s.

bulletStephen E. Christophe and Richard W. McEnally, "U.S. Multinationals as Vehicles for International Diversification," Journal of Investing, Winter 2000, pp. 67-75.  This paper debunks the myth that an inexpensive way of getting international exposure is to buy multinational companies headquartered in the US.  The paper finds that stocks of multinational companies tend to be strongly correlated with the US stock market, regardless of the location and extent of their foreign operations.

bulletPhilip L. Cooley, Carl M. Hubbard, and Daniel T. Walz, "Does International Diversification Increase the Sustainable Withdrawal Rates from Retirement Portfolios?," Journal of Financial Planning, January 2003, pp. 74-80.  Also here.  This study shows that over the period studied (1970-July 2001), international diversification would have provided almost no benefit to typical US investors.  This is consistent with the Sinquefield study (1996) below.  If the higher costs of foreign mutual funds were taken into account, the international diversification benefit would have been worse yet.

bulletIan Cooper, "An open and shut case for portfolio diversification," The Financial Times, July 16 2001, p. 4.  "Twenty years or less from now the challenge will be not 'the case for global investing' but 'why deviate from a globally diversified equity portfolio.'"

bulletClaude B. Erb, Campbell R. Harvey, and Tadas E. Viskanta, "Do World Markets Still Serve as a Hedge?," Journal of Investing, Fall 1995, pp. 23-46 (2.1mb).  "Do world markets still serve as a hedge?  The answer is affirmative."

bulletWalter V. Gerasimowicz, "Diversification from a U.S.$ perspective," J.P. Morgan Securities Inc., March 8 1995.  A good discussion of the benefits of diversifying bond investments into foreign bonds.

bulletJason T. Greene and Charles W. Hodges, "The dilution impact of daily fund flows on open-end mutual funds," Journal of Financial Economics, July 2002, pp. 131-158 (101kb).  This paper measures the effect of a certain kind of day trading that allows some active traders of mutual funds to earn significant abnormal returns at the expense of long-term investors in those funds.  It concludes that the effect detracts about 0.5% annually from foreign mutual funds subject to this effect.  Note that the foreign mutual funds Altruist recommends aren't subject to this effect: those of DFA (their distribution method precludes "day trading"), Vanguard (they instituted contingent fees in 2003 which significantly discourage the practice), and certain foreign stock ETFs (they aren't subject to this effect by their very nature).  The paper suggests that investors may be prudent in avoiding mutual funds which are subject to manipulation in this manner (i.e., those which haven't taken steps to avoid this effect).

bulletHerbert G. Grubel, "Internationally Diversified Portfolios: Welfare Gains and Capital Flows," American Economic Review, December 1968, pp. 1299-1314.  "... recent experience with foreign investment returns would have given rise to substantial gains in welfare to wealth holders.  If past experiences are considered to be indicative of future developments, then these data suggest that future international diversification of portfolios is profitable and that more of it will take place."

bulletMichael E. Hannah, Joseph P. McCormack, and Grady Perdue, "International Diversification with Market Indexes," Academy of Accounting and Financial Studies Journal, 4(2) 2000, pp. 96-104.  "In theory an investor's portfolio may benefit by being invested in the U.S. market and another market that is less than perfectly correlated with the U.S. market. Diversification typically reduces risk significantly at the cost of a small reduction in return. However, during the decade of the 1990s, U.S. investors were not rewarded for international diversification. They would have experienced small reductions in risk coupled with large reductions in return."

bulletSteven L. Heston and K. Geert Rouwenhorst, "Industry and Country Effects in International Stock Returns," Journal of Portfolio Management, Spring 1995, pp. 53-58.  "... the performance of international portfolios is largely country-driven, and international portfolio managers should pay more attention to the geographical composition than to the industrial composition of their portfolios."

bulletKwok Ho, Moshe, Arye Milevsky, and Chris Robinson, "International Equity Diversification and Shortfall Risk," Financial Services Review, 8 1999, pp. 11-25.  Also here.  "... [International Equity Diversification] does not appear to benefit Americans materially, because their equity portfolio is already closely-related to the international equity portfolio."  This paper's conclusions are consistent with those of Sinquefield (1996) below.

bulletJohn E. Hunter and T. Daniel Coggin, "An analysis of the diversification benefit from international equity investment," Journal of Portfolio Management, Fall 1990, pp. 33-36.  "[during the period studied (1970-1986)], ... international diversification would have reduced investment risk (defined by variance of return) to about 56% of the level that could have been achieved using only national  diversification.  Hence, while there is a limit on international diversification benefit, the potential gain is sizable indeed."

bulletDušan Isakov and Frédéric Sonney, "On the relative importance of industrial factors in international stock returns," University of Geneva, January 2002 (99kb).  This study analyzes whether international diversification across countries or across industries gives more diversification benefit.  It concludes that, on average, the country effect continued to dominate during the period studied.  However, the industry effect is increasing in importance and may dominate the country effect now.  It remains to be seen if this is a temporary or permanent effect.

bulletSarkis Joseph Khoury, "Country Risk and International Portfolio Diversification for the Individual Investor," Financial Services Review, 2003, pp. 73-93 (2.44mb).  "... the paper finds no excuse for an investor to ignore international diversification."

bulletJohn D. Kuethe, "Chapter One: International Diversification in the 2000s — Stay the Course," Ennis Knupp + Associates, September 2001 (338kb).  This paper notes that international diversification seemed to hurt US investors in the late 1990s.  It concludes that, going forward, it probably still makes sense to diversify internationally.

bulletDavid S. Laster, "Measuring Gains from International Equity Diversification: The Bootstrap Approach," Journal of Investing, Fall 1998, pp. 52-60.  This paper concludes that "... raising the equity allocation to foreign stocks from zero to 20% reduces the probability of realizing negative returns over a 5 year period by about a third. It also documents the near certainty of reducing portfolio risk by raising the equity allocation to foreign stocks above conventional levels."  The optimal allocation seems to be 60/40 domestic/foreign during the period studied (1970-1996).  Such an allocation would have increased risk-adjusted returns by about 0.65 percentage points annually over that of a purely domestic equity portfolio during the period studied, through reduction of risk/volatility (which would also allow an increased allocation to equities, which would further boost long-term returns).

bulletHaim Levy and Marshall Sarnat, "International Diversification of Investment Portfolios," American Economic Review, September 1970, pp. 668-675.  This paper discusses the risk-adjusted return benefits of diversifying internationally.

bulletSteven L. Heston and K. Geert Rouwenhorst, "Does Industrial Structure Explain the Benefits of International Diversification?," Journal of Financial Economics, August 1994, pp. 3-27.  This paper concludes that diversifying overseas by country makes more sense than diversifying overseas by industry.  "We find that industrial structure explains very little of the cross-sectional difference in country return volatility, and that the low correlation between country indices is almost completely due to country-specific sources of return variation. Diversification across countries within an industry is a much more effective tool for risk reduction than industry diversification within a country."

bulletJean-Francois L'Her, Oumar Sy, and Mohamed Yassine Tnani, "Country, Industry, and Risk Factor Loadings in Portfolio Management," Journal of Portfolio Management, Summer 2002, pp. 70-79.  "... on average, country effects dominated industry effects ... diversification across countries was more efficient than diversification across industries."  While the study reinforced the supremacy of country diversification over the nine year period studied, it noted that industry diversification is becoming an increasingly important factor to consider in attempting to gain maximal benefits from international diversification.

bulletJeff Madura and Thomas J. O'Brian, "International Diversification for the Individual: A Review," Financial Services Review, 1991-1992, pp. 159-175.  An excellent review of early work in this area.  "... individual investors can benefit from international diversification, in effect increasing the efficiency of their portfolios, but as over time the world market continues to integrate, the benefits may decline."

bulletRichard O. Michaud, Gary L. Bergstrom, Ronald D. Frashure, and Brian K. Wolahan, "Twenty years of international equity investing: still a route to higher returns and lower risks?," Journal of Portfolio Management, Fall 1996, pp. 9-22 (2.45mb).  "... thoughtful international equity diversification can improve the risk/return characteristics of investors' portfolios."  "Globally diversified portfolios hold out the very real promise of less risk for the same level of expected return ... than can be achieved with domestic portfolios."  An outstanding paper.

bulletPatrick Odier and Bruno Solnik, "Lessons for International Asset Allocation," Financial Analysts Journal, March/April 1993, pp. 63-77.  "Clearly, foreign asset classes provide attractive risk diversification and profit opportunities."  "The risk and return advantages of international diversification are very large for investors in all the major countries."

bulletSandeep Patel and Asani Sarkar, "Stock Market Crises in Developed and Emerging Markets," Financial Analysts Journal, November/December 1998, pp. 50-61.  This paper finds that, while foreign stocks tend to become less good diversifiers during severe bear markets (i.e., when you most want their diversification benefits), the effect only occurs at very short time horizons.  For longer time horizons, their diversification benefit remains intact.  "We confirm the often-held belief that correlations between U.S. and emerging markets tend to become higher in times of market decline. However, this is only true for investors who hold stocks for short periods of time---for less than one year, in the case of Asian stocks. For longer-horizon investors the correlations remain very small even when markets fall. For these investors, emerging market [and developed market] stocks continue to provide important diversification benefits even during periods of significant market declines."

bulletMattias Persson, "Long-Term Investing and International Diversification," SSRN Abstract #302682, March 2002 (110kb).  This paper finds that "investors gain more from internationally diversified portfolios if the investment horizon is longer, that is, the [optimal] weight in the international assets are significantly higher for long investment horizons compared to the one-year horizon."

bulletChristopher B. Phillips, "International Equity: Considerations and Recommendations," Vanguard Investment Counseling & Research, November 24 2006.  "We weigh these risks against the potential benefits and conclude that:
bulletInternational stocks should be included in a domestic portfolio.
bulletEmpirical and practical issues suggest a starting allocation to international stocks of 20%, with an upper limit based on the proportion of the global market they represent."

bulletGarrett Quigley, "Investing in International Small Company Stocks," Institute for Fiduciary Education, July 8 2001 (38kb).

bulletKenneth S. Reinker and Ed Tower, "Predicting Equity Returns for 37 Countries: Tweaking the Gordon Formula," Duke University Working Paper, July 12 2002 (243kb).  This paper shows that there is good reason to believe that equity returns outside the US in the near future may be somewhat higher than domestic returns.

bulletJudson W. Russell, "The International Diversification Fallacy of Exchange-Listed Securities," Financial Services Review, Volume 7 Number 2 1998, pp. 95-106 (999kb). This paper assesses the diversification benefit of international equities traded on US markets (i.e., ADRs, closed-end country funds, and stocks of multinational corporations).  It concludes that "... the U.S. exchange-listed securities included in this study behave more like the host exchange than their home exchange.  This result suggests that these U.S. exchange-listed securities, on average, do not perform an international diversification role for U.S. investors."  This finding is consistent with a strategy of using conventional (open-end) mutual funds in order to achieve whatever international diversification is desired.

bulletAsani Sarkar and Kai li, "Should US Investors Hold Foreign Stocks?," Federal Reserve Bank of New York Current Issues In Economics and Finance, March 2002, pp. 1-6.  Also here (47kb).  This paper finds that, if short selling is not allowed, there is no diversification benefit for US investors to diversify in foreign developed markets.  However, diversification into Emerging Markets remains beneficial under this constraint.

bulletSteven Schoenfeld, J. Lisa Chen, and Binu George, "ETFs offer the World to Investors," A Guide to Exchange-Traded Funds, Fall 2001, pp. 111-118.  "Index based strategies are the most efficient way to gain international exposure, and should outperform the average actively managed fund."

bulletRex A. Sinquefield, "Where are the Gains from International Diversification?," Financial Analysts Journal, January/February 1996, pp. 8-14.  This paper argues that international value and small stocks are much better portfolio diversifiers than international large cap (e.g., MSCI EAFE) during the period studied (1975-1994).

bulletBruno Solnik, "Why not diversify internationally rather than domestically?," Financial Analysts Journal, July/August 1974, pp. 48-54.  Reprinted in Financial Analysts Journal, January/February 1995, pp. 89-94.  This paper is often cited as being among the first to lay out a convincing case for international diversification of equity portfolios.

bulletBruno Solnik, Cyril Boucelle, and Yann Le Fur, "International Market Correlation and Volatility," Financial Analysts Journal, September/October 1996, pp. 17-34.  "Thus, a passive international diversification strategy of investing 20 percent abroad is still beneficial from a risk viewpoint. The risk diversification benefits could be enhanced by ... including emerging markets, which are less correlated with the U.S. market than developed markets."  "The benefits of international risk reduction are still robust, but the case for international diversification may be overstated ..."

bulletBruno Solnik, "The View After a Quarter Century," Investment Policy, May/June 1998, pp. 9-12.  A 25 year retrospective after the 1974 paper.  "... the risk-diversification benefits of investing internationally are clear ... overweighting one's home country stocks has a cost in terms of risk."

bulletMeir Statman and Jonathan Scheid, "Global Diversification," Journal of Investing Management, forthcoming (524kb).  It suggests that dispersion of returns is a better measure of the diversification benefit of an asset class than is correlation.  "Dispersion of returns is a better measure of the benefits of diversification because it accounts for the effects of both correlation and standard deviation and because it provides an intuitive measure of the benefits of diversification."

bulletYesim Tokat, "International Equity Investing: Long-Term Expectations and Short-Term Departures," Investment Counseling & Research/ ANALYSIS, May 2004.  A good discussion of issues surrounding investing internationally, including rational reasons to weight foreign equities somewhat less than theory might suggest.  "... this paper shows that a portfolio diversified into non-U.S. stocks has typically provided higher returns or lower volatility than a U.S.-only portfolio over such periods. However, we contend that behavioral and practical considerations call for a smaller allocation than standard theory may suggest.".

bulletJim Wiandt, "Diversifying Internationally — Safe and Sensible," Indexfunds.com, July 25 2000.

Frontier Markets

Frontier Markets are countries that aren't developed enough to be considered "Emerging Markets."  Conceptually, whatever makes Emerging Markets desirable (e.g., low correlation with other stuff) should apply even moreso with Frontier Markets.  At the moment, there is a paucity of viable investing options in this asset class, the most viable perhaps being the The iShares MSCI Frontier Markets ETF (FM; E/R: 0.79%) or the Guggenheim Frontier Markets ETF (FRN; E/R: 0.65%).  They are quite new and somewhat thinly traded at present.  Also, see Emerging Markets.

bulletAmy Schioldager and Heather Apperson, "The Next Emerging Markets: Pioneering in the frontier," Journal of Indexing, January/February 2013, pp. 21-26, 60.  This paper argues for the benefits of investing in frontier markets.

bulletLawrence Speidell and Axel Krohne, "The Case for Frontier Equity Markets," Journal of Investing, Fall 2007, pp. 12-22.  This paper argues for the benefits of investing in frontier markets.

bulletKaren Umland, "Frontier Markets: New Investment Opportunities and Risks," Institute for Fiduciary Education, 2008 (95kb).  A good primer on frontier markets.

Hedge Funds

Some very wealthy investors invest in Hedge Funds.  Hedge Funds are similar to mutual funds, but they are more risky, less regulated, less liquid, and dramatically more expensive (not only do they have annual expense ratios of about 2%, but they typically take 20% or more of all gains as well).  We discourage use of Hedge Funds because they are so very expensive and because virtually all of them are actively managed.

"If you want to waste your money, it's a good way to do it." "If you want to invest in something where they steal your money and don't tell you what they're doing, be my guest." — Dr. Eugene Fama, commenting on the prudence of investing in hedge funds

"If there's a license to steal, it's in the hedge fund arena." — Dr. Burton Malkiel, commenting on the high costs of hedge funds

"It takes about 35 years of returns to say with any statistical confidence that stocks have a higher expected return than the risk-free rate. Think about a hedge fund that has equity-like volatility. If the manager’s alpha was as large as the market risk premium — which would be huge — it would also take about 35 years to be confident the manager has any value added — and that’s before his fees of '2 and 20.' Even if that phenomenal manager is out there, is he likely to stick around long enough for us to be able to figure out he wasn’t just lucky?" — Dr. Kenneth French, commenting on the probability of being able to determine that any particular hedge fund manager had ANY skill

bulletVikas Agarwal and Narayan Y. Naik, "Multi-Period Performance Persistence Analysis of Hedge Funds," London Business School Working Paper, February 2000 (95kb).  This study concludes that there may be some very short term persistence, but it is primarily the poor performers whose performance appears to persist — persistence among good performers is dramatically less.  This suggests that it may not make sense to pick a Hedge Fund based on past performance (but it may make sense to avoid those with particularly poor past performance).

If it doesn't make sense to choose a hedge fund based on past performance, how would one do it?  By minimizing fees?  Virtually all hedge funds have fees ranging from "much too high" to "truly outrageous."

bulletClifford Asness, Robert Krail, and John Liew, "Do Hedge Funds Hedge?," Journal of Portfolio Management, Fall 2001, pp. 6-19 (242kb).  Also here.  This excellent paper looks at the risk-adjusted performance of Hedge Funds. It notes that illiquidity of underlying investments, among other effects, tends to distort performance numbers. Specifically, it notes that hedge fund performance tends to lag the performance of the market. After taking that effect into account, it doesn't appear that Hedge Funds are very good at "hedging".

bulletChris Brooks and Harry M. Kat, "The Statistical Properties of Hedge Funds Index Returns and Their Implications for Investors," The University of Reading, October 31 2000 (108kb).  "Sharpe Ratios will substantially overestimate the true risk-return performance of (portfolios containing) hedge funds.  Similarly, mean-variance analysis will over-allocate to hedge funds and overestimate the attainable benefits from including hedge funds in an investment portfolio."

bulletBernard Condon, "Hedge Fund Investing For Dummies," Forbes, May 14 2004.  "Warning to hedge fund investors: You would do better giving your money to a monkey."  You may have to register (for free) to read this article.

bulletRichard M. Ennis and Michael D. Sebastian, "A Critical Look at the Case for Hedge Funds: Lessons from the Bubble," The Journal of Portfolio Management, Summer 2003, pp. 103-112 (235kb).  "Notwithstanding evident market timing skill — at least during the extraordinary period covered here — the performance of hedge funds has not been good enough to warrant their inclusion in balanced portfolios.  The high cost of investing in funds of funds contributed to this result.  Many practitioners believe markets are imperfectly efficient, providing astute investors an opportunity to exploit security mispricing.  This may well be true.  One wonders, though, how realistic it is to expect funds of hedge funds to realize competitive returns for their investors after costs upward of 5% per year."

bulletDavid Harper, "Introduction to Hedge Funds - Part Two: Advantages and Questions," Investopedia.com, December 10 2003.  A good discussion of Hedge Funds for laypeople.

bulletWilliam Jahnke, "Hedge Funds Aren't Beautiful," Journal of Financial Planning, February 2004, pp. 22-25.  Also here.  "Hedge funds are a great product for the hedge fund industry and its support apparatchik ... but are likely, on average, to produce a negative return contribution relative to a benchmark consisting of stocks, bonds, and cash."  A scathing review of the utility (or lack thereof) which hedge funds might have for investors.

bulletBurton Malkiel and Atanu Saha, "Hedge Funds: Risk and Return," Financial Analysts Journal, November/December 2005, pp. 80-88.  Also here.  "We conclude that hedge funds are far riskier and provide much lower returns than is commonly supposed."

bulletAlejandro Murguía and Dean T. Umemoto, "An Alternative Look at Hedge Funds," Journal of Financial Planning, January 2004, pp. 42-49.  Also here.  An outstanding, frank discussion of hedge funds.  "Advisors relying on simple return data and traditional evaluation measures presented in many hedge fund tear sheets will be vulnerable to inaccurate conclusions and possibly expose their clients’ investments to an inappropriate amount of risk."  "Although this [hedge fund] manager may seem to be providing excess returns, a multifactor model that incorporates the dynamic trading strategy of the fund will indicate that the fund manager is essentially creating these returns by taking on more risk through the specific trading strategy and not necessarily through alpha."

"Until further advances are made [in empirical research on what drives hedge fund returns], advisors may be better served by diversifying their clients’ portfolios with other un-represented asset classes traded on major exchanges such as emerging markets or international small cap stocks. These different asset classes have traditionally been very effective portfolio diversifiers. Additionally they allow advisors a degree of liquidity and transparency not currently present in hedge funds."

bulletMichael W. Peskin, Michael S. Urias, Satish I. Anjilvel, and Bryan E. Boudreau, "Why Hedge Funds Make Sense," Morgan Stanley Dean Witter, November 2000 (820kb).  This often-cited paper concludes that Hedge Funds are beneficial for institutional investors.  However, before going out and buying any Hedge Funds, be sure to view the other studies listed here.

bulletChristopher B. Philips, "Understanding Alternative Investments: A Primer on Hedge Fund Evaluation," The Vanguard Group, January 2005.  A good primer on Hedge Funds.

bulletNolke Posthuma and Pieter Jelle Van Der Sluis, "A Reality Check on Hedge Funds Returns," Working Paper, July 8 2003 (218kb).  This paper finds that backfill bias causes Hedge Fund return databases to systematically overstate actual realized returns by about four percent per annum.  This brings into serious question any and all studies which might conclude that hedge funds are beneficial.

bulletWilliam Reichenstein, "What are you Really Getting When You Invest in a Hedge Fund?," AAII Journal, July 2004.  "... a review of the historical returns of hedge funds and other alleged advantages finds them suspect."

bulletThomas Schneeweis, Hossein Kazemi, and George Martin, "Understanding Hedge Fund Performance: Research Results and Rules of Thumb for the Institutional Investor, "Center for International Securities and Derivatives Markets, University of Massachusetts, November 2001 (1.2mb).  An outstanding discussion of various topics surrounding Hedge Funds.

bulletNeil Weinberg and Bernard Cohen, "The Sleaziest Show On Earth," Forbes, May 24 2004.  "Hedge funds will suck in $100 billion this year from an ever-broader swath of investors. Pretty good for a business rife with exorbitant fees, phony numbers and outright thievery."  You may have to register (for free) to read this article.

bulletAndrew B. Weisman and Jerome D. Abernathy, "The Dangers of Historical Hedge Fund Data." (62kb)  This paper presents a means of describing performance characteristics of Hedge Fund managers.  It also points out two troubling biases which tend to be present in the data.  It calls these biases "Short-Volatility Bias" and "Illiquidity Bias."  These biases tend to cause Hedge Fund performance data to understate the actual risk/volatility of the funds (and therefore overstate risk-adjusted performance).

bulletAndrew B. Weisman, "Informationless investing and hedge fund performance measurement bias: dangerous attractions," Journal of Portfolio Management, Summer 2002, pp. 80-91.  This paper describes how three phenomena typical of hedge funds each conspire to overstate the risk-adjusted performance of Hedge Funds (and understate their correlation with other assets).  The result is that most hedge fund database data is significantly biased, calling into question any conclusions based on them.

bulletMartin Sewell's Hedge Fund Bibliography.  An excellent bibliography of relevant papers on this topic — most with full text!

High-Yield Bonds (Junk Bonds)

High-yield bonds (a.k.a., "junk bonds") are any bonds issued by companies which are judged to be poor credit risks (i.e., they may default on their debt).  Because the value of these bonds is so dependent on the likelihood of default (which in turn is linked with the well-being of the company), they behave both like conventional investment-grade bonds and like stocks.  If you must invest in High-Yield bonds, we suggest one of the following selections: the Vanguard High-Yield Corporate Fund (VWEHX), the TIAA-CREF High-Yield Bond Fund (TCHYX), the iShares iBoxx $ High Yield Corporate Bond Fund (HYG), the PowerShares High Yield Portfolio (PHB), or the SPDR Barclays High Yield Bond ETF (JNK).  Also, see Bonds.

bulletMarshall E. Blume, Donald B. Keim, and Sandeep A. Patel, "Returns and Volatility of Low-Grade Bonds 1977-1989," Journal of Finance, March 1991, pp. 49-74.  This paper found that:
 
bulletLow grade bonds realized higher returns than high grade bonds and lower returns than common stocks, and low grade bonds had lower volatility than high grade bonds due to their shorter durations (which are a direct result of the high coupon payments).
bulletThere is no relation between the age of low-grade bonds and their realized returns.
bulletLow grade bonds behave like both bonds and stocks.  Despite this complexity, there is no evidence that low grade bonds are systematically over- or under-priced.

bulletBradford Cornell and Kevin Green, "The Investment Performance of Low-grade Bond Funds," Journal of Finance, March 1991, pp. 29-48.  "When adjusted for risk ... the returns on low-grade bond funds are not statistically different from the returns on high-grade bonds."

bulletChristopher C. Finger, Vladimir Finkelstein, Jean-Pierre Lardy, George Pan, Thomas Ta, and John Tierney, "CreditGrades Technical Document," RiskMetrics Group, May 2002 (723kb).  This document describes an approach for quantifying credit/default risk of bond issuers.  Quantitative assessments of default risks using this approach are available free here.

bulletMartin S. Fridson, "Do High-Yield Bonds Have an Equity Component?," Financial Management, Summer 1994, pp. 82-84.  "Correlation coefficients consistently show that straight noninvestment-grade bonds trade nearly as much like stocks as pure debt instruments.  The case for an equity component in high-yield bonds is buttressed by theory.  In effect, a corporate bond is a combination of a pure interest rate investment and a short position on the issuer's equity.  For a highly rated company, the put is well out of the money.  In the case of a noninvestment-grade bond, however, default is a realistic enough prospect to enable the equity put to affect the bond's price materially.  Empirical research has confirmed the equity effect."

bulletRobert C. Merton, "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, May 1974, pp. 449-470 (1.58mb).  This paper suggests that corporate bonds can be modeled as riskless bonds (i.e., Treasury bonds) plus a put (i.e., an option to sell the stock) that bondholders issue to the owners of the company’s stock.  As the company's prospects become better, the stock's price increases, which causes the value of the put to decrease (which is good for the bondholders who issue the virtual puts), which causes the value of the bond to increase, which causes the yield on the bond to decrease.  On a separate line of thought, as the company becomes riskier (i.e., more volatile), the value of the put increases (which is bad for the bondholders who issue the virtual puts), which causes the value of the bond to decrease, which causes the yield on the bond to increase.  This is how high-yield bonds get to be high-yield bonds!

bullet"Papers about Credit Pricing and Credit Spreads," DefaultRisk.com.  An excellent bibliography on this topic.

Illiquidity Premium

There is reason to believe that investing in relatively illiquid investments will, in the long run and on average, yield higher expected returns than a more liquid investment of similar risk.  If this weren't true, then nobody would buy them, which would tend to drive down their price, which would tend to increase the expected returns until it was true.  Also, see Bid-Ask Spreads and Private Equity.

bulletViral V. Acharya and Lasse Heje Pedersen, "Asset Pricing with Liquidity Risk," NYU Stern School Working Paper, July 17 2003 (416kb).  Also here.  "It is shown that a security's return depends on its expected illiquidity and on the covariances of its own return and illiquidity with market return and market illiquidity."

bulletYakov Amihud and Haim Mendelson, "Liquidity and Stock Returns," Financial Analysts Journal, May/June 1986, pp. 43-48.  This paper documents an illiquidity premium for stocks (i.e., the higher the bid-ask spread (a proxy for illiquidity), the higher the expected return).

bulletYakov Amihud and Haim Mendelson, "Liquidity and Asset Prices: Financial Management Implications," Financial Management, Spring 1988, pp. 5-16.  Another excellent discussion of this topic.

bulletYakov Amihud and Haim Mendelson, "The Effects of Beta, Bid-Ask Spread, Residual Risk, and Size, on Stock Returns," Journal of Finance, June 1989, pp. 479-486.  Another excellent discussion of this topic.

bulletYakov Amihud and Haim Mendelson, "Liquidity, Maturity, and the Yields on U.S. Treasury Securities," Journal of Finance, September 1991, pp. 1411-1425.  This paper confirms the existence of the illiquidity premium in bonds as well as stocks.

bulletYakov Amihud and Haim Mendelson, "Liquidity, Asset Prices and Financial Policy," Financial Analysts Journal, November/December 1991, pp. 56-66.  "When designing an investment portfolio, a portfolio manager should consider not only the client's risk aversion, but also its investment horizon.  A short horizon calls for investing in liquid assets, whereas a long investment horizon enables the investor to earn higher net returns by investing in illiquid assets."

bulletS. Brown, M.A. Milevsky, and T.S. Salisbury, "Asset Allocation and the Liquidity Premium for Illiquid Annuities," Journal of Risk & Insurance, Volume 70 Number 3 (345kb).  Here's an earlier version.  "...the required liquidity premium is an increasing function of the holding period restriction, the subjective return from the market, and is quite sensitive to the individual's endowed (preexisting) portfolio."

bulletElroy Dimson and Bernd Hanke, "The Expected Illiquidity Premium: Evidence from Equity Index-Linked Bonds," London Business School Working Paper, December 18 2002 (289kb).  This paper found that: "There is an economically significant expected return premium associated with illiquidity."

bulletRoger G. Ibbotson, Zhiwu Chen, Daniel Y.-J. Kim, and Wendy Y. Hu, "Liquidity as an Investing Style", Yale School of Management Working Paper, August 23, 2012 (322kb).  Also here.  This paper found that liquidity is a style that is different from size, value/growth or momentum. Liquidity can potentially be combined with any of the other traditional styles.  Given these findings, one can combine turnover, size, value and momentum in a model to predict future returns for individual stocks.  They primarily use turnover as a proxy for liquidity.

bulletThomas M. Idzorek, James X. Xiong, and Roger G. Ibbotson, "The Liquidity Style of Mutual Funds", forthcoming in the Financial Analysts Journal.  More on the illiquidity premium.

bulletRobert Novy-Marx, "On the Excess Returns to Illiqidity," CRSP Working Paper # 5555, April 8 2004 (85.1kb).  This paper argues that the high expected returns observed on illiquid assets should be expected theoretically, but are not actually a premium for illiquidity, per se. Instead, illiquidity, like size, is a proxy for any unobserved risk. Liquidity should therefore have explanatory power in any asset pricing model that is not perfectly specified, with low measured liquidity forecasting high expected returns.

bulletLubos Pastor and Robert F. Stambaugh, "Liquidity Risk and Expected Stock Returns," Journal of Political Economy, 2003, vol. 111, no. 3, pp. 642-685 (318kb).  Also here and here.  This paper finds that illiquid stocks produced higher returns than did liquid stocks, adjusted for exposures to the market, sizze, value, and momentum.

bulletEvan Simonoff, "Ibbotson Finds Liquidity Rules," Financial Advisor, September 2010.  Summarizes the Chen/Ibbotson/Hu paper above.
 
bulletZebra Capital Management web site.  This firm is the only firm we are aware of which is presently managing passively-managed illiquidity funds.

Index Weighting

Index weighting refers to how a securities index weights the constituent securities in its index.  Virtually all indexes weight their constituent securities by market capitalization (notable exception: the Dow Jones Industrial Average).  This makes a certain amount of sense.  For example, if you assume that the market in aggregate is capable of optimizing its allocation, then a market-cap weighted index makes sense.  However, some have pointed out that the market doesn't price ANYTHING "right" all the time.  Some securities end up being overpriced and some being underpriced at all times.  Unfortunately, the ones that are most overpriced would tend to be the largest constituents of market-cap-weighted indexes, while the ones that are most underpriced would tend to be the smallest constituents.  Of course, if you could, you would prefer to concentrate your investments in those securities which are underpriced, rather than those that are overpriced.  This is the qualitative argument for considering alternative weighting schemes.  Note that equal weighting is perhaps the simplest of the infinitely many possible alternative (i.e., non-market-cap) weighting schemes.

bulletRobert D. Arnott, Jason C. Hsu, and Philip Moore, "Fundamental Indexation," Financial Analysts Journal, March/April 2005, pp. 83-99.  This was the paper that most spurred interest in this topic.  "In this paper, we examine a series of equity market indexes weighted by fundamental metrics of size, rather than market capitalization. We find that these indexes deliver consistent and significant benefits relative to standard capitalization-weighted market indexes."

bulletAndré F. Perold, "Fundamentally Flawed Indexing," Financial Analysts Journal, November/December 2007, pp. 31-37.  This paper fairly definitively debunks the idea that alternative weighting schemes can systematically outperform without a "value effect."  "Holding a stock in proportion to its capitalization weight does not change the likelihood that the stock is overvalued or undervalued. The notion that capitalization weighting imposes an intrinsic drag on performance is, accordingly, false. Fundamental indexing is a strategy of active security selection through investing in value stocks. It is a strategy not everyone can follow. Investors who have no skill in evaluating value tilts and other active strategies should hold the cap-weighted market portfolio."

bulletWilliam J. Bernstein, "Fundamental Indexing and the Three-Factor Model," Efficient Frontier, May 2006.  "Fundamental indexing is a promising technique, but its advantage over more conventional cap-weighted value-oriented schemes, to the extent that it exists at all, is relatively small."  "Even assuming that fundamental indexation produces returns in excess of its factor exposure, caution should be used in the practical application of this methodology. Differences in the expenses, fees, and transactional costs incurred in the design and execution of real-world portfolios can easily overwhelm the relatively small marginal benefits of any one value-oriented approach. The prospective shareholder needs to consider not only the selection paradigm used, but just who is executing it."

bulletEric Brandhorst, "Fundamentals-Weighted Indexing Offers New Insight on Value Investing," State Street Global Advisors, December 22 2005.  A good discussion of the topic.

bulletSrikant Dash, "Unveiling the next generation of Style Indexing," Standard & Poor's, September 20 2005.  This white paper performs some comparison analysis on the Standard & Poor's "True Style" indexes.  These indexes are the first widely available indexes to use a fundamentals-weighting paradigm.

bulletMatthew Hougan, "Quieting The Noise," Journal of Indexing, September/October 2007, pp. 22-23, 46.  This article discusses the (then) unpublished working paper by Harvard Business School professor André Perold which debunks the idea that non-cap weighting can be expected to give better results than cap weighting solely because overvaluing of stocks tends to bias a cap-weighted portfolio towards being overvalued.  The paper quantitatively proves that this is not true.  The qualitative explanation is apparently that even the largest stocks, by market cap, are just as likely to be undervalued as they are to be overvalued.  So, while weighting by market cap does bias you towards large market cap companies, those large market cap companies may either be overvalued or undervalued.  So the portfolio is NOT necessarily biased towards overvalued companies (because some/many of the largest constituents may, in fact, be undervalued).

bulletJason C. Hsu, "Cap-Weighted Portfolios are Sub-Optimal Portfolios," Social Science Research Network paper #647001, December 2004.  This working paper was the unpublished predecessor to the important Arnott/Hsu/Moore paper above.

bulletJason C. Hsu and Carmen Campollo, "New Frontiers in Index Investing," Journal of Indexes, January/February 2006, pp. 32-37, 58.  Makes a compelling case for weighting based on fundamentals.

bulletBurton G. Malkiel and Kerek Jun, "New Methods of Creating Indexed Portfolios: Weighing the possibilities of creating portfolios through Fundamental Indexing," Yale Economic Review, Summer/Fall 2009, pp. 45-49.  "... we found that the measure of excess returns above those explained by the F-F risk factors is statistically equal to zero."  This paper notes that claimed outperformance of fundamental indexing is completely explained by its increased exposure to small and value risk factors, contrary to the claims of the Arnott/Hsu/Moore paper above.  The paper further states a hypothesis that value investing is likely to be more fruitful during periods where the dispersion of value measures in the market is greatest.

bulletJack Treynor, "Perspectives: Why Market-Valuation-Indifferent Indexing Works," Financial Analysts Journal, September/October 2005, pp. 65-69.  A good discussion of this issue by one of the great minds of financial economics.

Inflation-Indexed Bonds (TIPS and I-Bonds)

bulletMarcelle Arak and Stuart Robinson, "I Bonds versus TIPS: Should individual investors prefer one to the other?," Financial Services Review, Volume 15 (2006), pp. 265-280.  "Despite I Bonds’ less attractive real rate, they have several features that add to their value. They may be redeemed before maturity, at par value plus accrued interest, eliminating price risk. In addition, taxes may be deferred until redemption. We estimate the value of these two features, and find that they are substantial and could potentially offset the lower real rate of I Bonds."

bulletZvi Bodie, "TIPS for 401(k) Plans," Pensions & Investments, April 29 2002, p. 12.  Makes a compelling case for using TIPS in tax-exempt portfolios.

bulletPeng Chen and Matt Terrien, "TIPS as an Asset Class," Ibbotson Associates, 1999 (104kb).  Also here.  This paper also appeared in Journal of Investing, Summer 2001, pp. 73-81.  Makes a compelling case for the diversification benefits of TIPS.

bulletScott Grannis, "Why Are TIPS So Cheap?," Investment Policy, September/October 1999, pp. 73-80 (584kb).

bulletP. Brett Hammond, "Understanding and Using Inflation Bonds," TIAA-CREF Institute research dialogue, September 2002, pp.1-18.  A good summary of issues surrounding TIPS.

bulletScott E. Hein and Jeffrey M. Mercer, "Are TIPS Really Tax Disadvantaged?  Rethinking the tax treatment of U.S. Treasury Inflation Indexed Securities," Texas Tech University Working paper, May 2003.  Also here.  This paper argues that, contrary to conventional wisdom, the taxation of TIPS is very similar to the taxation of conventional treasuries.  Thus TIPS are no more and no less tax disadvantaged than conventional treasuries.

bulletDouglas R. Kahl and Jerry L. Stevens, "Inflation-Indexed Treasury Bonds: Cash Flows, Taxes, and Simulated Returns," Journal of Financial Planning, April 1999.

bulletS.P. Kothari and Jay Shanken, "Asset Allocation with Inflation-Protected Bonds," Financial Analysts Journal, January/February 2004, pp. 54-70 (100kb).  "... the measures of [risk-adjusted] portfolio performance ... increase by about 15% with indexed bonds, as compared to conventional bonds."  "These observations suggest an important role for indexed bonds in a diversified investment portfolio.  The risk-reduction benefits of indexed bonds reflect fundamental economic relations and are likely to persist in the future, though the magnitude of those benefits will vary with the inflationary environment."

bulletR. McFall Lamm Jr., "Asset Allocation Implications of Inflation Protection," Journal of Portfolio Management, Summer 1998, pp. 93-100.  This paper concludes that efficient frontier portfolios almost always contain substantial quantities of TIPS.

bulletGerald Lucas and Timothy Quek, "A Portfolio Approach to TIPS," Journal of Fixed Income, December 1998, pp. 75-84.  "We do believe that TIPS can and should be an integral part of most investors fixed-income portfolios because of their favorable risk/reward profile."

bulletStan Luxenberg, "Best of Breed: Vanguard Inflation Protected Securities Fund Provides Protection Against Turbulence," Bloomberg Wealth Manager, April 2003, pp. 78-80.  Discusses the premier TIPS mutual fund.

bulletRichard Roll, "Empirical TIPS," Financial Analysts Journal, January/February 2004 (927kb).  "Given plausible assumptions about future expected returns, an investment portfolio diversified across equities and nominal bonds would be improved by the addition of TIPS."

bulletSue Stevens, "Using Inflation-Indexed Bonds in Your Portfolio," Morningstar, February 22 2001.  An excellent description of TIPS and I-Bonds.  You may have to register (for free) in order to view this article.

bulletAnne Tergesen, "TIPS for Your Portfolio: Inflation-indexed bonds look smart," Business Week, May 26 2003.

bullet"TIPS: A long-term investment, a short-term unknown," The Vanguard Group, August 30 2004.  An excellent discussion of rational short-term return expectations for TIPS.

bullet"Investing in Treasury Inflation Protected Securities," Vanguard Investment Counseling & Research, October 2 2006.  "TIPS make sense for many investors, as their characteristics offer some advantages over those of conventional Treasury bonds."

bullet"Inflation Linked Bonds: US Inflation-Indexed Bonds," Bridgewater Associates, 1996 (216kb).  An excellent primer on TIPS.

bulletUS Department of the Treasury I-Bonds web site.

Investor Psychology/Behavioral Finance

There are many well-documented behavioral phenomena which often conspire to rob investors of investment performance.  Being aware of them may help you to steer clear of them.

bulletH. Kent Baker and John F. Nofsinger, "Psychological Biases of Investors," Financial Services Review, 11(2) Summer 2002, pp. 97-116.  A survey of these issues.

bulletBrad M. Barber and Terrance Odean, “Trading is Hazardous to your Wealth: The Common Stock Investment Performance of Individual Investors,” Journal of Finance,  April 2000 Vol 60 No 2, pp. 773-806 (262kb).  Also SSRN Working Paper 219228 (263kb).

bulletBrad M. Barber, Terrance Odean, and Lu Zheng, "The Behavior of Mutual Fund Investors," September 2000 (227kb).

bulletBrad M. Barber and Terrance Odean, "The Courage of Misguided Convictions: The Trading Behavior of Individual Investors,"  Financial Analysts Journal, November/December 1999, pp. 41-55 (208kb).  Also SSRN Working Paper 219175 (143kb).

bulletNicholas Barberis and Richard Thaler, "A Survey of Behavioral Finance," Chapter 18 of Handbook of the Economics of Finance, September 2003.

bulletShlomo Benertzi and Richard H. Thaler, "Myopic Loss Aversion and the Equity Premium Puzzle," Quarterly Journal of Economics, February 1995, pp. 73-92 (1.82mb).  Also here (1.82mb).  This paper coined the term "myopic loss aversion."  It refers to the tendency to be unusually sensitive to short term losses, relative to short term gains.

bulletWerner F. M. De Bondt and Richard H. Thaler, "Does the Stock Market Overreact?," Journal of Finance, July 1985, pp. 793-805 (1.5mb).

bulletJustin Fox, "Is the Market Rational?," Fortune, December 9 2002.  A good even-handed discussion of the Efficient Market vs. Behavioral debate.

bulletRussell J. Fuller, "Behavioral Finance and the Sources of Alpha,"  Journal of Pension Plan Investing, Winter 1998 (51kb).

bulletUri Gneezy, Arie Kapteyn, and Jan Potters, "Evaluation Periods and Asset Prices in a Market Experiment," Journal of Finance, April 2003, pp. 821-838 (181kb).  This experiment confirms the earlier work of Thaler/Tversky/Kahneman/Schwartz below: investors who look at their account balances more often tend to lessen the riskiness of their portfolios more, which tends to lessen their long-term returns.  Thus, it tends to pay to ignore your periodic investment account statements.

bulletDavid A. Hirshleifer, "Investor Psychology and Asset Pricing," Journal of Finance, Vol. 56 2001, pp. 1533-1597 (568kb).  "This survey sketches a framework for understanding decision biases, evaluates the a priori arguments and the capital market evidence bearing on the importance of investor psychology for security prices, and reviews recent models."

bulletDaniel Kahneman and Mark W. Riepe, "Aspects of Investor Psychology: Beliefs, preferences, and biases investment advisors should know about," Journal of Portfolio Management, Vol 24 No. 4 Summer 1998 (71kb).  Kahneman is a Nobel Prize winner.

bulletDaniel Kahneman and Amos Tversky, "Prospect Theory: An Analysis of Decision under Risk," Econometrica, March 1979, pp. 263-292 (2.9mb).  This paper is one of the cornerstones of behavioral finance.  Kahneman is a Nobel Prize winner.

bulletMartin Sewell, "Behavioural Finance Bibliography,"  University College London.  An excellent bibliography of this topic.

bulletRobert J. Shiller, "Human Behavior and the Efficiency of the Financial System," Cowles Foundation for Research in Economics at Yale University, 1997.  An outstanding survey of behavioral finance topics.

bulletRobert J. Shiller, "From Efficient Market Theory to Behavioral Finance," Journal of Economic Perspectives, Volume 17(1) 2003.  Also, Cowles Foundation Discussion paper number 1385, 2002 (153kb).

bulletLivio Stracca, "Behavioural finance and aggregate market behaviour: where do we stand?," May 2002 (119kb).  A survey of the subject area.

bulletLarry Swedroe, "The Most Important Determinant of Investment Returns," Indexfunds.com, August 23 2002.

bulletRichard H. Thaler, "The End of Behavioral Finance," Financial Analysts Journal, November/December 1999, pp. 12-17 (95kb).

bulletRichard H. Thaler, Amos Tversky, Daniel Kahneman, and Alan Schwartz, "The Effect of Myopia and Loss Aversion on Risk Taking: An Experimental Test," Quarterly Journal of Economics, May 1997, pp. 647-661.  This outstanding paper shows that investors who look at their account balances more often tend to lessen the riskiness of their portfolios more, which tends to lessen their long-term returns.  Thus, it tends to pay to ignore your periodic investment account statements.

bulletRichard H. Thaler, published papers.  A list (with links to full text!) to published papers (since 1995) from one of Behavioral Finance's leading researchers.

bulletJason Zweig, "Do You Sabotage Yourself?," Money, May 2001, p. 74.  A great look at the pioneering work of Kahneman and Tversky.

bullet"Psychology and Behavioral Finance," Investor Home, 1999.  An excellent survey of this subject area.

bullet"DALBAR Issues 2001 Update to 'Quantitative Analysis of Investor Behavior' Report: More Proof that Market Timing Doesn't Work for the Majority of Investors," Dalbar, Inc.  A press release announcing the 2001 update to their annual study.  The study concludes that the average fund investor dramatically underperforms the market, presumedly due to excessive fees, failed attempts at market timing, and general lack of investing discipline.

bullet Undiscovered Managers Behavioral Finance Research Library.  An excellent bibliography (with links!) on this topic.

Life Insurance

bulletRobert J. Carney and Lise Graham, "A Current Look at the Debate: Whole Life Insurance Versus Buy Term and Invest the Difference," Managerial Finance, Vol 24 Number 12 1998, pp. 25-44.  This paper quantitatively compares a routine of "Buy Term and Invest the Difference" with buying a whole life policy.  "In terms of terminal wealth at age 65, a 'buy term and invest the difference strategy' outperforms variable universal life insurance [a type of whole life policy] in almost every instance."

bulletJagadeesh Gokhale and Lawrence J. Kotlikoff, "The Adequacy of Life Insurance," TIAA-CREF Institute research dialogue, July 2002.  This article describes a preferred means of determining life insurance need and compares it with several "conventional" approaches.

bulletEric E. Haas, "Life Insurance," Altruist Financial Advisors, 2004.

Long Term Care Insurance

bulletMichael D. Everett, Murray S. Anthony, and Gary Burkette, "Long-Term Care Insurance: Benefits, Costs, and Computer Models," Journal of Financial Planning, February 2005, pp. 56-68.  A good discussion of the issue.

bullet"Do You Need Long-Term Care Insurance?," Consumer Reports, November 2003, pp. 20-24.  See this summary rating.  Good objective advice on this issue.
 
bullet"A Shopper's Guide to Long-Term Care Insurance,"  National Association of Insurance Commissioners, 2003 (727kb).  Also available here (6.4mb) and here (573kb, 1999 version).
 
bulletThe Federal Long Term Care Insurance Program.  This non-subsidized, individually underwritten program probably should be included when shopping around if you are eligible for it.

Market Timing

Market timing refers to an attempt to time investing decisions so as to invest in assets which are expected to go up in the near term and divest from assets which are expected to go down in the near term.  The most simple implementation may be to shift one's assets between cash and stocks generically in order to take advantage of anticipated stock market movements.  As you can see from the below studies, attempts at market timing are only likely to work spuriously, due to occasional good fortune.  We strongly advocate against market timing in all its various forms.  Also, see Dollar Cost Averaging.

"The long, sad history of market timing is clear: Virtually nobody gets it right even half the time.  And the cost of getting it wrong wipes out the occasional gain of getting it right.  So the average investor's experience with market timing is costly.  Remember, every time you decide to get out of the market (or get in), the investors you buy from and sell to are the best of the big professionals.  (Of course, they're not always right, but how confident are you that you will be 'more right' more often than they will be?)  What's more, you will incur trading costs or mutual fund sales charges with each move—and, unless you are managing a tax-sheltered retirement account, you will have to pay taxes every time you take a profit." — Charles Ellis, Winning the Loser's Game

"The mathematical expectation of the speculator is zero. ... The expectation of an operation can be positive or negative only if a price fluctuation occurs — a priori it is zero." — Louis Bachelier, Theory of Speculation, 1900

bulletWilliam F. Sharpe, "Likely Gains from Market Timing," Financial Analysts Journal, March-April 1975, pp. 60-69.  "... unless a manager can predict whether the market will be good or bad each year with considerable accuracy, (e.g., be right at least seven times out of ten), he probably should avoid attempts to time the market altogether."  Written by a Nobel Prize winner.  Also, see the QuickMBA summary below.

bulletRobert H. Jeffrey, "The folly of stock market timing: no one can predict the market's ups and downs over a long period, and the risks of trying outweigh the rewards," Harvard Business Review, July-August 1984,  pp. 102-110.  "... no one can predict the market's ups and downs over a long period, and the risks of trying outweigh the rewards."  "... only a few wrong [market timing] decisions ... deflate the long-term results produced by market timers to the point where the timers would be just as well off out of the stock market entirely."  Also, see the update/summary by Rothery below.

bulletDavid M. Blanchett, "Is Buy and Hold Dead?  Exploring the Costs of Tactical Reallocation," Journal of Financial Planning, February 2011,  pp. 54-61.  "The research conducted for this paper suggests that a long-term static allocation strategy is likely to produce higher risk-adjusted perfrormance than a tactical asset allocation [i.e., market timing] approach."

bulletKirt C. Butler, Dale L. Domian, and Richard R. Simonds, "International Portfolio Diversification and the Magnitude of the Market Timer's Penalty," Journal of International Financial Management and Accounting, 6(3) 1995.  This excellent study looks at the magnitude of the "market timer's penalty."  Basically, the market timer of this study desires to move assets from one country's stock market to another, presumedly in order to increase risk-adjusted returns.  This study compares a random timer (i.e., a market timer known to have no timing skill) with a buy-and-hold investor.  It finds that the timer's portfolio is 26.2 percent more risky with the same expected return as that of the buy and hold investor.  Equivalently, at the same level of risk, the unskilled market timer gives up 20.8% of the buy-and-hold investor's expected return over the risk-free rate.  The study correctly notes that the potential benefits of market timing are greatest when correlation between assets is lowest.  But this is also precisely the time when the "market timer's penalty" is the greatest.  A market timer without skill should clearly get out of the market timing business.

bulletJess H. Chua, Richard S. Woodward, and Eric C. To, "Potential Gains from Stock Market Timing in Canada," Financial Analysts Journal, September/October 1987, pp. 50-56.  This interesting paper finds that it is more important to correctly predict bull markets than bear markets.  And buy-and-hold investors effectively have a 100% accuracy in correctly forecasting bull markets.  "If the investor has only a 50% chance of correctly forecasting bull markets, then he should not practice market timing at all.  His average return will be less than a buy-and-hold strategy even if he can forecast bear markets perfectly [which is an extremely heroic assumption]."

bulletWilliam G. Droms, "Market Timing as an Investment Policy," Financial Analysts Journal, January/February 1989, pp. 73-77.  "Gains from market timing over the long run require forecast accuracies that are likely to be beyond the reach of most managers.  More frequent forecasting increases the potential return available and reduces the level of accuracy required to outperform the market, but the transaction costs incurred in more frequent switching reduce the advantage."  Note that the study ignored the largest transaction cost for taxable accounts: short-term capital gains taxes.  If taken into consideration, this would have dramatically lessened the attractiveness of market timing as a strategy even more.  Note also that prediction becomes much harder as the time period of the predictions becomes shorter.

bulletJohn R. Graham and Campbell R. Harvey, "Market timing ability and volatility implied in investment newsletters' market timing recommendations," Journal of Financial Economics, December 1996, pp. 397-421 (2.2mb).  This excellent paper examines whether investing newsletters exhibit market timing ability.  "We find no evidence that letters systematically increase equity weights before market rises or decrease weights before market declines."

bulletRoy D. Henriksson, "Market Timing and Mutual Fund Performance: An Empirical Investigation," Journal of Business, January 1984, pp. 73-96 (4.55mb).  This paper investigated whether mutual funds exhibited market timing ability.  "The empirical results ... do not support the hypothesis that mutual fund managers are able to follow an investment strategy that successfully times the return on the market portfolio."

bulletBurton G. Malkiel, "Models of Stock Market Predictability," Journal of Financial Research, Winter 2004, pp. 445-459 (159kb).  This study finds that, while there appears to exist some reversion to the mean behavior, "... there is no evidence of any systematic inefficiency that would enable investors to earn excess returns."  In other words, market timing models aren't likely to be fruitful.

bulletMario Levis and Manolis Liodakis, "The Profitability of Style Rotation Strategies in the United Kingdom," Journal of Portfolio Management, Fall 1999, pp. 73-86 (131kb).  This paper looks at the feasibility of market timing between growth and value stocks, and between large and small stocks, in the United Kingdom (i.e., if you wanted to tactically switch between growth and value, or between large and small, how accurate would your forecasting need to be in order to beat a buy and hold strategy?).  "Our simulation results suggest that forecasting the size spread with a 65%-70% accuracy rate may be sufficient to outperform a long-term small-cap strategy. Beating a long-term value strategy, however, is markedly more difficult; it requires more than 80% forecasting accuracy."

bulletStephen L. Nesbitt, "Buy High, Sell Low: Timing Errors in Mutual Fund Allocations," Journal of Portfolio Management, Fall 1995, pp. 57-60.  "Our finding is that market-timing activity by mutual fund investors costs over 1% per year in return performance versus what mutual funds actually report their performance to be."

bulletAustin Pryor, "Timing isn't as Significant as You Might Expect," Sound Mind Investing, July 2003.  An excellent article pointing out that even perfect timing doesn't do much better than essentially random timing (actually, it compares a perfect timing of deposits routine with a dollar cost averaging routine).

bulletS P Umamaheswar Rao, "Market Timing and Mutual Fund Performance," American Business Review, June 2000, pp. 75-79.  "The empirical results do not support the hypothesis that mutual fund managers are able to follow an investment strategy that successfully times the return on the market portfolio."  Note that if highly paid, highly educated, highly experienced mutual fund managers can't successfully time the market with the assistance of large support staffs of brilliant analysts, it seems imprudent to think that any particular layperson can expect do so.

bulletNorman Rothery, "Timing Disaster," Stingy Investor.  An update to (and summary of) the Jeffrey article above.

bulletRobert Sheard, "Market-Timing Futility," Motley Fool, July 1 1998.  This article supports disciplined periodic investment.  It suggests that, since the long-term return difference between making periodic investments with perfect timing and with perfectly imperfect timing is small, the important thing is to be making the periodic investments, not to try to time the markets.  "...for a genuine long-term investor/saver ... it makes precious little difference when you invest."

bulletJohn D. Stowe, "A Market Timing Myth," Journal of Investing, Winter 2000, pp. 55-59.  This paper points out that the often cited reason for avoiding market timing isn't a valid reason.  Many articles suggest that, because the majority of the stock market's gains are confined to a small number of days or weeks or months, imperfect market timing is likely to result in missing those runups, with catastrophic results.  This article argues that the same rationale might suggest that the market timer is just as likely to miss the few worst days, weeks or months, which would tend to increase returns.  Both results would likely be due to luck.  Market timing still seems imprudent, but this isn't the reason why.

bulletJack L. Treynor and Kay K. Mazuy, "Can Mutual Funds Outguess the Market?," Harvard Business Review, July-August 1966, pp. 131-136.  "Are mutual fund managers successfully anticipating major turns in the stock market? ...  [the study] shows no statistical evidence that the investment managers of the 57 funds have successfully outguessed the market."

bullet"Market Timing," QuickMBA.  This excellent article summarizes the Sharpe paper above.

Modern Portfolio Theory

Modern Portfolio Theory refers to the idea that each investment ought to be selected in consideration of how it will interact with other assets in one's portfolio.  Modern Portfolio Theory is the basis for Mean Variance Optimization. 

You should also read about Modern Portfolio Theory Using Downside Risk, which is a definite improvement on traditional MPT.  Also, see the sections on Asset Allocation and Diversification.

bulletHarry Markowitz, "Portfolio Selection," Journal of Finance, March 1952 Vol 7, pp. 77-91 (603kb).  Also here This paper laid the groundwork for Modern Portfolio Theory, which earned Dr. Markowitz a Nobel Prize.  The paper suggests that, instead of asking the question, "What is a good investment?", you ought to be asking, "What is a good investment for my portfolio?"  It turns out that the answer is heavily dependent on what else happens to be in your portfolio.  All else being equal, it is more beneficial (from the standpoint of maximizing your risk-adjusted return) to take on an investment which is likely to have low correlations with other elements of your portfolio than to take on an investment which is likely to have high correlations with other elements of your portfolio.  Thus, investment selection should involve getting maximum diversification benefit (with respect to the rest of the portfolio) from each investment.

bullet James S. Ang, Jess H. Chua, and Anand S. Desai, "Efficient Portfolios versus Efficient Market," Journal of Financial Research, Fall 1980, pp. 309-319.  This paper tested whether constructing "efficient frontier" portfolios based on past information resulted in superior performance.  The conclusion was that it did not, thus confirming the weak form of the Efficient Market Hypothesis (note the two different uses of the word "efficient").  This also proves the imprudence of blindly using a Mean Variance Optimizer (using historical data as inputs) to construct a portfolio based on past data.

bulletWilliam J. Bernstein, "The Appropriate Use of the Mean Variance Optimizer," Efficient Frontier, January 1998.  An excellent discussion of how this tool can be used and (as is more usual) misused.  "Can you use an MVO to help you shape your portfolio? Yes, but you've got to be very careful. An MVO is like a chainsaw. Used appropriately, it is a powerful tool for clearing your backyard. Used inappropriately it will send your local surgeon's kids to college. Same thing with MVOs. Want to wind up in the financial version of intensive care? Just throw in some historical (or even plausible) returns and believe what comes out the other end."  "So, what use is the thing? Well, first and foremost an MVO is a superb teaching tool. Play around with one for a few hours and you will begin to acquire a grasp of the rather counterintuitive way in which real portfolios behave."  "... you have to realize that the chances of your allocation, no matter how skillfully chosen, winding up exactly on the future efficient frontier are zero."

bulletDavid G. Booth and Eugene F. Fama, "Diversification Returns and Asset Contributions," Financial Analysts Journal, May/June 1992, pp. 26-32.  This paper provides a means for estimating the compound return contribution of a particular asset to a portfolio containing it.  Basically, it suggests subtracting one half of the asset's covariance (with the portfolio) from the asset's arithmetic mean return.  The resulting compound return contribution can then be weighted with those of other assets in the portfolio to obtain the portfolio's compound return.  This takes into account the asset's diversification benefit to the portfolio.

bulletGregory Curtis, "Modern Portfolio Theory and Quantum Mechanics," Journal of Wealth Management, Fall 2002, pp. 7-13 (536kb).  An interesting discussion of the limits of MPT.

bulletFrank J. Fabozzi, Francis Gupta, and Harry M. Markowitz, "The Legacy of Modern Portfolio Theory," Journal of Investing, Fall 2002, pp. 7-20.  A good discussion of the impact of MPT.

bulletPaula H. Hogan, "Portfolio Theory Creates New Investment Opportunities," Journal of Financial Planning, January 1994, pp. 35-37.  A very basic summary of MPT.

bulletMalcolm Mitchell, "Is MPT the Solution — or the Problem?," Investment Policy, July 2002.  A bit long, but this paper is a very readable critique of Modern Portfolio Theory.

bulletJohn Rekenthaler, "Strategic Asset Allocation: Make Love, Not War," Journal of Financial Planning, September 1999, pp. 32-34.  Also here.  This article criticizes blindly following Mean Variance Optimizer (MVO) outputs during strategic asset allocation decision-making.  We agree with the criticism.  MVO is an interesting tool, but the results are extremely sensitive to the inputs.  The inputs are either guesses about the future or facts about the past.  Either way, we know that the data inputs are extremely imperfect predictors of the future, which causes decision-making based on them to be significantly less optimal than may appear to be the case.  Dr Eugene Fama on optimizers: "They're junk.  You're wasting your time with an optimizer, but if you have a lot of time to waste, go ahead."

Modern Portfolio Theory Using Downside Risk

This refers to an improvement on Modern Portfolio Theory.  MPT suggests using volatility as the measure of an investment's risk.  The problem is that this suggests that abnormally high returns are as much "risk" as abnormally low returns.  Most investors welcome high returns and are only sensitive to low returns.  This inspires the idea of considering risk only to be related to abnormal low returns and ignoring abnormal high returns.  The most useful such measure of risk would be to consider only abnormal returns below some customized "minimum acceptable return" to be "risk."  This section contains papers which develop this idea.

While traditional MPT suggests optimizing a portfolio on two statistics -- return and volatility, this "Improved" Modern Portfolio Theory suggests optimizing a portfolio on return and some measure of downside risk.  Also, see the sections on Asset Allocation, Diversification, Risk Measures, and especially, Modern Portfolio Theory.

bulletVijay S. Bawa and Eric B. Lindenberg, "Capital Market Equilibrium in a Mean-Lower Partial Moment Framework," Journal of Financial Economics, November 1977, pp. 189-200.  This paper derived a version of the Capital Asset Pricing Model which embraced Lower Partial Moment (a fancy term for downside risk) as the measure of risk.  This model is a more generalized version of the more traditional CAPM.

bulletW. Van Harlow, "Asset Allocation in a Downside-Risk Framework," Financial Analysts Journal, September/October 1992, pp. 28-40.  An outstanding article on use of downside risk measures (e.g., downside variance or downside deviation).  Downside risk turns out to be a superior risk measure (i.e., better than standard deviation) in circumstances where the return distribution is not symmetrical and/or a "Minimal Acceptable Return" can be defined.

bulletJames C.T. Mao, "Survey of Capital Budgeting," Journal of Finance, May 1970, pp. 349-360.  This paper is among the earliest to point out the superiority of a downside risk measure to the standard volatility measures of risk.  This paper addresses the question from the perspective of an executive and notes that the concept of "risk" held by many financial decision makers is better described by downside risk measures than by volatility.  "Variance is the generally accepted measure of investment risk in current capital budgeting theory. There are theoretical reasons for preferring semivariance and the evidence is more consistent with semi-variance than variance."

bulletDavid N. Nawrocki, "Market Theory and the use of Downside Risk Measures," Working Paper, 1996.  A good discussion of the issues.

bulletDavid N. Nawrocki, "The Case for Relevancy of Downside Risk Measures," Working Paper, 1999.  Also here.  Also here.  "We need downside risk measures because they are a closer match to how investors actually behave in investment situations."

bulletDavid N. Nawrocki, "A Brief History of Downside Risk Measures," Journal of Investing, Fall 1999, pp. 9-25 (135kb).  Also Here.  Also Here.  A comprehensive discussion of downside risk measures.  Downside risk turns out to be a superior risk measure (i.e., better than standard deviation) in circumstances where the return distribution is not symmetrical and/or a "Minimal Acceptable Return" can be defined.

bulletBrian M. Rom, "Using Downside Risk to Improve Performance Measurement," Presentation, Investment Technologies.  A good summary of issues surrounding use of downside risk measures.

bulletA.D. Roy, "Safety First and the Holding of Assets," Econometrica, July 1952, pp. 431-450.  This may have been the first paper to suggest the idea of a "minimal acceptable return" as part of the measurement of risk-adjusted return.  Roy suggested maximizing the ratio "(m-d)/σ", where m is expected gross return, d is some "disaster level" (a.k.a., minimum acceptable return) and σ is standard deviation of returns.  This ratio is just the Sharpe Ratio, only using minimum acceptable return instead of risk-free return in the numerator!

bulletTien Foo Sing and Seow Eng Ong, "Asset Allocation in a Downside Risk Framework," Journal of Real Estate Portfolio Management, July-September 2000, pp. 213-223.  A good discussion of the issues.

bulletPete Swisher and Gregory W. Kasten, "Post-Modern Portfolio Theory," Journal of Financial Planning, September 2005, pp. 74-85.  Also here.  This outstanding article describes a clear improvement on traditional portfolio theory (a.k.a., Modern Portfolio Theory).  The principle idea is changing the statistics being optimized.  In traditional portfolio theory, the idea is to get the highest return (or perhaps highest return above a risk-free rate) for some given amount of volatility.  This paper suggests instead trying to get the highest return (above some Minimal Acceptable Return) for some given amount of volatility, with the volatility calculated as the deviations below that Minimum Acceptable Return.

bulletSusan Wheelock, "Risky Business," Plan Sponsor, September 1995.  An excellent, very readable description of downside risk.  All of the performance measures discussed in the Performance Evaluation section are risk-adjusted measures.  The Sortino Ratio and the Upside Potential Ratio use downside risk as their risk measure.

Momentum Investing

Momentum investing refers to buying stocks that have recently done well and selling stocks that have recently done poorly.  There is evidence that this strategy can be successful in the short term before transaction fees are considered, but there is also some reason to believe that transaction fees may tend to "eat up" most, if not all, of any potential profits.  By transaction fees, you need to include brokerage commissions, bid-ask spreads, and market-impact costs.

bulletNarasimhan Jegadeesh and Sheridan Titman, "Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency," Journal of Finance, March 1993, pp. 65-91 (2.8mb).  This paper documented a short term (3 to 12 month) momentum effect for stocks.  The paper suggests that it may make sense to buy recent winning stocks and sell recent losing stocks.  Unfortunately, the paper doesn't investigate the costs associated with implementing such a strategy.  For the bad news on momentum investing, see the Keim and Lesmond/Schill/Zhou papers below.

bulletClifford S. Asness, Tobias J. Moskowitz, and Lasse H. Pedersen, "Value and Momentum Everywhere," Journal of Finance, January 2013.  Also here.  This paper finds both that positive value and momentum risk factors exist and that they are negatively correlated with each other.  This suggests that it may be beneficial to complement value stocks/funds with momentum stocks/funds.

bulletAdam L. Berger, Ronen Israel, Tobias J. Moskowitz, "The Case for Momentum Investing," AQR Funds, Summer, 2009.  An outstanding discussion of why momentum investing might make sense.  Specifically, it makes the case for AQR's momentum funds: AMOMX, ATMOX, ASMOX, ATSMX, AIMOX, and ATIMX.

bulletLouis K.C. Chan, Narasimhan Jegadeesh, and Josef Lakonishok, "Momentum Strategies," Journal of Finance, Dec 1996, pp. 1681-1713.  This paper concludes that, if transaction costs are ignored, momentum strategies were profitable over a 6 month horizon.  But it goes on to add, "A momentum strategy is trading-intensive, and stocks with high momentum tend to be smaller issues whose trading costs tend to be relatively high.  These implementation issues will reduce the benefits from pursuing momentum strategies."  This statement was confirmed in a quantitative fashion by the Keim and Lesmond/Schill/Zhou papers below.

bulletLouis K.C. Chan, Narasimhan Jegadeesh, and Josef Lakonishok, "The Profitability of Momentum Strategies," Financial Analysts Journal, Nov/Dec 1999, pp. 80-90.  This paper concludes that, if transaction costs are ignored, momentum strategies were profitable over a 6 to 12 month horizon.  But it goes on to add, "Chasing momentum can generate high turnover, so much of the potential profit from momentum strategies may be dissipated by transaction costs."  The latter statement was confirmed in a quantitative fashion by the Keim and Lesmond/Schill/Zhou papers below.

bulletJon Eggins and Robert J. Hill, "Momentum and Contrarian Stock-Market Indexes," Journal of Applied Finance, January 2010, pp. 78-94, also Australian School of Business Research Paper No. 2008 ECON 07, 2008.  This paper makes a case for the feasibility and desirability of "a new class of investable momentum and contrarian stock-market indices".

bulletEugene F. Fama and Kenneth R. French, "Multifactor Explanations of Asset Pricing Anomalies," Journal of Finance, Mar 1996, pp. 55-84.  Also here.  This paper studied several so-called market anomalies using the Fama-French three-factor model to see how much of them were redundant.  It found that the only anomaly to survive and not be explained by the size and value effects was short-term momentum.

bulletGene Fama, Jr., "The Big Mo," Financial Planning, May 2008, pp. 127-130.  The pragmatic article looks at a practical way that a mutual fund can make momentum work for it, while avoiding the negative effects.  This describes the rationale behind DFA's momentum screens.

bulletMark Hulbert, "Value and Momentum Investing, Together at Last" New York Times, September 13, 2008.  Discusses benefits from combining a momentum strategy with a value strategy.  Such a combination outperforms either approach individually due to the negative correlation between the momentum premium and the value premium.

bulletDonald B. Keim, "The Cost of Trend Chasing and the Illusion of Momentum Profits," Wharton School working paper, July 29 2003 (1.21mb).  While some studies, such as Jegadeesh/Titman above, suggest that significant abnormal returns can be gained by following short-term momentum strategies, few have investigated the trading costs such strategies would require.  This paper studies the actual trading costs incurred by such trading and finds that the costs exceed the (pre-cost) beneficial effect.  In other words, short-term momentum trading strategies may be successful before costs are considered, but they aren't sufficiently superior to a more conventional approach to justify their high transaction costs.

bulletDavid A. Lesmond, Michael J. Schill, and Chunsheng Zhou, "The Illusory Nature of Momentum Profits," Journal of Financial Economics, February 2004, pp. 349-380 (248kb).  Here's another copy.  This paper confirms the results of the Keim study above.  It finds that the stocks which generate the largest pre-cost momentum returns are the ones with the highest costs.  "We conclude that the magnitude of the abnormal returns associated with these trading strategies creates an illusion of profit opportunity when, in fact, none exists."

bulletBelle Mellor, "Why Newton was Wrong: Theory says that past performance of share prices is no guide to the future.  Practice says otherwise," The Economist, January 6, 2011.  A good layman's discussion of the momentum effect.
 
bulletTobias J. Moskowitz, "Momentum Investing: Finally Accessible for Individual Investors," Investments & Wealth Monitor, July/August 2010, pp. 22-26.  also here.  Good layperson's discussion of momentum.
 
bulletLynn O'Shaughnessy, "The Truth Behind Momentum Investing: The theory works, until you factor in trading costs," Financial Advisor, March 2004, pp. 61-62.  A good layman's discussion of the above Keim and Lesmond/Schill/Zhou papers.
 
bulletK. Geert Rouwenhorst, "International Momentum Strategies," Journal of Finance, February 1998, pp. 267-284.  This paper finds the momentum effect in all twelve european countries studied during the period 1980-1995.  This suggests that the momentum effect is NOT a result of data-mining and is a fundamental feature of stocks.

bulletLarry Swedroe, "How the four stock premiums work," CBS MoneyWatch, April 16, 2012.  A good layperson's discussion of the size of the Market, Size, Value, and Momentum premiums and their interaction with each other.

bulletShawn Tully, "Cliff Asness: A hedge fund genius goes retail," Fortune, December 19, 2011.  Profiles Cliff Asness, whose company AQR runs several passively-managed momentum funds.

bullet Momentum Investing Bibliography at AQR, one of the only firms we are aware of doing passively-managed momentum funds.

Mortgage Refinancing

Mortgage refinancing is largely an investing issue.  Homeowners are always wondering whether they should refinance, whether they should take additional cash out of their homes, what term of mortgage should they get, what points should they pay, etc.

bulletGene Amromin, Jennifer Huang, and Clemens Sialm, "The tradeoff between mortgage prepayments and tax-deferred retirement savings," Journal of Public Economics, 91 2007, pp. 2014-2040.  This paper addresses the related question of whether it is beneficial to pay off a mortgage early.  It suggests that, in general, it may be more beneficial to increase contributions to tax-deductible retirement plans (e.g., 401(k), 403(b), 457, deductible traditional IRA, etc.) rather than using that money to pre-pay mortgages.

bulletRandall S. Billingsley and Don M. Chance, "Reevaluating Mortgage Refinancing 'Rules of Thumb'," Journal of Financial Planning, Spring 1986, pp. 37-45.  A good discussion of the refinancing question.

bulletRich Fortin, Stuart Michelson, Stanley D. Smith, and William Weaver, "Mortgage refinancing: the interaction of break even period, taxes, NPV, and IRR," Financial Services Journal, Volume 16 (2007), pp. 197-209.  This paper goes into great detail regards how a professional can do a quantitative analysis in support of the refinancing question.

bulletDelbert C. Goff and Don R. Cox, "15-Year Versus 30-Year Mortgage: Which is the Better Option?," Journal of Financial Planning, April 1998.  This paper concentrates on the 15-year or 30-year question.

bulletVance P. Lesseig and John G. Fulmer, Jr., "Including a Decreased Loan Life in the Mortgage Decision," Journal of Financial Planning, December 2003, pp. 66-71.  This excellent paper thoroughly discusses the tradeoffs between a 15-year and a 30-year mortgage.  It also discusses the issue of how much to pay in points.

Mutual Fund Fees

Fees should be one of the primary considerations when selecting a mutual fund.  Much of investing requires dealing with uncertainties.  Fees, however, are one of the few important factors that you have complete control over.  It is almost always prudent to minimize fees, unless you have a compelling reason not to.

"Beware of small expenses; a small leak will sink a great ship." — Benjamin Franklin

bulletAntonio Apap and John M. Griffith, "The Impact of Expenses on Equity Mutual Fund Performance," Journal of Financial Planning, February 1998.  "... the results indicate that a significant inverse relationship exists between expense ratios and both abnormal and total returns ..."

bulletJohn C. Bogle, "What Can Active Managers Learn from Index Funds?," Lecture delivered on December 4 2000.

bulletJohn M.R. Chalmers, Roger M. Edelen, and Gregory B. Kadlec, "Fund Returns and Trading Expenses: Evidence on the Value of Active Management," Working Paper, October 15 2001.  "We find a strong negative relation between fund returns and trading expenses.  In fact, we cannot reject the hypothesis that every dollar spend on trading expenses results in a dollar reduction in fund value."  "In this paper we reject the hypothesis that active fund management enhances performance.  We attribute our strong results to our more direct measure of mutual fund trading expenses.  ... we find a strong negative relation between fund returns and trading expenses, while we find no relation between fund returns and turnover."

bulletStephen P. Ferris and Don M. Chance, "The Effect of 12b-1 Plans on Mutual Fund Expense Ratios: A Note," Journal of Finance, September 1987, pp. 1077-1082.  This paper notes that 12b-1 plan fees definitely increase current expenses and therefore decrease current returns.  It remains to be seen if they subsequently tend to allow mutual funds to realize economies of scale which then result in a net decrease in fees.  This paper is consistent with a strategy of avoiding funds that have 12b-1 fees.

bullet Irving L. Gartenberg v. Merrill Lynch Asset Management (694 F.2d 923 (2d Cir. 1982), cert denied , 461 U.S. 906(1983).  Would you like to sue your mutual fund managers for charging you outrageous fees?  This case established what you need to do to be successful (or at least, to avoid having your case dismissed): "To be guilty of a violation of § 36(b), therefore, the adviser-manager must charge a fee that is so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm's-length bargaining."

bulletEric E. Haas, "Mutual Fund Expense Ratios: How High is Too High?," Journal of Financial Planning, September 2004, pp. 54-63 (135kb).  Also here.  This paper quantitatively answers the question, "How high can a mutual fund's expense ratio be before it detracts from, rather than adds to, the expected risk-adjusted performance of a portfolio?"  This question is central to building a portfolio of mutual funds.  If the expense ratio of a prospective additional fund is too high, it will have a negative impact on your portfolio's performance.  This paper won the 2004 Journal of Financial Planning Call for Papers Competition.

bulletEric E. Haas, Comment to the SEC on proposed elimination of mutual fund 12b-1 fees, May 23 2004.  A frank discussion of the principal issues surrounding the SEC's prospective elimination of mutual fund 12b-1 fees.

bulletJason Karceski, Miles Livingston, and Edward S. O'Neal, "Portfolio Transactions Costs at U.S. Equity Mutual Funds," Zero Alpha Group Working Paper, November 15 2004 (68.2kb).  Here's an article about this study.  This paper quantitatively investigates the extent of "implicit" expenses incurred by mutual funds.  These expenses, not reflected in a fund's expense ratio, can be as high, or higher, than the "explicit" expense reflected by the expense ratio.

bulletTom Lauricella, "This is news?  Fund fees are too high, study says," SFGate.com, August 27 2001.  This article discusses a study which shows that mutual funds charge their retail customers higher fees than they charge their institutional customers for the same services.

bulletAlan Lavine and Gail Liberman, "Fund Managers are Good Stock Pickers but Expenses Kill Returns," Brill.com, January 2003.

bulletMiles Livingston and Edward S. O'Neal, "Mutual Fund Brokerage Commissions," Journal of Financial Research, Summer 1996, pp. 273-292.  "... investors can on average reduce exposure to high commissions by concentrating on larger, low expense ratio mutual funds."  "... some mutual fund managers may be charging investors high management fees even though investors finance much of the research services through soft dollar commissions."  This paper's conclusions reinforce the strategy of buying passively managed mutual funds with low expense ratios.

bulletJohn Markese, "How Much Are You Really Paying For Your Mutual Funds?," AAII Journal, February 1999.  "Loads and expenses decrease your mutual fund return dollar-for-dollar. Looking forward—the best direction in which to look to make judgments—loads and expenses are predictable; returns are not. Loads are sales commissions paid to sales personnel and have only a negative impact on fund performance. Fund expenses that are significantly higher than the average for a category are difficult for fund managers to overcome."

bulletRobert W. McLeod and D.K. Malhotra, "A Re-Examination of the Effect of 12b-1 plans on Mutual Fund Expense Ratios," Journal of Financial Research, Summer 1994, pp. 231-240.  "Our study confirms ... that 12b-1 charges are a deadweight cost to shareholders."  "... the introduction of 12b-1 plans has not resulted in the benefits suggested by proponents ..."  The conclusions of this paper are consistent with a strategy of avoiding mutual funds with 12b-1 fees.

bulletRoss M. Miller, "Measuring the True Cost of Active Management by Mutual Funds," SUNY Albany, June 2005 (92.4kb).  This interesting paper derives a method for allocating fund expenses between active and passive management and constructs a simple formula for finding the cost of active management.  Computing this “active expense ratio” requires only a fund’s published expense ratio, its R-squared relative to a benchmark index, and the expense ratio for a competitive fund that tracks that index. At the end of 2004, the mean active expense ratio for the large-cap equity mutual funds tracked by Morningstar was 7%, over six times their published expense ratio of 1.15%.  More broadly, funds in the Morningstar universe had a mean active expense ratio of 5.2%, while the largest funds averaged a percent or two less.

bulletMatthew R. Morey, "Should You Carry the Load?  A Comprehensive Analysis of Load and No-Load Mutual Fund Out-of-Sample Performance," Pace University, 2001.  This paper debunks the myth that loaded mutual funds outperform no-load funds.  It concludes that, even before loads are figured in, no-load funds tend to outperform loaded funds.

bulletSpuma M. Rao, "Does 12b-1 Plan Offer Economic Value to Shareholders of Mutual Funds?," Journal of Financial and Strategic Decisions, Fall 1996, pp. 33-37.  This paper examined the effect of 12b-1 fees on mutual fund performance.  "Results suggest that the existence of 12b-1 plans ... did not offer economic value to shareholders."

bulletS P Umamaheswar Rao, "Economic Impact of Distribution Fees on Mutual Funds," American Business Review, January 2001, pp. 1-5.  "The main conclusion is that the 12b-1 plan did not offer economic value to shareholders."

bulletJohn D. Rea, Brian K. Reid, and Travis Lee, "Mutual Fund Costs, 1980-1998," Investment Company Institute Perspective,  September 1999, pp. 1-12 (452kb).  Note that the ICI's studies tend to be flawed in that they rely on sales-weighted costs of funds in their analyses of fund costs.  Their conclusion that fund costs are decreasing isn't valid based on that information — their conclusion should be that consumers' sensitivity to costs is increasing, but costs are also increasing (which the ICI studies tend not to measure).

bulletPaul F. Roye, Director of US Securities and Exchange Commission Division of Investment Management, Memorandum on Mutual Fund Fees, June 9 2003 (1.25mb).  This memo expounds on the SEC's position on various issues related to Mutual Fund Fees.  It was generated in response to this letter.

bulletStephen Schurr, "False Advertising: The Truth about 12b-1 Fees," TheStreet.com, August 13 2003.  A great article about 12b-1 fees.

bulletStefan Sharkansky, "Mutual Fund Costs: Risk Without Reward," PersonalFund.com, July 2002 (189kb).  "... what, if anything, can an investor do to improve the odds of selecting a winning fund, and to reduce the odds of getting stuck with a losing fund?  The answer is surprisingly simple: invest only in low-cost funds and avoid high-cost funds."

bulletNicolaj Siggelkow, "Expense Shifting: An Empirical Study of Agency Costs in the Mutual Fund Industry," Wharton School, January 1999 (208kb).  This paper exposes 12b-1 fees as a significant detriment to mutual fund performance (i.e., the paper supports a strategy of avoiding mutual funds that charge 12b-1 fees).

bulletNicolaj Siggelkow, "Caught between two principals," Wharton School, May 2004 (137kb).  Here's the link to the actual paper.  This paper finds that mutual funds tend, through their actions, to favor the interests of the fund company over the interests of fund shareholders.

bulletDawn Smith, "A Baby Step on Fund Fees," SmartMoney.com, January 10 2001.  A summary of the SEC report below.

bulletLori Walsh, "The Costs and Benefits to Fund Shareholders of 12b-1 Plans: An Examination of Fund Flows, Expenses, and Returns," U.S. Securities and Exchange Commission, April 26 2004 (785kb).  "The paper finds that while funds with 12b-1 plans do, in fact, grow faster than funds without them, shareholders are not obtaining benefits in the form of lower average expenses or lower flow volatility."  "These results highlight the significance of the conflict of interest that 12b-1 plans create. Fund advisers use shareholder money to pay for asset growth from which the adviser is the primary beneficiary through the collection of higher fees."

bulletNeil Weinberg and Emily Lambert, "The Great Fund Failure," Forbes.com, September 15 2003.  An outstanding discussion of issues surrounding excessive mutual fund fees.

bulletGreg Wolper, "Girl Scout Cookies, the Mutual Fund Way," Morningstar.com, January 27 2004.  A great tongue-in-cheek article about how girl scout cookie sales might work if they were sold like mutual funds.  You may have to register (for free) to read this article.

bullet"Division of Investment Management: Report on Mutual Fund Fees and Expenses," U.S. Securities and Exchange Commission, December 2000.  A comprehensive study of trends in mutual fund fees and expenses.

bullet"Mutual Fund Fees: Additional Disclosure Could Encourage Price Competition," United States General Accounting Office, June 2000 (9.3mb).  This report recommends that the SEC require mutual funds to disclose the approximate dollar amount that each individual implicitly pays in fees on periodic statements.

bullet"Mutual Fund Fees and Expenses", Investment Company Institute.  Links to several studies on this topic.  Note that the ICI's studies tend to be flawed in that they rely on sales-weighted costs of funds in their analyses of fund costs.  Their conclusion that fund costs are decreasing isn't valid based on that information — their conclusion should be that consumers' sensitivity to costs is increasing, but costs are also increasing (which the ICI studies tend not to measure).

bullet"Mutual Fund Fees and Expenses," U.S. Securities and Exchange Commission, October 19 2000.  A brief tutorial on the major types of fees associated with mutual funds.

bullet"Funds With Low Expense Ratios Outperforming Their More Expensive Peers Over Long Term, Says S&P," Standard & Poor's, June 11 2003.  An excellent short press release which makes the case for minimizing a mutual fund's expense ratio, all else being the same.  Interestingly, you'll note from studying the data that the difference in expense ratios has a strong correlation with the difference in returns (implying that, for every dollar of additional expenses paid, you lose a dollar in returns).

Mutual Fund Persistence

Mutual Fund Persistence refers to the question of whether past performance of a mutual fund has any positive correlation with future performance.  The lack of persistence in mutual funds (and pension funds, etc.)  is a large part of the empirical argument for passive management.

The root of this issue is whether it is possible for ANY actively-managed mutual fund to consistently achieve superior risk-adjusted returns.  This is an important question.  If the answer is no, then it implies that actively managed funds should be avoided (because they tend to be more expensive).  If the answer is yes, then it inspires a separate, but equally important, question of whether it is possible to identify the few funds which will consistently outperform in advance.  We believe that, while it is possible for an actively managed fund to occasionally achieve superior returns through good luck, it is impossible to identify those lucky mutual fund managers in advance.  The majority of well-done studies tend to support a lack of persistence for all but the worst performing equity mutual funds.

bulletMark M. Carhart, "On Persistence in Mutual Fund Performance," Journal of Finance, March 1997, pp. 57-82 (3.1mb).  This may be the best and most authoritative study of persistence.  The study concludes that there is virtually no persistence, except for the worst performing mutual funds (which is explainable either by their having high fees, poor strategies, and/or tax-loss harvesting by investors).

bulletWilliam J. Bernstein, "Sucker's Bet: Overwhelming empirical evidence shows that attempting to select successful active managers is virtually impossible, so why try?," Financial Planning, April 1 2001.

bulletStephen J. Brown and William N. Goetzmann, "Performance Persistence," Journal of Finance, June 1995, pp. 679-698 (2.1mb).  This paper concludes that some persistence does seem to exist among mutual funds, but it is mostly due to poor performers (i.e., poor performance persists, but good performance doesn't).  This paper's conclusions confirm the prudence of a passive strategy of investing in low cost index mutual funds.

bulletKeith C. Brown and W. Van Harlow, "Staying the Course: Mutual Fund Investment Style Consistency and Performance Persistence," University of Texas Working Paper, April 2 2004 (408kb).  This paper tests and finds support for each of the following hypotheses:

bulletA negative relationship exists between a fund's style consistency and portfolio turnover.
bulletA positive relationship exists between a fund's style consistency and the future actual and relative returns it produces.
bulletA positive relationship exists between the consistency of a portfolio's investment style and the persistence of its performance over time.

bulletJeffrey A. Busse, Amit Goyal, and Sunil Wahal,, "Performance Persistence in Institutional Investment Management ," Journal of Finance, April 2010, pp. 765-790.  An older version is also here.  "... there is only modest evidence of persistence in three-factor models and little to none in four-factor models."  This paper largely confirmed the results of the older Carhart paper above, using similar methodology.

bulletJames L. Davis, "Mutual Fund Performance and Manager Style," Financial Analysts Journal, January/February 2001, pp. 19-27.  "The results of this study are not good news for investors who purchase actively managed mutual funds."

bulletF. Larry Detzel and Robert A. Weigand, "Explaining Persistence in Mutual Fund Performance," Financial Services Review, 1998 Vol 7 issue 1, pp. 45-55 (990kb).  This paper found that there was virtually no persistence that could not be explained by market risk, expense ratios, market capitalization, and book to market ratio.

bulletMiranda Lam Detzler, "The Value of Mutual Fund Rankings to the Individual Investor," Journal of Business and Economic Studies, 2002 Vol 8 issue 2, pp. 48-72 (97kb).  "This paper investigates whether an investment strategy based on mutual fund rankings by the popular press can earn abnormal returns ... The ranked funds have higher excess returns relative to peer funds during the pre-ranking period, but have similar excess returns as their peers in the post-ranking period. These results do not support the short-term persistent performance hypothesis. The ranked funds also have higher risk, measured by standard deviations, in both the pre- and post-ranking periods."

bulletWilliam G. Droms and David A. Walker, "Performance Persistence of International Mutual Funds," Global Finance Journal, 12 2001, pp. 237-248.  This paper finds that, consistent with studies of domestic funds, international funds also have no unexplainable persistence beyond a one-year momentum effect.

bulletRonald N. Kahn and Andrew Rudd, "Does Historical Performance Predict Future Performance?," BARRA Newsletter, Spring 1995 (735kb).  This paper also appeared in Financial Analysts Journal, November/December 1995, pp. 43-52.  This paper finds no persistence in stock funds, but some persistence in bond funds.  However, the persistence in bond funds still points to a passive strategy because the small benefit of being able to pick winning (active) bond funds is more than cancelled out by the disadvantage of higher expense ratios associated therewith.

bulletBurton G. Malkiel, "Returns from Investing in Equity Mutual Funds 1971 to 1991," Journal of Finance, Vol L No. 2 June 1995, pp. 549-572.  Dr. Malkiel finds persistence in the 70s, but not in the 80s.  He concludes that if persistence exists, it is not robust and that passive management appears to be the best choice.

bulletShawn Phelps and Larry Detzel, "The nonpersistence of mutual fund performance," Quarterly Journal of Business and Economics, Spring 1997, pp. 55-69.  "The lack of reliable positive persistence indicates that investors should not select mutual funds on the basis of past performance."

bulletGary E. Porter and Jack W. Trifts, "The Performance Persistence of Experienced Mutual Fund Managers," Financial Services Review, 1998 Vol 7 issue 1, pp. 57-68 (1.04mb).  The study finds that having an experienced manager at the helm of a fund doesn't help its performance persistence.  "While superior performance is not persistent, there is evidence that inferior performance does persist."

bulletGarrett Quigley and Rex A. Sinquefield, "The Performance of UK Equity Unit Trusts," Institute for Fiduciary Education, October 1 1999 (198kb).  This paper also appeared in Journal of Asset Management, February 2000.  This provides a look at mutual fund persistence in the United Kingdom.  "Does performance persist?  Yes, but only poor performance."

bulletJenke R. ter Horst, Theo E. Nijman, and Marno Verbeek, "Eliminating Biases in Evaluating Mutual Fund Performance from a Survivorship Free Sample," October 1998.  "Our results are in accordance with the persistence pattern found by Carhart [1997], and do not support the existence of a hot hand phenomenon in mutual fund performance."

Passive vs. Active Management

The question of whether to invest in actively or passively managed mutual funds is an important one.  Both theoretical arguments (see Efficient Market Hypothesis) and empirical evidence (see Mutual Fund Persistence) suggests that passive management (e.g., investing in index mutual funds) is usually prudent.

bulletWilliam F. Sharpe, "The Arithmetic of Active Management," Financial Analysts Journal, January/February 1991, pp. 7-9.  "If 'active' and 'passive' management styles are defined in sensible ways, it must be the case that (1) before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar and (2) after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar.  These assertions will hold for any time period."  This brief, lucidly written article is perhaps the simplest and most persuasive theoretical case ever made for passive management.  Written by a Nobel Prize winner.

bulletAnna Bernasek, "The Man Your Fund Manager Hates," Fortune, December 1999.  An interview with Burton Malkiel, author of A Random Walk Down Wall Street: The Best Investment Advice for the New Century.

bulletJohn C. Bogle, "Selecting Equity Mutual Funds: Why is it virtually impossible to pick the winners, yet so easy to pick a winner?  And what should you do about it in the 1990s?," Journal of Portfolio Management, Winter 1992, pp. 94-100.  "Picking the winning fund is virtually impossible, because reliance on past performance is of no apparent help."  "Picking a winning fund is made easy by selecting a passive all-market index fund, or perhaps by engaging in thorough research and careful analysis."  "... intelligent investors simply cannot disregard the heavy burden of costs endemic to most actively managed funds, and clearly should consider index funds for at least a core portion of their equity holdings."

bulletJohn C. Bogle, "Equity Fund Selection: The Needle or the Haystack?," a speech presented before the Philadelphia Chapter of the American Association of Individual Investors, November 23 1999.

bulletJohn C. Bogle, "Three Challenges of Investing: Active Management, Market Efficiency, and Selecting Managers," a speech given in Boston on October 21 2001.

bulletDavid G. Booth, "Index and Enhanced Index Funds," Dimensional Fund Advisors, April 2001.  "In summary, logic and empirical evidence overwhelmingly favor an investment approach based on index funds. The returns are higher and the fees are lower. The returns of an asset class are assured. The discipline keeps the portfolio fully invested, thereby avoiding the adverse timing pitfall inherent in investment committees and active managers."

bulletEric Brandhorst, "Problems with Manager Universe Data," State Street Global Advisors, November 22 2002.  This article debunks the often repeated notion that active managers tend to beat passively managed portfolios in small and international asset classes.  "Even the two asset classes (international equity and U.S. small cap) that are often held up as examples of arenas where active managers can consistently add value lose their active management luster when appropriate adjustments are made to the median manager data."

bulletAnthony W. Brown, "Why Indexing Makes Sense," Hammond Associates, June 1999.  An excellent layperson's discussion of why passive management makes sense.

bulletWarren E. Buffet, "How to Minimize Investment Returns," Berkshire Hathaway 2005 Annual Report, 2005.  An extremely brief, tongue-in-cheek look at the active vs. passive management issue, indirectly by focusing on fees charged by investing middle men.  Also see the similar Sharpe 1976 below.

bulletScott Burns, "Major Index Funds are Superior, not 'Average'," Dallas Morning News, September 21 2004.  Also here.

bulletJohn M.R. Chalmers, Roger M. Edelen, and Gregory B. Kadlec, "Fund Returns and Trading Expenses," Working Paper, August 30 2001 (183kb).  "We find a strong negative relation between fund returns and trading expenses.  In fact, we cannot reject the hypothesis that every dollar spent on trading expenses results in a dollar for dollar reduction in fund value."  "... our evidence suggests that fund managers fail to recover any of their trading expenses [i.e., trading does not increase returns]."  "In this paper, we reject the hypothesis that active fund management enhances performance."  This paper supports a passive investing strategy.

bulletCharles Duhigg, "Fund Fees Complicate the Manager-vs.-Index Equation," Washington Post, July 6 2003, p. F04.  A very basic article discussing the passive vs. active issue at a high level.

bulletEdwin J. Elton, Martin J. Gruber, Sanjiv Das, and Matthew Hlavka, "Efficiency with Costly Information: A Reinterpretation of Evidence from Managed Portfolios," Review of Financial Studies, 6(1) 1993, pp. 1-22 (260kb).  "Mutual Fund managers underperform passive portfolios.  Furthermore, funds with higher fees and turnover underperform those with lower fees and turnover."

bulletRichard M. Ennis and Michael D. Sebastian, "The Small -Cap Alpha Myth," Journal of Portfolio Management, Spring 2002, pp. 11-16 (180kb).  This paper debunks the popular perception that it is beneficial to use active management in small-cap stocks.

bulletEugene F. Fama and Kenneth R. French, "Luck versus Skill in the Cross Section of Mutual Fund Returns," Journal of Finance, October 2010, pp. 1915-1947.  This paper uses an approach similar to that used in the Murphy paper below, only using more real-world data.  This paper takes real data of mutual fund performance (i.e., which shows a range of estimated alphas) and deliberately adjusts each fund's performance data set so that its alpha is zero (i.e., its estimated alpha is subtracted from each data point).  Thus, each synthetic fund now has a known alpha exactly equal to zero.  This data base of synthetic zero alpha funds was then used to generate 10,000 monthly returns using a bootstrap sampling approach (with replacement).  These monthly returns yielded an example of what might be expected in real life if it were true that the true alphas of each fund were, in fact, exactly equal to zero.  The paper found that the distribution of realized alphas from the simulation (i.e., where it was known that the true alpha was zero -- that any resulting apparent alpha was merely due to good luck) was similar to that found for actual funds.  In fact, if anything, the distribution of alpha estimates for real funds showed that the actual alpha of real funds was probably negative, but no better than approximately zero.  Thus, good alpha estimates for real funds were consistent with what would be expected through luck alone (i.e., suggesting that good results of actively managed funds are due to good luck and not skill).

bulletEugene F. Fama and Kenneth R. French, "Luck versus Skill in Mutual Fund Performance," Fama/French Forum, November 30, 2009.  This is a slightly less technical description of the above Fama/French paper.  The paper uses a simulation to show that the actual alphas of actively managed funds are no better than, and probably worse than, those expected purely through good luck alone (i.e., worse than they would be through simulations with alphas pre-programmed to be exactly zero).  This suggests that apparently good performance of actively managed funds is generally consistent with what would be expected through luck alone (i.e., good performance should generally be attributed to good luck and not to skill).  However, this is not evident from merely evaluating an active manager's performance, even if it is adjusted for risk (e.g., a calculated "alpha").

bulletRich Fortin and Stuart Michelson, "Indexing vs. Active Mutual Fund Management," Journal of Financial Planning, September 2002, pp. 82-94.  Also here.  This paper supports the superiority of passive management.  Unfortunately, they used a database which is subject to survivorship bias (which they readily admit, but seem to ignore when generating their conclusions).  Therefore, their observation that active management appears to be beneficial for small and international stocks cannot be considered conclusive.

bulletAlex Frino and David R. Gallagher, "Tracking S&P 500 Index Funds," Journal of Portfolio Management, Fall 2001, pp. 44-55.  "Active funds on average significantly underperform passive benchmarks. S&P 500 index mutual funds, on the basis of this research, earned higher risk adjusted excess returns after expenses than large-capitalization-oriented active mutual funds in the period examined."  "These findings strongly suggest no economic benefit accrues to the average investor using actively managed equity mutual funds."

bulletBeverly Goodman, "Passive Management: It's Not an Oxymoron," TheStreet.com, August 19 2002.  A very readable article.

bulletBeverly Goodman, "Active Mismanagement: The Case for Index Funds," TheStreet.com, August 12, 2002.

bulletPhilip Halpern, Nancy Calkins, and Tom Ruggels, "Does the Emperor wear clothes or not? The final word (or almost) on the parable of investment management," Financial Analysts Journal, July/August 1996, pp. 9-15. This paper uses the children's tale of "The Emperor's New Clothes" to expose how investors may be fooled into believing that active management is beneficial (just as the Emperor was fooled into believing that his tailors had made him new clothes when he was, in fact, naked).  "The questions are: 1. Have plan sponsors, like the Emperor, been tricked by the tailors of the investment management business into believing that active management adds value? 2. Can money managers be identified and hired that will consistently beat the market? Most studies seem to suggest that the answer to the first question is yes, and the answer to the 2nd question is no."

bulletBurton G. Malkiel, "Reflections on the Efficient Market Hypothesis: 30 Years Later," The Financial Review, February 2005, pp. 1-9.  "The evidence is overwhelming that active equity management is, in the words of Ellis (1998), a 'loser’s game.' Switching from security to security accomplishes nothing but to increase transactions costs and harm performance. Thus, even if markets are less than fully efficient, indexing is likely to produce higher rates of return than active portfolio management. Both individual and institutional investors will be well served to employ indexing"

bulletThomas P. McGuigan, "The Difficulty of Selecting Superior Mutual Fund Performance," The Journal of Financial Planning, February 2006, pp. 50-56.  An interesting study.  They conclude that the overwhelming majority of actively managed funds underperform passive alternatives.  While they concede that there have been a very small minority of actively managed funds which have consistently outperformed passive alternatives, it is "difficult" to identify them in advance.

bulletRoss M. Miller, "Measuring the True Cost of Active Management by Mutual Funds," SUNY Albany, June 2005 (150kb).  This interesting paper derives a method for allocating fund expenses between active and passive management and constructs a simple formula for finding the cost of active management.  Computing this “active expense ratio” requires only a fund’s published expense ratio, its R-squared relative to a benchmark index, and the expense ratio for a competitive fund that tracks that index. At the end of 2004, the mean active expense ratio for the large-cap equity mutual funds tracked by Morningstar was 7%, over six times their published expense ratio of 1.15%.  More broadly, funds in the Morningstar universe had a mean active expense ratio of 5.2%, while the largest funds averaged a percent or two less.

bulletWilliam F. Sharpe, "The Parable of the Money Managers," Financial Analysts Journal, July/August 1976, p. 4.  An extremely brief, tongue-in-cheek look at active vs. passive management.  Written by a Nobel Prize winner.

bulletWilliam F. Sharpe, "Indexed Investing: A Prosaic Way to Beat the Average Investor," a speech presented at the Spring President's Forum, Monterey Institute of International Studies, May 1 2002.  Written by a Nobel Prize winner.

bulletRex A. Sinquefield, "Active vs. Passive Management," Dimensional Fund Advisors, October 1995.  A speech given during a debate on the merits of active vs. passive management.

bulletSteven R. Thorley, "The Inefficient Markets Argument for Passive Investing," Brigham Young University, September 1999.  This paper argues that passive investing is indicated even if you assume that markets are inefficient and that stock-picking can successfully "beat the market."

bulletSteven R. Thorley, "Beating the Odds: Active vs. Passive Investing," Marriott Alumni Magazine, Summer 2002.  An excellent, very readable discussion of the issue.

bulletRuss Wermers, "Mutual Fund Performance: An Empirical Decomposition into Stock-Picking Talent, Style, Transaction Costs, and Expenses," Journal of Finance, Vol LV No. 4 August 2000, pp. 1655-1695 (182kb).  This paper concludes that the stocks held by active mutual funds exceeded the market index by 1.3% per year, but that those same funds underperform the same market index by 1% per year after fund costs and "cash-drag" are accounted for.  The bottom line is that this paper's data suggests that it is beneficial to invest in a market index fund (NOT an actively managed fund) as long as that fund's costs and "cash drag" are less than 1% per year.  This hurdle is easily cleared by, for example, the Vanguard Total Stock Market Index Fund (VTSMX), whose costs and cash drag appear to be less than 0.2% per year.  In other words, the average active equity fund investment dollar could have annual returns of about 0.8 percentage points higher simply by investing in a good market index fund.

bulletJason Zweig, "I don't know, I don't care," CNNmoney, August 29, 2001.  The benefits of passive investing.

bulletJason Zweig, "Can We Still Rely On Index Funds?," Money, September 2002.

bullet"Myths and Misconceptions about Indexing," Vanguard, July 2003.

bullet"The Case for Indexing," Vanguard, February 2011.

Pension Fund Management

This section addresses how a corporation should invest its pension assets.  In practice, the average pension plan is funded somewhere in the vicinity of a 60/40 stock/bond mix.  Note that what is appropriate for a corporation is not necessarily also appropriate for individuals trying to fund their own retirements.

bulletKeith Ambachtsheer, "Would the Real Investment Policy Please Stand Up?," Financial Analysts Journal, May-June 1991, pp. 7-9.  This short article summarizes the Bodie and Ippolito papers below and tries to reconcile them.

bulletFisher Black, "The Tax Consequences of Long-Run Pension Policy," Financial Analysts Journal, July-August 1980, pp. 21-28.  A similar paper is available here.  This paper suggests that pension funds ought to be invested 100% in bonds.  The rationale is one of tax arbitrage:  First, the company fully funds its pension plan with 100 bonds, of the approximate same credit quality as those of the company itself.  If it needs to borrow in order to get the funds to do so, it should borrow by issuing bonds itself.  The benefit here is that the bonds in the pension fund earn pre-tax returns (because pension fund profits are not taxed).  But the company can deduct the interest payments it makes on bonds it issues.  So the company makes pre-tax returns on the bonds in its pension fund and pays post-tax interest rates on the borrowed money.  If the pension bonds and the bonds the company issued have similar duration and credit quality (which you should try to ensure), that means that the company has a guaranteed profit of the amount of taxes saved through the interest deduction.  Guaranteed profit is good.

But won't investors be concerned about the company's increased debt level?  They shouldn't be.  If they look at the combined balance sheet of the the company and its pension fund (which they should), they would notice that the company's valuation hadn't changed.  If anything, the company's balance sheet should look more attractive to investors since the risk of underfunding the pension plan has been removed.  Less risk of need for future additional pension funding is good.

Of course, another benefit is that the pension plan participants would be well served by this policy, as would the Pension Benefit Guaranty Corporation.

bulletZvi Bodie, "The ABO, the PBO, and Pension Investment Policy," Financial Analysts Journal, September-October 1990 (39.2kb).  A good paper summarizing likely trends in pension funding.

bulletRichard A. Ippolito, "The Role of Risk in a Tax-Arbitrage Pension Portfolio," Financial Analysts Journal, January-February 1990, pp. 24-32. "It is optimal for firms to invest pension assets primarily in equities."  This paper argues that stocks exclusively should be used to fund pensions.

bulletIrwin Tepper, "Taxation and Corporate Pension Policy," Journal of Finance, March 1981, pp. 1-13.  This paper suggests that corporations should fully fund their pension plans and should fund them 100% with bonds.  This paper is largely consistent with the Black paper above.

bulletTongxuan Yang, "Defined Benefit Pension Plan Liabilities and International Asset Allocation," Pension Research Council Working Paper 2003-5, 2003 (283kb).  "... U.S. defined benefit pension plans could benefit substantially from more international investment."

bullet"Pension Plan Issues: Investment Framework," The Vanguard Group, 2006.  An even-handed discussion of the pros and cons of the two major strategies for pension investment: total return and asset-liability matching.

Performance Evaluation

Is it possible to evaluate the relative "goodness" of an investment manager?  If so, how should one go about it?  What should be avoided?  The concern here is to avoid evaluation strategies which might tend to cause one to embrace unskilled managers and/or to exclude skilled managers.  Also, see the section on Risk Measures and Performance Measurement.

"Good clients will, if they decide to use active managers, insist that their managers adhere to the discipline of following through on agreed-upon investment policy. In other words, the investor client will be equally justified and reasonable to terminate a manager for out-of-control results above the market as for out-of-control results below the market. Staying with a manager who is not conforming his or her portfolio performance [to agreed-upon investment policy] or to prior promises is speculation and ultimately will be 'punished.'

But staying with the competent investment manager who is conforming to his or her own promises
particularly when out of phase with the current market environment shows real 'client prudence' in investing and ultimately will be well rewarded." — Charles Ellis, Winning the Loser's Game

bulletElroy Dimson and Andrew Jackson, "High-Frequency Performance Monitoring," Journal of Portfolio Management, Fall 2001, pp. 33-43 (519kb).  Also here.  This excellent paper warns that basing a judgment of an investment manager's relative "skill" on very short-term results increases the probability of incorrectly judging an unskilled manager to have skill and, just as badly, increases the probability of incorrectly judging a skilled manager to NOT have skill.

bulletEugene F. Fama and Kenneth R. French, "Luck versus Skill in the Cross Section of Mutual Fund Returns," Journal of Finance, October 2010, pp. 1915-1947.  This paper uses an approach similar to that used in the Murphy paper below, only using more real-world data.  This paper takes real data of mutual fund performance (i.e., which shows a range of estimated alphas) and deliberately adjusts each fund's performance data set so that its alpha is zero (i.e., its estimated alpha is subtracted from each data point).  Thus, each synthetic fund now has a known alpha exactly equal to zero.  This data base of synthetic zero alpha funds was then used to generate 10,000 monthly returns using a bootstrap sampling approach (with replacement).  These monthly returns yielded an example of what might be expected in real life if it were true that the true alphas of each fund were, in fact, exactly equal to zero.  The paper found that the distribution of realized alphas from the simulation (i.e., where it was known that the true alpha was zero -- that any resulting apparent alpha was merely due to good luck) was similar to that found for actual funds.  In fact, if anything, the distribution of alpha estimates for real funds showed that the actual alpha of real funds was probably negative, but no better than approximately zero.  Thus, good alpha estimates for real funds were consistent with what would be expected through luck alone (i.e., suggesting that good results of actively managed funds are due to good luck and not skill).

bulletEugene F. Fama and Kenneth R. French, "Luck versus Skill in Mutual Fund Performance," Fama/French Forum, November 30, 2009.  This is a slightly less technical description of the above Fama/French paper.  The paper uses a simulation to show that the actual alphas of actively managed funds are no better than, and probably worse than, those expected purely through good luck alone (i.e., worse than they would be through simulations with alphas pre-programmed to be exactly zero).  This suggests that apparently good performance of actively managed funds is generally consistent with what would be expected through luck alone (i.e., good performance should generally be attributed to good luck and not to skill).  However, this is not evident from merely evaluating an active manager's performance, even if it is adjusted for risk (e.g., a calculated "alpha").

bulletS.P. Kothari and Jerold B. Warner, "Evaluating Mutual Fund Performance," Journal of Finance, October 2001, pp. 1985-2010.  An earlier version is available here.  An interesting study.  They generated synthetic stock portfolios, simulated their operating as mutual funds and then analyzed their performance as though they were mutual funds.  "... standard mutual fund performance measures are unreliable and can result in false inferences.  It is hard to detect abnormal performance when it exists, particularly for a fund whose style characteristics differ from those of the value-weighted market portfolio."  In particular, the study found that it is easy to detect abnormal performance and market-timing ability when none exists.

bulletJ. Michael Murphy, "Why No One Can Tell Who's Winning," Financial Analysts Journal, May/June 1980, pp. 49-57.  This outstanding paper demonstrates why it is so hard to identify truly skilled investment managers (assuming that they exist at all).  The author created 100 synthetic investment managers, each with a predetermined probability distribution of returns.  10 were pre-programmed to be more likely to outperform the market, 10 were pre-programmed to underperform the market, and 80 were pre-programmed to average the market returns.  He simulated ten years of returns.  The results were stunning: while the outperformers as a group dramatically outperformed both the random performers and the underperformers, the top two funds, four of the top five, and six of the top nine best performing funds over the simulated ten year period were random performers (i.e., those who were preprogrammed to have an expected return equaling the market return).  In other words, two managers with absolutely no skill got lucky to an extent which allowed them to outshine one hundred percent of the managers who definitely had skill OVER A TEN YEAR PERIOD.  This really drives home how dangerous it is to assume skill based on performance measurements over any "short" time period.  "Given enough time, the outperformers should produce results significantly superior to those of the random performers.  But the time required undoubtedly exceeds the lifetimes of the managers being measured."

Performance Measurement

When evaluating the performance of a mutual fund or other investment, one must somehow adjust it for the relative riskiness inherent therein.  There are three primary means of doing so: the Jensen index, the Treynor index, and the Sharpe Ratio.  More recent, but less well known and used, are the Sortino Ratio and the Upside Potential Ratio.  Also, see the section on Risk Measures and Performance Evaluation.

bulletAswath Damodoran, "Estimating Risk-Free Rates," NYU Stern School of Business  (22kb).  Nearly all measures of risk-adjusted performance require estimation of a "risk-free" return.  This paper thoroughly discusses issues surrounding estimating such a value.

bulletMichael C. Jensen, “The Performance of Mutual Funds in the Period 1945-1964,” Journal of Finance, May 1968, pp. 389-416 (178kb). Also here.  Introduces "alpha," more commonly known as "Jensen's Alpha."  This is a risk adjusted measure of how much a particular investment's return exceeds that of some benchmark.

bulletPaul D. Kaplan and James A. Knowles, "Kappa: A Generalized Downside Risk Performance Measure," Journal of Performance Measurement, 8(3) (225kb).  Introduces "kappa," a measure of risk-adjusted return.

bulletCon Keating and William F. Shadwick, "A Universal Performance Measure," Journal of Performance Measurement, 6(3) (491kb).  Introduces "gamma," a measure of risk-adjusted return.

bulletFranco Modigliani and Leah Modigliani, "Risk-Adjusted Performance," Journal of Portfolio Management, Winter 1997, pp. 45-54.  This paper introduces the measure popularly known as M2 ("M-square").  M2 is a measure closely related to the Sharpe Ratio.  Its major benefit over the Sharpe ratio is that, rather than being a dimensionless ratio, it states the result in terms of percentage return, which is much more appealing and understandable by most people.  Co-written by a Nobel prize winner.  Also, see the Modigliani article below.

bulletLeah Modigliani, "Yes, You Can Eat Risk-Adjusted Returns," Morgan Stanley U.S. Investment Research, March 17 1997 (36kb).  An excellent discussion of the M2 ("M-square") measure of risk-adjusted performance.  This is a much easier-to-read discussion than the Modigliani/Modigliani paper above.

bulletRobert L. Padgette, "Performance Reporting: The Basics and Beyond, Part II," Journal of Financial Planning, October 1995, pp. 172-180.  A pretty good discussion of four major measures of risk-adjusted performance: Jensen, Treynor, Sharpe, and Sortino.

bulletAuke Plantinga, Robert van der Meer, and Frank A. Sortino, "The Impact of Downside Risk on Risk-Adjusted Performance of Mutual Funds in the Euronext Markets," Social Science Research Network working paper number 277352, July 21 2001 (171kb).  This excellent paper concludes that Upside Potential Ratio is a better measure of risk-adjusted performance than the Sharpe Ratio.  However, it goes on to note that this is only the case where return distributions are skewed (i.e., unsymmetrical) and that the mutual funds they analyzed seemed to have symmetrical returns, meaning that the (easier to calculate) Sharpe Ratio should generally give reliable results.

bulletJeffrey H. Rattiner, "Adjust for Comfort: Keep your Clients Comfortable by Matching Risk-Adjusted Returns with their Risk-Tolerance Profiles — The Quantifiable Way," Financial Planning, May 1 2001, pp. 111-113.  A very readable summary description of the three most popular measures for risk-adjusted performance.

bulletA.D. Roy, "Safety First and the Holding of Assets," Econometrica, July 1952, pp. 431-450.  This may have been the first paper to suggest the idea of a "minimal acceptable return" as part of the measurement of risk-adjusted return.  Roy suggested maximizing the ratio "(m-d)/σ", where m is expected gross return, d is some "disaster level" (a.k.a., minimum acceptable return) and σ is standard deviation of returns.  This ratio is just the Sharpe Ratio, only using minimum acceptable return instead of risk-free return in the numerator!

bulletWilliam F. Sharpe, "Mutual Fund Performance," Journal of Business, January 1966, pp. 119-138.  This paper first introduced what would eventually be termed "the Sharpe Ratio."  Written by a Nobel Prize winner.

bulletWilliam F. Sharpe, "The Sharpe Ratio," Journal of Portfolio Management, Fall 1994, pp. 49-58.  An excellent discussion of one of the most popular measures of risk-adjusted investment performance.  Written by a Nobel Prize winner.

bulletFrank A. Sortino, Robert van der Meer, Auke Plantinga, and Hal Forsey, "Upside Potential Ratio," Pension Research Institute, 1998.  This article describes the "Upside Potential Ratio," another means of measuring risk-adjusted return.  In order to perform the calculation, you must define a Minimum Acceptable Return (MAR).  The Upside Potential Ratio assumes that the investment objective is to maximize the expected return above the MAR, subject to the risk of falling below the MAR.  It is calculated by dividing the upside potential by the downside deviation.

bulletJack L. Treynor, “How to Rate Management Investment Funds,” Harvard Business Review, January/February 1966, pp. 63-74.  While not used as often as the Jensen Index or the Sharpe Ratio, the "Treynor Index" introduced here is sometimes used for evaluating risk-adjusted performance.

bullet Performance Measurement Bibliography.  An excellent bibliography for this subject area.  No downloadable links.

Portfolio Insurance

"Portfolio Insurance" refers to a strategy for ensuring that a portfolio's value never falls below some "floor" value.  Among the approaches are Options-Based Portfolio Insurance (OBPI) and Constant Proportion Portfolio Insurance (CPPI).

bullet Fisher Black and Robert C. Jones, "Simplifying Portfolio Insurance," Journal of Portfolio Management, Fall 1987, pp. 48-51.  This paper describes a method of Constant Proportion Portfolio Insurance (CPPI) that is simpler to implement than the more traditional (at that time) Options-Based Portfolio Insurance (OBPI).
 
bulletFisher Black and Andre F. Perold, "Theory of Constant Proportion Portfolio Insurance," Journal of Economic Dynamics & Control, July-October 1992, pp. 403-426.
 
bulletHayne E. Leland, "Who Should Buy Portfolio Insurance?," Financial Analysts Journal, May 1980, pp. 581-594.  This article describes the development of the idea of Options-Based Portfolio Insurance (OBPI).  Basically, it followed directly from the derivation of the famous Black-Scholes option pricing formula.
 
bulletHayne E. Leland and Mark Rubinstein, "The Evolution of Portfolio Insurance," Dynamic Hedging: A Guide to Portfolio Insurance, edited by Don Luskin 1988.  This article describes the development of the idea of Options-Based Portfolio Insurance (OBPI).  Basically, it followed directly from the derivation of the famous Black-Scholes option pricing formula.
 
bullet Portfolio Insurance Using Index Puts, The Options Guide.  This short article gives an easy-to-understand example of how it would work to use an index put to implement OBPI.

Private Equity

Also, see the section on the Illiquidity Premium.

bullet Steve Kaplan and Antoinette Schoar, "Private Equity Performance: Returns, Persistence, and Capital Flows," MIT Working Paper, November 2003 (278kb).  This paper finds that returns on private equity partnerships, net of fees, are about the same as those for the S&P 500.

Profitability Investing

There is reason to believe that stocks of currently profitable companies tend to have higher subsequent returns than stocks of less profitable companies, all else being equal.

bulletEugene F. Fama and Kenneth R. French, "Profitability, investment, and average returns," Journal of Financial Economics, 82 2006, pp. 491-518.  Among the relevant findings of this paper are:
bulletTheory suggests that future stock returns ought to be positively related with future profitability.
bulletEmpirical evidence suggests that profitability has persistence (i.e.,  current profitability has predictive power for future profitability).
bulletTherefore, theory suggests (and empirical evidence confirms) that current profitability should have (and does have) predictive power for future stock returns (i.e., they are positively related).
 
bulletRobert Novy-Marx, "The Other Side of Value: The Gross Profitability Premium," Journal of Financial Economics, forthcoming.  Among the relevant findings of this paper are:
bulletProfitability has roughly the same predictive power as "value-ness" in predicting the cross-section of average returns.
bulletStocks of profitable firms have significantly higher returns than stocks of less profitable firms, suggesting a "profitability premium".
bulletThe "profitability premium" is negatively correlated with the "value premium" suggesting that stocks of profitable companies provide a good complement for value stocks.
 
bulletLarry Swedroe, "A new way to be a value investor?," cbsnews.com, October 31 2012.  An excellent layperson's summary of the above Novy-Marx paper.

Prudent Investor Rule

In addition to the articles below, for a good introduction to the Prudent Investor Rule, see here.

bullet Robert J. Aalberts and Percy S. Poon, "The New Prudent Investor Rule and the Modern Portfolio Theory: A New Direction for Fiduciaries," American Business Law Journal, Fall 1996, pp. 39-71. A good discussion of the Prudent Investor Rule.

bullet Frederic J. Bendremer, "Modern Portfolio Theory and International Investments under the Uniform Prudent Investor Act," Real Property, Probate and Trust Journal, Winter 2001, pp. 791-809. "Inclusion of international investments within a fiduciary portfolio is appropriate and may indeed be required under the UPIA [Uniform Prudent Investor Act] and MPT."

bullet Edward C. Halbach, Jr., "Trust Investment Law in the Third Restatement," Real Property, Probate and Trust Journal, Fall 1992.  A good discussion of the background behind many of the trust issues covered in the Third Restatement (including the Prudent Investor Rule).  Written by the recorder of the proceedings.

bullet Eugene F. Maloney, "The Investment Process Required by the Uniform Prudent Investment Act," Journal of Financial Planning, November 1999.

Real Estate Investment Trusts (REITs)

Real Estate Investment Trusts (REITs) are basically companies whose business is to own and operate Real Estate (at least that is what equity REITs do — there are other types).  The company stock trades just like any other stock.  Equity REITs are an excellent means to get exposure to the Real Estate asset class.

bulletScott Burns, "Location, Location, Location: REITs in Your Portfolio," The Dallas Morning News, June 19, 2001.

bulletHsuan-Chi Chen, Keng-Yu Ho, Chiuling Lu, Cheng-Huan Wu, "Real Estate Investment Trusts," Journal of Portfolio Management, September 2005, pp. 46-53.  This paper concludes that Equity REITs have significant diversification benefit.  On the other hand, mortgage REITs do not: "... there is no role for mortgage REITs in the optimal portfolio."

bulletJoseph Gyourko and Donald B. Keim, "What Does the Stock Market Tell Us About Real Estate Returns?," Journal of the American Real Estate and Urban Economics Association, Fall 1992, pp. 457-485.  This paper concludes that equity REIT performance is correlated with changes in real estate valuation, but equity REIT performance leads corresponding changes in real estate valuation.  In other words, if you wanted to predict real estate valuation trends, it would be useful to note equity REIT stock performance trends in the recent past.  This suggests that equity REIT holdings might be redundant with other real estate holdings from an asset allocation perspective.  So if you already hold large amounts of real estate, you may not want to buy equity REITs.

bulletJoseph Gyourko, "Real Estate Returns in the Public and Private Markets: A Reexamination Following the Rise of Equity REITs," TIAA-CREF Institute Working Paper 17-100-103, October 13 2003 (204kb).  For a discussion of this paper, see here.  This study updates the Gyourko/Keim 1992 study above and finds that the conclusions of the earlier paper still hold.

bulletRaymond Fazzi, "The Great Diversifier: REITs' Strong Returns in a Down Market are Attracting Attention," Financial Advisor, April 2002.

bulletSusan Hudson-Wilson, Frank J. Fabozzi, and Jacques N. Gordon, "Why Real Estate?," Journal of Portfolio Management, Special Real Estate Issue, 2003, pp. 12-25.  "We have seen that real estate is a risk reducer in a  low- to moderate-risk portfolio, and has no role in a very highly risk-tolerant portfolio. We have also seen that real estate is not reliable as a producer of the highest absolute returns but that stock equities are better suited for that task. We have learned that private equity real estate is an effective partial hedge against inflation, although different property types deliver different degrees of inflation hedge. We have seen that there is a lot of real estate, so a decision to leave real estate out of a portfolio altogether is a dramatic one and requires a rationale in itself. Finally, we have seen that real estate is an excellent generator of cash yield, outperforming stocks and bonds."

bulletStephen R. Mull and Luc A. Soenen, "U.S. REITs as an Asset Class in International Investment Portfolios," Financial Analysts Journal, March/April 1997, pp. 55-61. This paper points out that REITs are an excellent hedge against inflation.

bulletDevin I. Murphy, Ted Bigman, and Kevin G. Midwinter, "REITs: Providing Core Real Estate Exposure," Institute for Fiduciary Education, 2003 (243kb).  This paper explores whether REITs are a separate asset class and whether REITs are a good proxy for direct ownership of real estate properties.

bulletYaniv Tepper and Paul E. Adornato, "Appealing Tax Considerations often Overlooked for Individual REIT Investors," Journal of Financial Planning, March 2000, pp. 98-102.  Also here.  While we generally recommend REITs be used only in tax-exempt portfolios, this article describes a little-known tax benefit of having them in taxable accounts:  a portion of REIT dividends is considered a "return of capital" and is not taxed the same as other dividends.

bulletLeo F. Wells III, "In the Land of Dividends: Many clients rely on dividend-paying assets.  A small allocation of real estate investment trusts can boost income while reducing risk.," Financial Planning, October 2001.

bullet"REITS' Low Correlation to Other Stocks and Bonds is Key Factor for Portfolio Diversification: Ibbotson Analysis Shows REITs Lower Risk, Raise Return," National Association of Real Estate Investment Trusts, May 29 2001 (179kb).  This press release discusses the results of a study done by the highly respected Ibbotson Associates.  Yes, it is a self-serving note from an industry trade organization, but the content is still valid.

bullet"Real Estate Investment Trusts: Review and Outlook," Munder Funds, 2004.  A good review of the benefits of REITs.  Here's a paraphrased summary of why to invest in a REIT fund rather than directly in Real Estate:
bulletGeographic diversification.
bulletProperty type diversification.
bulletLiquidity.
bulletSmall capital outlay.
bulletProfessional management.
bulletIn many cases, REIT stocks are trading at discounts to prices in which private real estate transactions are occurring.
bulletEase of investment.
bulletLimited liability.

Rebalancing

Rebalancing refers to periodically restoring a portfolio's asset allocation to its target proportions.  If you don't rebalance, the portfolio naturally drifts from its target allocation.  This either increases or decreases your portfolio's risk profile, neither of which is desirable (assuming that the risk profile is appropriate for the investor in the first place).

bulletGobind Daryanani, "Opportunistic Rebalancing: A New Paradigm for Wealth Managers," Journal of Financial Planning, January 2008, pp. 48-61.  Also here, here, and here.  An outstanding discussion of the rebalancing routine we've been using since 2001, which we call "Opportunistic Partial Rebalancing."

bulletGobind Daryanani, "Balancing Acts: In Turbulent Times, Opportunistic Rebalancing Can Help You Capture Alpha," Financial Planning, December 2008, pp. 81-85.  A slightly more readable version of the above paper.

bulletRobert D. Arnott and Robert M. Lovell, Jr., "Rebalancing: Why? When? How Often?," Journal of Investing, Spring 1993, pp. 5-10 (52kb).  An excellent discussion of the benefits of rebalancing and a comparison of various rebalancing routines.

bulletWilliam J. Bernstein, "The Rebalancing Bonus," Efficient Frontier, Fall 1996.  This paper presents a formula which quantifies the benefits of rebalancing.

bulletWilliam J. Bernstein, "Case Studies in Rebalancing," Efficient Frontier, Fall 2000.  "The returns differences among various rebalancing strategies are quite small in the long run."

bulletGerald Buetow Jr., Ronald Sellers, Donald Trotter, Elaine Hunt, and Willie A. Whipple J., "The Benefits of Rebalancing: Worth the Effort," Journal of Portfolio Management, Winter 2002, pp. 23-32.  This paper's principal contribution is that if one uses a "threshold" to determine when to rebalance, five percent of the target allocation seems optimal (e.g., if the target allocation of an asset class is 30%, then rebalance any time it gets out of the range 28.5% to 31.5%).

bulletRobert M. Dammon, Chester S. Spatt, and Harold H. Zhang, "Capital Gains Taxes and Portfolio Rebalancing," TIAA-CREF Institute research dialogue, March 2003, pp. 1-15 (192kb).  The authors capture the trade-off over the investor’s lifetime between the tax costs and diversification benefits of trading. They find that the investor’s incentive to re-diversify the portfolio declines with the size of the capital gain and the investor’s age. Unlike conventional financial advice, the reset of the capital gains tax basis and the resulting elimination of the capital gains tax liability at death, suggests that the optimal equity proportion of the investor’s portfolio increases as he ages.

bulletChristopher Donohue, "Optimal Portfolio Rebalancing with Transaction Costs," Journal of Portfolio Management, Summer 2003, pp. 49-63.  "Academic research has proven the optimality of a no-trade region around an investor's desired asset proportions so that trading occurs only when asset proportions drift outside this region, and then only to bring proportions back to the boundary of the no-trade region, not to the target proportions."  Note that the preceding quote only applies to proportional rebalancing fees (e.g., capital gains taxes).

bulletMarlena I. Lee, "Rebalancing and Returns," Dimensional Fund Advisors internal working paper, October, 2008.  This paper extends the Daryanani paper above.

"Aside from avoiding excessive trading, there are no optimal rebalancing rules that will yield the highest returns on all portfolios and in every period. The good news for investors is that without an optimal way to rebalance, the burden of producing returns through optimal rebalancing is lifted. Return generation is again the responsibility of the market, which sets prices to compensate investors for the risks they bear. The primary motivation for rebalancing should not be the pursuit of higher returns, as returns are determined through the asset allocation, not through rebalancing.
The bad news, of course, is that there is no easy one-size-fits-all rebalancing solution.

Rebalancing decisions should be driven by the need to maintain an allocation with a risk and return profile appropriate for each investor. The optimal rebalancing strategy will differ for each investor, depending on their unique sensitivities to deviations from the target allocation, transaction frequency, and tax costs.
"

bulletHayne E. Leland, "Optimal Asset Rebalancing in the Presence of Transactions," SSRN Working Paper, August 1996.  This paper discusses rebalancing in the presence of proportional transaction costs.

bulletHayne E. Leland, "Optimal Portfolio Implementation with Transactions Costs and Capital Gains Taxes," Haas School of Business Working Paper, December 20 2000 (247kb).  This paper discusses rebalancing in the presence of proportional rebalancing fees, including capital gains taxes.

bulletSeth J. Masters, "Rules for Rebalancing," Financial Planning, December 2002, pp. 89-93.  This article also appeared in Journal of Portfolio Management, Spring 2003, pp 52-57.  An extremely well-written authoritative article on the subject.  There is also an excellent sidebar by John Thompson at this link called "What History Tells Us: 'Tis Better to Have Rebalanced Regularly Than Not at All."

bulletMark W. Riepe and Bill Swerbenski, "Rebalancing for Taxable Accounts," Journal of Financial Planning, April 2007, pp. 40-44.  "Tips When Rebalancing a Taxable Account:
  1. Exert more care when rebalancing in taxable accounts.
  2. Avoid generating rebalancing trades by directing new money into underweighted asset classes.
  3. When sensible, execute trades to generate tax losses that can then be used to offset any capital gains generated by rebalancing trades.
  4. Be patient and wait until eligible for long-term capital gains treatment.
  5. If taxable and tax-deferred accounts are both allocated toward the same goal, have the tax-deferred account bear as much of the rebalancing load as possible."

bulletBert Stine and John Lewis, "Guidelines for Rebalancing Passive-Investment Portfolios," Journal of Financial Planning, April 1992, pp. 80-86.  Also here.  "... in most cases, the investor would be advised to rebalance only when the portfolio reaches a predetermined level of risk exposure rather than to make the adjustment on a calendar basis."

bulletYesim Tokat, "Portfolio Rebalancing in Theory and Practice," Vanguard Investment Counseling & Research, February 15 2006.  This also appeared in the Journal of Investing, Summer 2007, pp. 52-59.  A good discussion of the issue.

bulletCindy Sin-Yi Tsai, "Rebalancing Diversified Portfolios of Various Risk Profiles," Journal of Financial Planning, October 2001, pp. 104-110.  Also here.  "Portfolios should be periodically rebalanced.  This paper shows that neglecting rebalancing produces the lowest Sharpe ratios."  "However, ... it does not matter much which [rebalancing] strategy they adopt."

Retirement Investing

Also, see Social Security Retirement Benefits and Variable Annuities.

bulletIan Ayres and Barry J. Nalebuff, "Diversification Across Time," Yale Law & Economics Research Paper No. 413, Oct 4, 2010.  This outstanding paper discusses the idea of spreading one's stock exposure more evenly across their lifetime, which should then reduce the riskiness surrounding the ending wealth.  Here's an excellent website where the authors discuss this idea.  Here's the outstanding book where they elaborate in depth on this idea.

bulletWilliam P. Bengen, "Conserving Client Portfolios During Retirement, Part IV," Journal of Financial Planning, May 2001, pp. 110-119.  This article analyzes various withdrawal strategies during retirement.

bulletSusan K. Bradley, "Realizing Unrealized Capital Gains," Journal of Financial Planning, January 2000.  A discussion of the little known "Net Unrealized Appreciation" rule (tax code section 402(e)(4))  for retiring employees who have shares of highly appreciated company stock.  Also, see these follow-on comments on this article.

bulletLeonard E. Burman, William G. Gale, and David Weiner, "The Taxation of Retirement Saving: Choosing Between Front-Loaded and Back-Loaded Options," Brookings Institution, May 2001 (102kb).  This paper also appeared in National Tax Journal, Vol 54 No. 3 2001, pp. 689-702.  "Despite the fact that effective tax rates on [traditional] IRAs were generally negative, many investors would have benefited from contributing to a Roth instead of a traditional IRA over the 1982-95 time period because of the larger effective sheltering provided by a Roth IRA."

bulletFrank Caliendo and W. Cris Lewis, "Myths and Truths of IRA Investing," Journal of Financial Planning, October 2002, pp. 86-94.  This excellent paper definitively answers two questions: 1) How do you choose between investing in a taxable account and a Traditional IRA?  2) How do you choose between investing in a Traditional IRA and a Roth IRA?

bulletPhilip L. Cooley, Carl M. Hubbard, and Daniel T. Walz, "Retirement Savings: Choosing a Withdrawal Rate that is Sustainable," AAII Journal, February 1998.  This often-cited study, known as "the Trinity study," does an excellent job of laying out the variables surrounding selecting a withdrawal rate during retirement.

bulletTerry L. Crain and Jeffrey R. Austin, "An Analysis of the Tradeoff Between Tax Deferred Earnings in IRAs and Preferential Capital Gains," Financial Services Review, 6(4) 1997, pp. 227-242 (1.74mb).  This paper analyzes the decision of whether to invest in a mutual fund either in a taxable account or through one of the three available IRAs: the deductible IRA, the Roth IRA, and the nondeductible IRA.

bulletRobert M. Dammon, Chester S. Spatt, and Harold H. Zhang, "Optimal Asset Location and Allocation with Taxable and Tax-Deferred Investing," Journal of Finance, 59 2004.  Also here (1.1mb).  "Our results indicate that the [after-tax wealth maximizing] investor has a strong preference for locating taxable bonds in his tax-deferred retirement account and equity in his taxable account."

bulletJohn A. Herbers, "The Tax-Saving Opportunities of NUA," ABA Trust & Investments, July/August 2001, pp. 12-17.  An excellent discussion of the little known "Net Unrealized Appreciation" rule (tax code section 402(e)(4))  for retiring employees who have shares of highly appreciated company stock.

bulletStephen M. Horan, Jeffrey H. Peterson, and Robert McLeod, "An Analysis of Nondeductible IRA Contributions and Roth IRA Conversions," Financial Services Review, Volume 6 Number 4, 1997 (1.38mb).  A good discussion of issues surrounding the topics mentioned in the title.

bulletStephen M. Horan and Jeffrey H. Peterson, "A Reexamination of Tax-Deductible IRAs, Roth IRAs and 401(k) Investments," Financial Services Review, Volume 10 N1-4, 2001 (142kb).  A good discussion of these three retirement savings vehicles.

bulletJennifer Huang, "Taxable and Tax-Deferred Investing: A Tax-Arbitrage Approach," Review of Financial Studies, September 2008, pp. 2173-2207.  Also here.  This paper's conclusions are dependent on whether a person anticipates needing access to assets before age 59.5.  If they do anticipate such a need (that is, they have a liquidity need), then it is prudent to locate taxable bonds in both taxable and tax-deferred accounts.  If they do not anticipate such a need, then investors always should prefer bonds to be in tax-deferred accounts.  The bottom line is that, in the absence of liquidity needs, you should put the investments with the highest dividend payout ratio in the tax-deferred account (an investment's dividend payout ratio is defined as its dividend yield divided by its total return).

bulletMimi Lord, "Wrong Place, Wrong Time: Asset mislocation could cost investors up to 20% of their after-tax returns, according to a new study," Financial Planning, April 2002, pp. 65-67.  A layman's guide to the Dammon, Spatt, and Zhang paper.

bulletOlivia Mitchell and Stephen P. Utkus, "Lessons From Behavioral Finance for Retirement Plan Design," Pension Research Council Working Paper 2003-6 (357kb).  An outstanding study with pragmatic suggestions on how a corporate pension plan ought to be designed.  Outstanding bibliography.

bulletJohn A. Nersesian and Frances L. Potter, "Revisiting Net Unrealized Appreciation: A Tax-Wise Strategy That May Realize More Benefits Than Ever," Journal of Financial Planning, February 2004, pp. 50-55.  An excellent summary of the ins and outs of this little-known feature of the tax code.

bulletJames M. Poterba, John B. Shoven, and Clemens Sialm, "Asset Location for Retirement Savers," NBER Working Paper 7991, November 2000 (603kb).  Also "Private Pensions and Public Policies", The Brookings Institution, 2004, pp. 290-331.  Also here, here and here.  "... a risk averse retirement accumulator would historically have fared better with an index [equity] fund, and an asset location strategy that held this fund in a taxable setting, than with a randomly chosen actively managed [equity] fund ..."  This paper suggests that if you must have a tax-inefficient actively managed stock fund, it is best kept in a tax-exempt account with tax-exempt bonds in a taxable account.  However, it suggests that a superior strategy would be to instead use tax-efficient passively managed stock funds in the taxable account and taxable bonds in the tax-exempt account.  In short, they advocate locating the least tax-efficient investments in the tax-exempt account.

bulletJ. Tim Query, "An analysis of the Medical Savings Account as an alternative retirement savings Vehicle," Financial Services Review, 2000, pp. 107-123.  An interesting discussion of Archer Medical Savings Accounts.  Not only could they meet your health insurance needs (if you are employed by a small company which uses them), but they can help you save for retirement too!

bulletWilliam Reichenstein, "Savings Vehicles and the Taxation of Individual Investors," Journal of Private Portfolio Management, Winter 1999 (88kb).  "When saving for retirement, the most important consideration is the tax structure.  In this case, the better choice between two savings vehicles is the one that produces the greater after-tax ending wealth."

bulletWilliam Reichenstein, "After-Tax Wealth and Returns Across Savings Vehicles," Journal of Private Portfolio Management, Spring 2000 (90kb).  An outstanding comparison of the pros and cons of various vehicles for retirement saving.

bulletJohn B. Shoven and Clemens Sialm, "Asset Location in Tax-Deferred and Conventional Savings Accounts," Journal of Public Economics, 88 2003, pp. 23-38.  Also here and here.  "... assets with high tax rates should be located in the tax-deferred environment.  In particular, taxable bonds should be held in the tax-deferred environment, whereas tax-exempt municipal bonds should be held in the taxable environment.  Stocks can be located in either environment depending on the tax-efficiency of the stock portfolios."

bulletJohn J. Spitzer and Sandeep Singh, "Extending Retirement Payouts by Optimizing the Sequence of Withdrawals," Journal of Financial Planning, April 2006 (795 kb).  The most important contribution of this article is its insight in answering the following question: if you have both a traditional IRA and a Roth IRA, what is the optimal sequence of tapping those accounts in retirement?  On the one hand you might think that you should take the traditional IRA out first, thus maximizing the tax-free benefit of the Roth IRA.  On the other hand, you might think that you should use the Roth IRA first, thus delaying payment of taxes associated with the traditional IRA as long as possible.  It turns out that the optimal approach is a hybrid of the two: each year, use the traditional IRA as necessary to get to the top of a low tax bracket -- then supplement that as necessary with Roth IRA withdrawals.  This gets you the best of both worlds: the traditional IRA is taxed at a low marginal rate and the Roth withdrawals allow you to avoid a high marginal rate.

bulletAnne Tergesen, "Sleep Soundly without Stocks: Author Zvi Bodie says the safest possible approach to retirement savings is to stick closely to TIPS and I-Bonds," Business Week, July 28 2003.  This article lays out Zvi Bodie's vision of how to save for retirement with virtually zero risk: buy TIPS of the proper amount to guarantee that you will reach your real income goal.

bulletAndy Terry and William C. Goolsby, "Section 529 Plans as Retirement Accounts," Financial Services Review, 12 (2003), pp. 309-318 (586kb).  An extremely interesting paper which concludes that 529 college savings plans might be a better vehicle to save for retirement than either an ordinary taxable account or Variable Annuities.

bulletThomas G. Walsh, "How Much Should a Person Save for Retirement?," TIAA-CREF Institute Working Paper, November 2003.  A nice paper designed to give basic guidance on how much one needs to save for retirement.

bulletLiz Pulliam Weston, "Should you give up on stocks?  Most retirement planners preach that you can't afford to miss the growth potential of stocks. Then there's Zvi Bodie, who argues that investors can't afford the risk of losing everything," MSN Money.  This article lays out Zvi Bodie's vision of how to save for retirement with virtually zero risk: buy TIPS of the proper amount to guarantee that you will reach your real income goal.

bullet"Replacement Ratio Study: A Measurement Tool For Retirement Planning," Aon Consulting/Georgia State University, 2004 (700kb).  A good study discussing replacement ratios (i.e., the percentage of pre-retirement gross income that is needed post-retirement in order to maintain the same standard of living).

bullet"Rousey v. Jacoway; 03-1407," United States Supreme Court, April 4 2005.  This Supreme Court decision confirms that IRA accounts are subject to the same bankruptcy protections that 401(k) and other ERISA plans are subject to.

Reversion to the Mean

Reversion to the mean is the phenomenon (discovered by Charles Darwin's cousin, Sir Francis Galton (1822-1911)) whereby a stock's average performance (or a mutual fund's, or many other non-investing statistics) tend to become more average (i.e., less extreme) over time.  If true, this implies that recent good performers are perhaps somewhat more likely than average to be below average performers in the future (and vice versa).  This idea is supported by much of the research.  Also, see Mutual Fund Persistence.

bulletJohn C. Bogle, "Bogle on Investment Performance and the Law of Gravity: Reversion to the Mean—Sir Isaac Newton Comes to Wall Street," Speech given at MIT Lincoln Laboratory on January 29 1998.  "... RTM is a rule of life in the world of investing—in the relative returns of equity mutual funds, in the relative returns of a whole range of stock market sectors, and, over the long-term, in the absolute returns earned by common stocks as a group."

bulletBob Bronson, "Reversion-to-the-mean is not a glide path phenomenon," December 14 2000.  This commentator notes that mean reversion doesn't mean that an investment's future performance is likely to gradually approach some asymptote.  Rather, it is likely to cycle to the other extreme (i.e., good performance is likely to be followed by bad performance, and vice versa), which over time will cause the average performance to approach some asymptote.

bulletJennifer Conrad and Gautam Kaul, "Mean Reversion in Short-Horizon Expected Returns," Review of Financial Studies, Vol 2 Number 2 1989, pp. 225-240 (1.52mb).

bulletWerner F.M. De Bondt and Richard Thaler, "Does the Stock Market Overreact?," Journal of Finance, July 1985, pp. 793-805.  This paper suggests a behavioral explanation for observed mean reversion: overreaction.  It suggests that "loser stocks" tend to subsequently outperform "winner stocks" because the "loser stocks" became loser stocks to an extent that exceeded rational justification (i.e., they were previously  bid down lower than justified by rational expectations).  Likewise, the "winner stocks" were previously bid up higher than justified by rational expectations.  Over time, those expectations become more rational and the overreactions disappear, causing a reversion to the mean.

bulletEugene F. Fama and Kenneth R. French, "Permanent and Temporary Components of Stock Prices," Journal of Political Economy, 96 1988, pp. 246-273 (1.8mb).  Also here.  "A slowly mean-reverting component of stock prices tends to induce negative autocorrelation in returns."  "In tests for the 1926-1985 period, large negative autocorrelations for return horizons beyond a year suggest that predictable price variation due to mean reversion accounts for large fractions of 3-5 year return variances.  Predictable variation is estimated to be about 40 percent of 3-5 year return variances for portfolios of small firms.  The percentage falls to about 25 percent for portfolios of large firms."

bulletEugene F. Fama and Kenneth R. French, "Forecasting Profitability and Earnings," Journal of Business, 73(2) 2000, pp. 161-175.  This paper looks at mean reversion of a corporation's earnings.  "Standard economic arguments say that in a competitive environment, profitability is mean reverting.  Our evidence is in line with this prediction."

bulletJonathan W. Lewellen, "Temporary Movements in Stock Prices," MIT Sloan School Working Paper, May 2001.  Also available here (105kb).  "Mean reversion in stock prices is stronger than commonly believed. ... The reversals are also economically significant. The full-sample evidence suggests that 25% to 40% of annual returns are temporary, reversing within 18 months. The percentage drops to between 20% and 30% after 1945. Mean reversion appears strongest in larger stocks and can take several months to show up in prices."

bulletBurton G. Malkiel, "Models of Stock Market Predictability," Journal of Financial Research, Winter 2004, pp. 445-459 (159kb).  This study finds that, while there appears to exist some reversion to the mean behavior, "... there is no evidence of any systematic inefficiency that would enable investors to earn excess returns."  In other words, market timing models aren't likely to be fruitful.

bulletJames M. Poterba and Lawrence H. Summers, "Mean Reversion in Stock Prices: Evidence and Implications," Journal of Financial Economics, 22 1988, pp. 27-59.  "Our results suggest that stock returns show positive serial correlation over short periods [reflecting a short-term momentum effect] and negative correlation over longer intervals [reflecting a reversion to the mean effect]."

bulletBill Schultheis, "Reversion in Action," 1999.  A great explanation of this concept for lay people.

bulletTony Weisstein, "Reversion to the Mean."  An excellent brief formal mathematical description of this generic concept.

Risk Measures

bulletRobert D. Arnott, "What Risk Matters?  A Call for Papers," Financial Analysts Journal, May/June 2003, pp. 6-8 (655kb).  A good discussion of the nature of risk.

bulletAndrew W. Lo, "The Three P's of Total Risk Management," Financial Analysts Journal, January/February 1999, pp. 13-26 (197kb).  A good discussion of the nature of risk.

bulletDavid N. Nawrocki, "A Brief History of Downside Risk Measures," Journal of Investing, Fall 1999, pp. 9-25 (135kb).  Also Here.  Here is a related piece by the same author.  A comprehensive discussion of downside risk measures.  Downside risk turns out to be a superior risk measure (i.e., better than standard deviation) in circumstances where the return distribution is not symmetrical and/or a "Minimal Acceptable Return" can be defined.

bulletDavid N. Nawrocki, "The Case for Relevancy of Downside Risk Measures," Working Paper, 1999.  Also here.  "We need downside risk measures because they are a closer match to how investors actually behave in investment situations."

bulletBrian M. Rom, "Using Downside Risk to Improve Performance Measurement," Presentation, Investment Technologies.  A good summary of issues surrounding use of downside risk measures.

bulletA.D. Roy, "Safety First and the Holding of Assets," Econometrica, July 1952, pp. 431-450.  This may have been the first paper to suggest a downside risk measure.  Roy suggested maximizing the ratio "(m-d)/σ", where m is expected gross return, d is some "disaster level" (a.k.a., minimum acceptable return) and σ is standard deviation of returns.  This ratio is just the Sharpe Ratio, only using minimum acceptable return instead of risk-free return in the numerator!

bulletFrank A. Sortino and Robert van der Meer, "Downside Risk," Journal of Portfolio Management, Summer 1991, pp. 27.31.  Concludes that Downside Variance is a superior measure of risk.

bulletLarry Swedroe, "Risk: What Exactly is it?," Indexfunds.com, August 8 2003.  A great article on the topic.

bulletW. Van Harlow, "Asset Allocation in a Downside-Risk Framework," Financial Analysts Journal, September/October 1992, pp. 28-40.  An outstanding article on use of downside risk measures (e.g., downside variance or downside deviation).  Downside risk turns out to be a superior risk measure (i.e., better than standard deviation) in circumstances where the return distribution is not symmetrical and/or a "Minimal Acceptable Return" can be defined.

bulletSusan Wheelock, "Risky Business," Plan Sponsor, September 1995.  An excellent, very readable description of downside risk.  All of the performance measures discussed in the Performance Evaluation section are risk-adjusted measures.  The Sortino Ratio and the Upside Potential Ratio use downside risk as their risk measure.

Social Security Retirement Benefits

Most US workers are entitled to Social Security Retirement Benefits when they get old enough.  This benefit can be substantial and should be considered as part of retirement planning.  A strong case can be made not only to include the income in future cash-flow plans, but to include the present value of future Social Security benefits as a current asset in your portfolio when doing asset allocation (it is closer to an inflation protected bond than anything else).

bulletLynn Brenner, "'Reset' Social Security and collect more ," InvestmentNews IN retirement, March 12, 2009.  This article discusses an interesting option.  You start taking Social Security retirement benefits sometime before age 70.  Then, at age 70, you can pay back the benefits you received (without any interest) and start taking a higher level of benefits -- for the rest of your life -- at age 70.  Apparently it is possible to also recover income taxes paid on those benefits you are paying back.  An interesting option for those who, at age 70, feel that their health is such that they (or their spouse) expects to be fairly long-lived.

bulletKirsten A. Cook, William W. Jennings, and William Reichenstein, "When Should you Start your Social Security Benefits?," AAII Journal, November 2002.  "... assuming life expectancies are average and benefits are not reduced by the earnings test, the benefits schedule is actuarially fair for single males and females."

bulletJohn H. Detweiler, “A Note on the 62-65 Social Security Decision,” National Estimator, Spring 1999, pp. 39-42.  "If one does not need the cash at age 62, deciding when to receive the Social Security retirement benefit is just another investment decision and should be so treated."

bulletSteve P. Fraser, William W. Jennings, and David R. King, "Strategic asset allocation for individual investors: The impact of the present value of Social Security Benefits," Financial Services Review, Winter 2000, pp. 295-326 (3.99mb).  "... Social Security wealth has a dramatic impact on asset allocation and should be included in strategic asset allocation."

bulletMimi Lord, "Choosing Early or Normal-Age Social Security Benefits: Factors to Consider," Retirement Planning, July/August 2002, pp. 39-42 (62kb).  This article summarizes the two Walsh papers below.

bulletJoseph P. McCormack and Grady Perdue, "Optimizing the initiation of Social Security benefits," Financial Services Review, Volume 15 (2006), pp. 335-348.  "Early initiation of benefits is the correct course of action for individuals with lower life expectancies. However, delayed initiation of benefits may often be the correct course of action for a single person with a long life expectancy or for a married male who is the higher income-earning spouse."

bulletRobert Muksian, "The Effect of Retirement Under Social Security at Age 62," Journal of Financial Planning, January 2004, pp. 64-71.  "Unless early retirement is 'mandated' due to health reasons, it appears one should wait until normal retirement age or later to begin collecting Social Security."

bulletWilliam Reichenstein and William Jennings, Integrating Investments & The Tax Code (John Wiley & Sons, Inc, 2003), pp. 169-212.  An excellent discussion of exactly how to calculate the present value of future Social Security benefits.

bulletClarence C. Rose and L. Keith Larimore, "Social Security Benefit Considerations in Early Retirement," Journal of Financial Planning, June 2001, pp. 116-121.  Also here.  "... the economic value of beginning Social Security at age 62 for men is greater than waiting for full retirement. For women, the economic value of waiting for full retirement is slightly greater than early retirement for those attaining age 62 in the year 2000."  "The differences in the economic values do not appear to be significant enough in any of the situations to be the major factor influencing the decision as to when to begin Social Security benefits."

bulletJohn J. Spitzer, "Delaying Social Security payments: a bootstrap," Financial Services Review, Volume 15 (2006), pp. 233-245.  "This paper reconciles previous research outcomes and explains why prior studies offer conflicting recommendations regarding the decision to delay Social Security payments. ... When life expectancy and realistic investment returns are incorporated into the analysis, there are few circumstances that warrant postponing Social Security payments for early retirees."

bulletKenn B. Tacchino and Cynthia Saltzman, "Should Social Security Be Included When Projecting Retirement Income?," Journal of Financial Planning, March 2001 Volume 14, Issue 3, pp. 98-112.  Also here.  "Financial services professionals should make a conscious estimate of the amount of Social Security their clients will receive."

bulletThomas G. Walsh, "Spousal and Survivor Elections of Normal Versus Early Retirement Benefits," TIAA-CREF Institute, July 2002.  "The breakeven after tax interest rates to justify an early retirement election for a survivor are lower than for a worker or spouse.  This means that a survivor could be more inclined from a financial perspective to elect early retirement benefits than a worker or spouse, all other factors being equal."

bulletThomas G. Walsh, "Electing normal retirement social security benefits versus electing early retirement social security benefits," TIAA-CREF Institute, July 2002.  "In most situations, persons can make a decision about when to begin Social Security benefits that are unrelated to the potential for a slight financial advantage for one option versus another."  The author goes on to comment that a person in poor health, and/or who has dependent children should prefer early benefits and that wealthy individuals who don't require the cash flow may prefer waiting as long as possible to begin. 

Survivorship Bias

Survivorship bias refers to the phenomena whereby the past records of existing mutual funds are examined to determine various trends.  The problem lies in the fact that you are only examining the past records of currently existing funds — funds which ceased existence in the past are not included in your data.  This tends to cause one to (falsely) conclude that the average mutual fund has performed better than is actually the case (because the funds which cease to exist and are therefore removed from the sample universe tend to be the poor performers).  Due to survivorship bias, it is actually possible to (falsely) conclude that the average dollar invested in mutual funds performed better than average!  Also, see mutual fund persistence.

bulletMark M. Carhart, Jennifer N. Carpenter, Anthony W. Lynch, and David K. Musto, "Mutual Fund Survivorship," Review of Financial Studies, Issue 5 2002, pp. 1439-1463 (371kb).  Also here.  This paper shows that mutual fund survivorship bias is about 0.07% over one year periods, but about one percent for periods of 15 years of longer (in other words, if one studied mutual fund performance over a 15 year period, the annual return of the average fund dollar would be overstated by about one percentage point annually).  An excellent comprehensive analysis of survivorship issues in mutual fund performance studies.

bulletStephen J. Brown, William N. Goetzmann, and Stephen A. Ross, "Survival," Journal of Finance,  July 1995, pp. 853-873 (1.9mb).  This paper concludes that survivorship bias increases "the probability of false rejection of temporal independence."  In other words, survivorship bias tends to cause one to conclude that phenomena such as mutual fund persistence exists, when it may not.

Synthetic/Enhanced Indexing

Synthetic indexing refers to a strategy of replicating an index by buying futures (or derivatives) on an index, rather than buying the underlying securities making up the index.  Implicit in the price of a futures contract is an assumed interest rate covering the period from purchase of the contract to the contract expiration date.  The futures themselves are typically a relatively small portion of the portfolio (enough futures are bought to simulate full investment in the index).  An even smaller portion of the portfolio is set aside in very short-term treasuries as collateral.  The remaining cash is typically invested in a bond portfolio with a goal of trying to exceed the interest rate assumed in the pricing of the futures contract.  If the bond portfolio can earn a better risk-adjusted return than the interest rate implicit in the futures price, it is possible to have better risk-adjusted returns than the index (before fees).

The above discussion describes synthetic indexing.  There are several other means of "enhanced" indexing.

bulletJoanne M. Hill and Humza Naviwala, "Synthetic and Enhanced Index Strategies using Futures on U.S. Indexes," Journal of Portfolio Management, May 1999, pp. 61-74.  A good overview of several variations on this investment strategy.

bulletTodd Miller and Timothy S. Meckel, "Beating Index Funds with Derivatives," Journal of Portfolio Management, May 1999, pp. 75-87.  A good overview of several variations on this investment strategy.

bulletMark W. Riepe and Matthew D. Werner, "Are Enhanced Index Funds Worthy of their Name?," Journal of Investing, Summer 1998, pp. 6-15.  This paper investigates whether synthetic index funds have been successful in exceeding the returns of their target index.  It finds that two of eight such funds did so during the period studied.

Tax Loss Harvesting

Anybody who has investments in a taxable account (i.e., stocks, bonds, or mutual funds that are NOT in an IRA, Roth IRA, 403(b), 401(k), etc.) should be concerned about minimizing their tax burden.  Tax loss harvesting is an important means of doing so.  Also, see the section on Tax Managed Investing.

bulletRobert D. Arnott, Andrew L. Berkin, and Jia Ye, "Loss Harvesting: What's It Worth To The Taxable Investor?," Journal of Wealth Management, Spring 2001 (170kb).

bulletAndrew L. Berkin and Jia Ye, "Tax Management, Loss Harvesting, and HIFO Accounting," Financial Analysts Journal, July/August 2003 pp. 91-102.  "Our findings show that no matter what market environment occurs in the future, managing a portfolio in a tax-efficient manner gives substantially better after-tax performance than a simple index fund [i.e., a buy and hold routine], both before and after liquidation of the portfolio."

bulletGeorge M. Constantinides and Jonathan E. Ingersoll Jr., "Optimal Bond Trading With Personal Taxes," Journal of Financial Economics, 13 - 1984, pp. 299-335 (1.9mb).  This paper extends the idea of tax-loss harvesting to bonds.

bulletGeorge M. Constantinides, "Optimal Stock Trading With Personal Taxes," Journal of Financial Economics, 13 - 1984, pp. 65-89 (1.2mb).  This paper suggests that it may be beneficial to realize long term gains in order to increase the possibility of realizing short-term losses in the future (which are worth more if short term capital gains tax rates are higher than long-term capital gains rates).  The Dammon/Spatt paper below elaborates on this point.

bulletRobert M. Dammon, Kenneth B. Dunn, and Chester S. Spatt, "A Reexamination of the Value of Tax Options," Review of Financial Studies, Fall 1989, pp. 944-972 (307kb).  This paper builds on the Constantinides paper above.  It finds that the value of realizing long-term gains (in order to "reset the clock" for prospective realization of additional short term losses) has less value than Constantinides suggested.

bulletRobert M. Dammon and Chester S. Spatt, "The Optimal Trading and Pricing of Securities with Asymmetric Capital Gains Taxes and Transaction Costs," Review of Financial Studies, Fall 1996, pp. 921-952 (327kb).  This paper plumbs the question of exactly at what point capital losses ought to be harvested (the "Asymmetric Capital Gains" refers to a situation where long-term capital gains are taxed at a lower rate than short term gains).  The optimal point at which to harvest losses depends on several variables: the level of transaction costs, the volatility of the security in question, and the time remaining in the "short term region" until capital gains become classified as "long term gains."

bulletDonald Jay Korn, "Bummer Crop: While fall turns to winter on Wall Street, clients who harvest losses may reap rich rewards when the stock market springs back," Financial Planning, September 2002, pp. 63-69.  A good article on tax-loss harvesting.

bulletMargaret Hwang Smith and Gary Smith, "Harvesting Capital Gains and Losses," Financial Services Review, Winter 2008, pp. 309-321 (154kb).  This paper finds that a very attractive tax-based strategy is to realize all losses and realize gains as necessary to rebalance those assets most exceeding their target allocations.

bulletTerry L. Zivney, James P. Hoban, and John H. Ledbetter, "Taxes and the Investment Horizon," Journal of Financial Planning, November 2002, pp. 84-91.  An excellent article which concludes that taxable investors should harvest capital losses regularly and defer capital gains indefinitely.

Tax Managed Investing

Anybody who has investments in a taxable account (i.e., stocks, bonds, or mutual funds that are NOT in an IRA, Roth IRA, 403(b), 401(k), etc.) should be concerned about minimizing their tax burden.  Taxes are just another type of investing expense that ought to be prudently minimized.  Also, see the sections on Dividends and Tax Loss Harvesting.

bulletFrank Armstrong, "New Generation of Tax Managed Funds," Investor Solutions, April 8 2002.  This article discusses the most tax-efficient passive funds available, which not only manage to minimize capital gains distributions, but also dividend distributions.  The author doesn't mention it, but Vanguard has three such funds, in addition to several at DFA.

bulletRobert D. Arnott, Andrew L. Berkin, and Jia Ye, "How well have taxable investors been served in the 1980s and 1990s?," Journal of Portfolio Management, Summer 2000, pp. 84-93 (425kb).  Also here"Most mutual funds do a disservice to their clients by ignoring or dismissing the taxes triggered by their trades."

bulletRobert D. Arnott, Andrew L. Berkin, and Jia Ye, "The Management and Mismanagement of Taxable Assets," Journal of Investing, Spring 2001, pp. 15-21 (177kb).

bulletRobert Baker, "Inoculating Your Portfolio Against Taxes," Business Week, April 19 2002.

bulletBrad M. Barber and Terrence Odean, "Are Individual Investors Tax Savvy?  Evidence from Retail and Discount Brokerage Accounts," University of California, Davis, October 2002 (758kb).

bulletJoel M. Dickson and John B. Shoven, "A Stock Index Mutual Fund Without Net Capital Gains Realizations," NBER Working Paper number 4717, April 1994.  Also here and here.  This paper showed that a tax-managed passive mutual fund was feasible.  For non-taxable investors, such a fund would fair about as well as a non-tax-managed alternative during the period studied.  For taxable investors, there would be a definite significant advantage with the tax-managed fund.

bulletJoel M. Dickson, John B. Shoven, and Clemens Sialm, "Tax Externalities of Equity Mutual Funds," National Tax Journal, September 2000, pp. 607-628 (139 kb).  Also here.  This paper suggests that tax externalities (i.e., the fact that net redemptions in a mutual fund adversely affect shareholders while net purchases benefits them) have a dramatic tax effect on mutual funds.  This effect can be managed both by the mutual fund choosing a tax-favorable accounting method (i.e., HIFO instead of FIFO) and a routine of selling losing investments instead of winning investments.  Implications for taxable investors are that, all other things being equal, it might be beneficial to invest in a mutual fund that has a tax-minimizing investing strategy and a tax-minimizing share accounting method.

bulletJames P. Garland, "The Attraction of Tax-Managed Index Funds," Journal of Investing, Spring 1997, pp. 13-20.  "The great majority of taxable investors are engaged in a foolish fancy.  They spend great time and effort trying to improve gross returns, when what they should be doing is reducing costs."  By "costs," the author means primarily taxes, and, secondarily, commissions and investment management fees.  According to the paper, a typical actively managed fund needs a 2.63% annual alpha to break even on an after-tax basis with a tax-efficient index fund.

bulletBeverly Goodman, "You Can Spare Your Returns the Tax Ax," TheStreet.com, August 26 2002.

bulletBeverly Goodman, "Funds That Keep Taxes Low Can Save Your Portfolio," TheStreet.com, September 9 2002.

bulletRobert H. Jeffrey and Robert D. Arnott, "Is your alpha big enough to cover its taxes?," Journal of Portfolio Management, Spring 1993, pp. 15-25 (134kb).  In answer to the question posed in the title, "... most managers' alphas are not big enough to cover their taxes."  This suggests that actively managed mutual funds don't increase returns enough to compensate for the increased taxes their active management causes.

bulletChristopher G. Luck, "Tax-Advantaged Investing," Journal of Private Portfolio Management, Spring 1999 (142kb).

bulletMerton H. Miller, "Do Dividends Really Matter?," The University of Chicago Graduate School of Business, Selected Paper #57.  One strategy for tax-management in a taxable portfolio is to avoid dividend-paying stocks.  This paper validates the idea that whether or not any particular stock pays dividends is irrelevant to the investor (except that the dividend-paying stocks are less tax-efficient).  Written by a Nobel Prize winner.

bulletJames D. Peterson, Paul A. Pietranico, Mark W. Riepe, and Fran Xu, "Explaining After-Tax Mutual Fund Performance," Financial Analysts Journal, January/February 2002, pp. 75-86 (205kb).  "When choosing equity funds for a taxable account, investors should focus on funds with good past pre-tax performance, low expenses, and high past tax-efficiency ..."  "Our results suggest that the benefits of being a tax-aware investor are substantial."  The paper's results are consistent with selecting passively-managed funds, preferably those which are specifically managed to minimize both dividend and capital gains distributions.

bulletWilliam Reichenstein, "Tax Efficient Saving and Investing," TIAA-CREF Trends and Issues, February 2006, pp. 2-15.  This excellent article discusses many important means of investing in a tax-sensitive manner.

bulletDavid M. Stein, "Tax Advisor: Pay Now, or Later?," Investment Advisor, September 2004, pp. 169-170.  This excellent article discusses the trade-off between realizing capital gains now vs. realizing them later at what is likely to be a higher tax rate.

bullet"How to be a Tax-Savvy Investor," Vanguard.  An excellent on-line brochure at Vanguard's web site.

bullet"Why tax-managed funds still make sense," Vanguard, December 31 2003.  An excellent discussion of the continuing utility of tax managed funds in light of the 2003 tax-law changes.

Variable Annuities

Variable Annuities are appropriate for almost nobody.  Their high costs generally dramatically outweigh the potential benefit of tax deferral except for the lowest cost annuities for persons with investment time horizons of many decades.  However, if you are stuck in one, you ought to consider getting out of your high cost VA by doing a tax-free 1035 exchange into one of the excellent low-cost options at TIAA-CREF or Vanguard.

bulletFrank Armstrong, "Making Sense of Annuities," Investor Solutions, 2000.  An objective look at annuities.

bulletWilliam J. Bernstein, "A Limited Case for Variable Annuities," Efficient Frontier, Summer 2001.  The author makes a VERY limited case for a small amount of Variable Annuities in your portfolio IF (and only if) several important criteria are met.

"So, it’s clear that an annuity makes sense only if all four of the following conditions are met:
bulletThe asset class is highly tax-inefficient.
bulletThe asset class’s expected return is significantly higher than that of a comparable tax-efficient stock or bond expected return after reducing it by the higher expenses incurred in the annuity.
bulletThe asset class is held for a long period of time, say for a child’s trust.
bulletYou have run out of retirement vehicles in which to put this investment."

bulletScott Burns, "Variable annuity getting you down?  There are ways out," Dallas Morning News, May 13 2003.  A good description of how to harvest a loss in a variable annuity for its tax benefit.

bulletGail Buckner, "How to Write Off a Loss in a Variable Annuity," Fox News, November 15 2002.  A good description of how to harvest a loss in a variable annuity for its tax benefit.  There is a reference to Revenue Ruling 61-201.

bulletGlenn Daily, "Just say no to cash values," Glenndaily.com Information Services, Inc., May 1 2002.  This fascinating article suggests an interesting reason to use a Variable Annuity: in order to take advantage of a (currently unrealized) loss in a whole life policy that you no longer want/need.  If you just cash in such a policy (i.e., one whose current surrender value is less than the total premiums you've paid in to date), you don't have to pay any taxes, but you lose the tax benefit of the loss (i.e., you can't use the loss to offset other gains).  But if you instead do a 1035 exchange into a low-cost variable annuity, and then wait for the annuity to grow to the level of the tax basis, and then cash in the variable annuity, you get to avoid taxes on the gains between the current value and the (higher) basis, which is inherited from the whole life policy.

bulletYongling Ding and James D. Peterson, "Are Variable Annuities Right for Your Clients?," Journal of Financial Planning, January 2003, pp. 66-73.

bulletCarolyn T. Geer, "The Great Annuity Rip-Off," Forbes, February 1998, p. 106.  Also here.  This article exposes Variable Annuities as the poor investments they usually are.  Actually, that's not completely true — they are the preferred choice for Variable Annuity salespeople (who make large commissions on each sale).

bulletMoshe Arye Milevsky and Kamphol Panyagometh, "Variable Annuities versus mutual funds: A Monte-Carlo analysis of the options," Financial Services Review, Vol 10 2001, pp. 145-161.  "... for the average cost variable annuity with 66 basis points of insurance expenses, the risk-adjusted break even horizon can be as high as 30 years."  This paper concludes that the ability to harvest losses in taxable mutual fund accounts substantially increases the breakeven period before a post-tax variable annuity beats the taxable mutual fund.

bulletWilliam Reichenstein, "An Analysis of Non-Qualified Tax-Deferred Annuities," Journal of Investing, Summer 2000, pp. 73-85.  This paper shows that average cost annuities are appropriate for virtually nobody.  Low cost annuities, however, may make sense for investors who are in a lower tax-bracket in retirement and/or who have very long investment time horizons.

bulletWilliam Reichenstein, "Claim that Variable Annuities Usually Beat Mutual Funds Proves Lame: Critique of Huggard's Analysis in March 1999 Issue of Financial Planning," Baylor University, February 16 2001.  This paper critiques work by John Huggard which is often cited by Variable Annuity salespeople, professing to prove the superiority of Variable Annuities.  Reichenstein exposes Huggard's work as sloppy charlatanism.  "Based on his examples but after removing his errors, Huggard’s claim that variable annuities usually beat mutual funds proves lame."

bulletWilliam Reichenstein, "Who Should Buy a Nonqualified Tax-deferred Annuity?," Financial Services Review, Spring 2002, pp. 11-31.  In answer to the question posed in the title, there are three classes of investors for whom low cost VAs may make sense: those seeking protection from creditors, those with VERY long investment time horizons, and those in the distribution stage of life who are interested in annuitizing their investment portfolio distributions.  He goes on to point out that average or high cost VAs are appropriate for nobody.

bulletWilliam Reichenstein, "Tax-aware investing: implications for asset allocation, asset location, and stock management style," Journal of Wealth Management, Winter 2004, pp. 7-18.  A good summary of tax management issues.

bulletRichard B. Toolson, "Tax-Advantaged Investing: Comparing Variable Annuities and Mutual Funds," Journal of Accountancy, May 1991, pp. 71-77.  Toolson points out that the break even point whereby the tax-deferral benefit of a variable annuity outweighs the VA's extra costs may be as long as 50 years, or perhaps even longer.

bulletRuss Wiles, "Tax Law Cuts Appeal of Variable Annuities," Chicago Sun-Times, July 14 2003.  This article points out that the Jobs and Growth Tax Relief Reconciliation Act of 2003 has made Variable Annuities even less attractive than they were before.

bullet"NASD Notice to Members 99-35: The NASD Reminds Members Of Their Responsibilities Regarding The Sales Of Variable Annuities," National Association of Securities Dealers, May 1999. This note puts brokers and commission-based financial advisers on notice that their industry's self-regulatory organization is wise to their efforts to prey on unsuspecting consumers through forced sales of these almost-always unsuitable products.

bullet"Variable Annuities: What You Should Know," U.S. Securities and Exchange Commission, June 2002.  An overview of Variable Annuities.

bulletRonald A. Uitz, "Merits Of Using A Deferred Annuity To Fund A Tax Qualified Retirement Plan."  A bibliography of almost 300 citations criticizing use of variable annuities inside tax-qualified retirement plans.

Miscellaneous Other

bulletFrank Armstrong, "Strategy vs. Outcome," Investor Solutions, December 12 2002.  A good article pointing out the truth that a good strategy doesn't necessarily produce good short term results and a bad strategy doesn't necessarily produce bad short term results.  Put somewhat differently, you can have good results from poor strategy (if you are particularly lucky) and bad results from good strategy (if you are particularly unlucky).  Thus, you can't necessarily judge the "goodness" of an investing strategy based on how it well it performed (or would have performed) in the recent past.

bulletJohn H. Cochrane, "New Facts in Finance," Economic Perspectives, XXIII (3) Third quarter 1999 (Federal Reserve Bank of Chicago), pp. 36-58 (344kb).  Good readable summary of "recent" developments in financial economics.

bulletEugene Fama, Jr., "The Error Term," Dimensional Fund Advisors, December 2001.  An excellent discussion of the types of random "tracking error" you should expect in certain types of passive portfolios, in particular those of tax-managed funds which also minimize dividends.

bulletMerton H. Miller, "The History of Finance," Journal of Portfolio Management, Summer 1999, pp. 95-101.  An excellent overview of many of the leading innovations in financial economics.  Written by a Nobel Prize winner.

bullet"How the Really Smart Money Invests: A Brief History of Investing," McGriff Publications, 1999.  This excellent video describes prudent investing in general.

This web page contains the current opinions of Eric E. Haas at the time it is written and such opinions are subject to change without notice.  This web page is intended to serve two purposes:

bulletTo educate the public; and
bulletTo provide disclosure of Mr. Haas' opinions to prospective clients.  We believe that prospective clients are well-served by being made aware of what they are buying — and what they are buying is advice that is based on these opinions.

We believe the information provided here to be useful and accurate at the time it is written.  Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed. 

No investor should invest solely on the basis of information listed here.  Before investing, it is important to consult each prospective investment's prospectus and consider both its risk/return characteristics and its effect on your overall portfolio.

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