Showing papers in "The Journal of Wealth Management in 2004"

A New Paradigm for Practical Application of Behavioral Finance: Creating Investment Programs Based on Personality Type and Gender to Produce Better Investment Outcomes

Abstract: The authors believe that the next phase in the practical application of behavioral finance is to correlate established investor biases with the psychographic and gender profiles of specific investors. They ask, “Are certain personality types or genders susceptible to biases identified in the behavioral finance literature? If so, can this information be helpful to investors and advisors?” Their study examines the responses of 100 investors given a detailed Myers-Briggs Type Indicator® personality test and a questionnaire designed to reveal investor biases. They find that personality types and genders are differentially susceptible to numerous investor biases; accordingly, they introduce a new paradigm of practical application of behavioral finance that leverages their findings.

Goals-Based Investing: Integrating Traditional and Behavioral Finance

Abstract: This article examines opportunities to improve wealth management by combining traditional finance theory with the observations of behavioral finance. Areas of focus include risk measurement, risk profiling, and methods for managing behavioral biases. In the area of risk measurement, the author stresses the importance of capturing investor preferences and goals and proposes several measures that are consistent with this objective. The author also critiques common risk profiling techniques, advocating separate risk tolerance estimates for separate goals rather than an overall risk tolerance for each investor, noting that the total portfolio framework of traditional finance is inconsistent with investors9 tendencies towards mental accounting. A better result may be achieved by linking individual strategies to a specific goal or goals. The author describes a process for implementing his recommendations through examples, considering the challenges of investing to meet current lifestyle expenses and investing for a fixed planning horizon. The article closes with a call to align investment strategy development with common investor goals, arguing that this will promote consistency between the investment principles of the practitioner and the perspective of the individual investor.

Modern Portfolio Theory and Behavioral Finance

Abstract: The author starts with a brief history of the ‘discoveries’ of modern portfolio theory and behavioral finance and suggests that the latter may well create just as much of a revolution in the wealth management world as the former did in institutional asset management. So which is better? modern portfolio theory, which describes how markets work, or behavioral finance, which describes how people work? The answer, of course, is that we need both. MPT and behavioral finance are both important tools in helping us design and manage successful investment portfolios. Both have advantages and disadvantages. MPT is very useful, but it is descriptive, not prescriptive, and relies on assumptions that may not always be valid. Behavioral finance picks up where modern portfolio theory leaves off, completing the circle, but the author identifies seven potential areas of weakness that can vitiate outcomes driven solely by it. He concludes by proposing an iterative combination of the two: for example, could one design the client9s portfolio in the traditional manner, using MPT-based strategic asset allocation techniques and, simultaneously, design the client9s portfolio using techniques informed by behavioral finance and then compare the two results in an instructive way.

Hedge Fund Investing: A Quantitative Approach to Hedge Fund Manager Selection and De-Selection

Abstract: This paper introduces a number of quantitative tools for manager selection, due diligence, and the ongoing monitoring of hedge funds that we believe to be particularly suited to the nature of hedge fund returns. The analyses introduced typically address information relevant to the entire distribution function as compared to the more conventional practice of utilizing lower moments such as mean returns and standard deviations. They start by illustrating the degree to which dispersion occurs in hedge fund returns, indicating the need for a high level of both quantitative and qualitative manager selection. They note a strong relationship between volatility and the inter-quartile return statistic that may be a result of the leveraged nature of the strategies involved. They then test the hypothesis that hedge fund performance will persist, suggesting through parametric and non-parametric tests that it is flawed. However, they find by comparison that risk, as defined by volatility, is highly persistent and conclude that this strongly supports a risk budget approach to hedge fund allocation, offering a new, objective algorithm for risk budgeting. For manager selection, they propose the use of the Hurst exponent in conjunction with the D-statistic to identify managers with persistent good performance, also introducing a formal methodology, utilizing a logit model to isolate the characteristics of a database of liquidated funds and find agreement with an earlier model proposed for liquidation. Finally, noting that while a manager9s returns, standard deviation, downside deviation, and a number of other statistics should be analyzed, they find the Omega function has particular relevance to hedge funds given its statistical equivalence to the return series and its sensitivity to the investor utility function.

Revisiting the Role of Hedge Funds in Diversified Portfolios

Abstract: Observing that hedge funds have clearly become one of the most important building blocks in diversified portfolios over the last several years, the author starts by digging into the error associated with the classification of these strategies under one single header (i.e., hedge funds). He demonstrates that the hedge fund universe is really quite heterogeneous and that it should therefore be broken down into distinct subgroups. The author then revisits the critical issue of the difference in the return distribution experienced by hedge funds in general: the skewness of many return series, the survivorship bias inherent in these series, the dangers associated with self-reporting, the excess kurtosis that affects many strategies, and their general lack of tax-efficiency. Finally, the author addresses the question of the place of hedge fund strategies in a diversified portfolio, suggesting that a traditional mean-variance optimization model is not likely to produce a successful allocation.

Wealthy Investor Attitudes, Expectations, and Behaviors Toward Risk and Return

Abstract: The article discusses findings of surveys conducted by the Institute for Private Investors, about wealthy investors9 attitudes toward risk, expectations of future portfolio returns, and behaviors in the use of risk metrics. These attitudes, expectations, and behaviors are examined in relation to historical stock market performance and demographic factors such as age, gender, and respondent status as a family office executive. In a cross-sectional analysis, the author reports on the lack of correlation of risk and expected return, and on evidence of investor overreaction. These conclusions seem to support behavioral finance theory. The author concludes with suggestions for investors and advisors to ameliorate these biases.

Trends in Private Equity

Abstract: The author starts with the observation that there has been a distinct change in the private equity market. What was previously thought to be a segmented, inefficient marketplace has turned into an efficient, auction driven asset class. Defining private equity as comprising the market for leveraged buyouts and corporate restructuring and excluding other segments such as venture capital, mezzanine debt, and distressed debt, the author reviews the current state of the private equity market, observing trends such as the increasing prevalence of auctions, the growing role of secondary purchases, and even the internationalization of the marketplace, and draws implications on return expectations. He considers a few interesting new trends such as a focus on middle market deals, business development companies, and the cross-over between private equity and hedge fund offerings. He concludes with the view that the competitive environment for private equity firms has changed significantly, forcing private equity firms to seek new sources of revenues and businesses, but one should be careful to note that the skill sets needed to extract value from a privately run operating company versus the skill sets needed to extract trading/arbitrage opportunities from publicly traded securities are very different.

Are Managers of Funds of Hedge Funds Good Market Timers

Abstract: The author gathers evidence about the market-timing skills of fund of funds (FOF) managers during the 1993-2001 period using FOF indices as benchmarks. He uses the Treynor-Mazuy (1966) (TM) and the Henriksson-Merton (1981) (HM) unconditional and conditional market-timing models and follows the methods used by Ferson and Warther (1996) and Ferson and Schadt (1996). By conditioning betas, the author investigates whether FOF managers can in times of changing economic conditions successfully interpret publicly available market information to their benefit using public information variables. He examines FOF returns with public information variables using the TM and HM models.

The Enviable Dilemma: Hold, Sell, or Hedge Highly Concentrated Stock?

Abstract: It9s not unusual for investors, fiduciaries, and trustees to find themselves with too much of a good thing: owning or overseeing a large quantity of a highly appreciated low-basis stock. In this emotional issue, investors are typically torn: hold the stock that9s made them rich and avoid the large tax bill, begin to diversify, or hedge? On average, investors haven9t gotten paid to take on the incremental risk of single stocks. But that fact alone isn9t enough to act upon? and indeed there are no singular answers. In this study the authors present an analytical framework that highlights the critical trade-offs underlying any single-stock decision, which has to factor in the investor9s unique circumstances. These include his long-term goals, risk tolerance, and total portfolio, as well as the volatility of his single stock. We use all of this information to identify courses of action to consider. This analysis can be applied to other risk-management diversification strategies, such as liquidating over time and hedging with derivatives.

The Portfolio Management Problem of Individual Investors: A Quantitative Perspective

Abstract: The authors start by observing that, over the past 30 to 40 years, a generally accepted approach has evolved for the management of institutional investment funds, noting that, today, one sees an effort to adapt this approach to managing the funds of individual investors. They note that there are difficulties, as the investment problems of institutions and individuals differ in some fundamental ways. Until institutional methods are suitably modified to account for these differences, the experience of individual investors is likely to remain less than it could be. This article identifies some of these key differences and suggests appropriate adaptations of institutional methods to suit individual investors.

In Search of the Optimal Fund of Hedge Funds

Abstract: In this paper, the author investigates whether it is possible for a fund of hedge funds to not only offer investors access to a diversified basket of hedge funds but to provide skewness protection at the same time. He studies two different strategies. The first is for a fund to buy stock index puts and leverage itself, in line with the skewness reduction strategy proposed earlier in Kat (2003). In general, the latter strategy is too dependent on the actual asset allocation strategy followed by investors to allow a fund to be constructed that is optimal for all investors at the same time. However, for investors that invest more or less equal amounts in equities and fixed income instruments such a fund can indeed be structured. The second strategy is for a fund to buy put options on itself. The author shows that this does allow a fund to offer skewness protection to different types of investors at the same time, but compared to the optimal strategy the protection will be less accurate.

Absolute Returns: The Future in Wealth Management?

Abstract: The author focuses on absolute return strategies as the third paradigm of active asset management. He argues that the asset management industry is about to move from its second stage into its third. The first stage was a holistic approach as individuals and institutions sought to generate returns by balancing stocks, bonds, and cash in a single portfolio. This paradigm suffered two great weaknesses: mediocre returns due to the lack of specialization and lack of manager accountability. These weaknesses were the seeds that enabled a whole new investment management industry to grow, and a shift to the second paradigm: the relative performance game, the second paradigm, which fits nicely with modern portfolio theory (MPT) and seminal academic work on performance evaluation. Fostering as this does mediocrity as opposed to meritocracy, the second paradigm led to poor performance, a strong disincentive to use risk management techniques to preserve investors9 wealth, and a focus on asset growth rather than performance. The absolute return approach, on the other hand, seeks to solve some of the issues of the relative return approach. The author then proceeds to analyze the critical feature of absolute return strategies and concludes that there is still a lot of mythology with respect to hedge funds, much of it built on anecdotal evidence, oversimplification, myopia, or simply a misrepresentation of facts.

Hedge Fund Risk Factors With Option-like Structures: Examples and Explanations

Abstract: The authors start with the observation that hedge funds are not obliged to disclose sources of earnings and trade strategies. For this reason little is known on how returns are achieved. One approach to shed some light on this matter is based on Sharpe [1992], which introduced a model for the explanation of returns of traditional mixed funds (e.g., composed of equities and bonds). Mixed funds usually pursue a strategy of “long only” whereas hedge funds also use short selling and leveraging, and act in a much more flexible way. These trade strategies of hedge funds lead to option-like structures, which are not covered by the basic Sharpe model. They discuss and describe the possibilities to include such structures into a regression model. Offering data on the various such strategies, they present the empirical results of an analysis of the risk factors of the Standard & Poor9s hedge fund indices. They conclude with the view that their study confirms the findings documented in the literature and that further research could be directed toward capturing further risk factors in order to increase the explanatory power of regression models.

Making Hedge Funds More Tax-Efficient

Abstract: The author starts with the fundamental observation that hedge funds are generally tax-unfriendly. They often employ trading strategies that generate attractive pre-tax returns, but unfortunately these strategies also produce income taxed at the highest rate of 35%. In addition, while the funds generate no cash income for their investors, those same investors must nevertheless pay taxes each year on their shares of partnership income. He suggests that there are two approaches to minimizing the tax treatment of hedge fund investments: portfolio-level management and investor-level management. None of these ideas will wipe out taxes; they are meant to defer taxes as long as possible, and when tax is to be paid the goal is to only pay a 15% rate. Care is given to not disturbing the investment goals in achieving tax efficiency; in other words, don9t let the tail wag the dog. Thus, the article breaks the possibilities into what can be done at the fund level and what investors can do on their own if the hedge funds do not employ such opportunities.

Illiquid Asset Allocation and Policy Weights: How Far Can They Deviate?

Abstract: The author develops a simple approach for computing the probability that an initial asset allocation will breach a pre-specified policy weight over a given time horizon. The model is consistent with assumptions made in most Asset Liability Management (ALM) studies and the closed-form analytic expression “buys” the user a variety of robust insights. After calibrating this model to broadly defined alternative investment asset class data, the author concludes that a conservative 5% commitment to an illiquid asset class has a 1/3 chance of doubling (i.e., to 10% of the fund) within 5 years, and tripling (i.e., to 15% of the fund) within 15 years. Paradoxically, the lower the effective correlation between the performance of a given asset class and the remainder of the portfolio—which is normally something to be coveted in strategic asset allocation—the greater the chances of breaching a given policy weight. The results suggest that initial target allocations to illiquid asset classes should be reduced relative to their liquid counterparts, when a conventional mean-variance analysis was used to obtain these policy weights.

Private Equity Performance Measurement and Its Role in a Portfolio

Abstract: Based on analysis of private equity performance, this article challenges the widespread assumption that private equity investments can provide both exceptional returns and enhanced diversification. Private equity investments entail significant and unique risks, including a necessarily long investment horizon, rigid liquidity constraints, and high bankruptcy rates among portfolio companies, that can make it difficult for investors to realize the potentially superior performance of private equity investments. Furthermore, the article stresses that diversification should not be considered a major benefit of private equity investing. Rather, private equity should be treated as but one small component of a portfolio9s allocation to all equity investments, private and public.

The Strengths and Weaknesses of Various Financial Simulation Methods

Abstract: Financial planners employ one of two statistical procedures to generate estimates of future asset values: historical simulation and Monte Carlo simulation. Through an application of statistical analysis, financial simulation, and intuition, this paper appraises the relative merits and limitations of these disparate approaches. In short, Monte Carlo simulators possess distinct advantages, but overall they do not offer a superior alternative to appropriately conducted historical simulations.

Long/Short Equity Hedge Fund Investing: Are Sector Specialists Better Than Generalists?

Abstract: Investors in long/short equity hedge funds frequently debate the relative merits of generalist and sector specialist hedge fund managers. Most of this debate has been anecdotal. Conventional wisdom favors specialists for their focus, dedication, and expertise in a single sector. Based on an empirical study, the authors found that sector specialists as a whole are not better off than generalists in terms of their exposure to systematic risks. After adjusting for volatility, the percentage of funds with positive performance Graham-Harvey measures is almost identical for generalists and sector specialists. They also present evidence that skilled managers are not an overwhelming majority within their sample of the long/short hedge fund managers. Finally, the study suggests that the more extreme the market dislocation, the lower the diversification benefits that average hedge fund managers can offer. On average, many sector specialists have higher correlation to relevant benchmarks than generalists in extreme market dislocations. However, all strategies fail to provide adequate downside protection under the worst market conditions. Furthermore, after accounting for market activities (such as volatility) in a specified market, their study shows, using various performance measures, that there is no major significant difference between generalists and sector specialists when observed as a group.

The Long and Short of Tax Efficiency

Abstract: For many private investors, tax efficiency is often addressed by employing investment managers with low portfolio turnover or by incorporating a “tax efficient core” as part of a more diversified portfolio. In this paper, the author suggests that there are situations where the pursuit of tax efficiency can and should take place outside of an investor9s core portfolio. His proposed solution, ironically, relies on hedge funds, which are notoriously known as tax inefficient investment strategies. He maintains that certain types of hedge funds—when managed appropriately—can be excellent vehicles for increasing the tax efficiency of a portfolio.

Investing in Emerging Stock Markets

Abstract: By blending theoretical and empirical approaches, the authors suggest that an allocation to emerging-markets stocks can enhance a portfolio9s long-term risk-adjusted returns. The benefit of such an allocation is the opportunity to increase a portfolio9s return while reducing its risk through diversification. However, the cycle of bull and bear markets, financial crises, and stock market booms and bubbles can break down the long-term case. Over certain short periods of time, investments in emerging markets have reduced a portfolio9s return while increasing its volatility. To decide on the appropriate allocation to emerging markets, investors must weigh their expectations of long-run risk-adjusted returns against the potential regret of their portfolios9 underperforming benchmarks or peer group averages over shorter investment horizons. In addition, practical factors such as transaction costs and the need to fund local liabilities may call for a smaller allocation than standard recommendations.

Tax-Aware Investing: Implications for Asset Allocation, Asset Location, and Stock Management Style

Abstract: This study has three major sections. The first section examines how management style affects the share of returns received by and risk borne by the investor when stocks are held in a taxable account. One good management strategy is to manage stocks passively, ideally until the capital gains qualify for a step-up in basis at death or are used to fund a charitable contribution. The second examines the optimal location of assets in a portfolio comprising both taxable and tax-exempt pockets. It concludes that, to the degree possible without violating the target asset allocation, stocks should be passively held in taxable accounts and bonds should be held in retirement accounts. The third section examines dynamic tax-aware investing. Predictably, a good approximation to optimal behavior for a tax-aware investor is to realize all losses and let capital gains grow unrealized.

Family Governance in 2004: Parallels from World Politics and Corporate Boardrooms

Abstract: This article addresses three questions, all of which are highly relevant to the broader issue of family governance. The author first asks who are the families for whom governance is an issue and who “counts” as members of those families. Second, she turns to defining what “governance” means in the family context. Finally, she discusses how a family can deliberately establish an internal governance structure to achieve its goals. The author concludes that family governance works in the same way as does any other form of governance. A good governance system is one that provides fairly for its members and adapts well to changing circumstances. Each member feels consulted, respected, and treated fairly. The pride in the family can then be passed on to future generations, who will be able to participate in the same flexible process. The shade from the trees that were planted long ago will protect the future generations.

Strategy and Technology for the New Wealth Management

Abstract: The author suggests that financial service institutions9 interest in the “new wealth management” is a natural evolutionary response of institutions seeking to regain and renew their competitive advantage. He discusses the business and technology drivers that should be considered by financial institutions when deciding to implement technology solutions to enhance their wealth management business. He concludes that, without a dedicated commitment to changing culture, actively reforming process, and engaging in strategic collaboration, the firm (and its divisions and advisors) will remain an island unto itself—a value proposition that cannot be sustained when clients and their fortunes are at stake.

Market Timing and the Business Cycle

Abstract: In the pursuit of superior portfolio returns, some portfolio managers have turned to market timing for the extra edge. There is, however, no consistent strategy that earns returns above the benchmark. For an asset class to provide higher return requires a shift in the economy such as from an expansion to a contraction. Since valid economic data is not available until long after the period under consideration, the National Bureau of Economic Research often dates the turning points of an economic cycle months after the event. The results of this study show that the portfolio manager must be able to recognize the transition from expansion to contraction within one month of the turning point and act accordingly. To attempt to identify the shift the authors establish a set of rules with respect to economic data and test them on a hypothetical portfolio. The result is an annual return less than that of the S&P 500 over the same period. How can an investor recognize the peak or trough so soon? Certainly not by using any data that is readily available. The idea that excess returns can be earned by market timing is obviously a fascinating one, but thus far, there has been no accurate method to consistently realize these returns.

A New Endowment Distribution Plan: How to Insure Current Spending While Growing the Fund Corpus

Abstract: The management of an endowment fund poses unique investment challenges. Obviously there is the choice concerning the allocation of the endowment corpus between riskier investments with higher returns and virtually risk free investments. There is also a need to provide stability in the amounts distributed for spending to further the purposes of the endowment. The authors show one way to achieve these objectives is to split the fund principal between essentially risk-free commercial annuities for a selected fixed term and a diversified stock portfolio. This will allow the fund to guarantee fixed expenditures for current needs and provide an excellent opportunity to grow the fund.

Strategies for Maximizing Estate Wealth

Abstract: The conventional wisdom that using tax-sheltered accounts such as Keogh plans, IRAs, 401(k) programs, etc. is an excellent way to save for retirement but a poor way to accumulate an estate is shown to be incorrect at least under a variety of reasonable circumstances. It is shown that net estate wealth (i.e., after income and estate taxes) generally will be greater by saving in such plans compared to saving in conventional (i.e., taxable) accounts. The misconception arises because the net wealth left after taxes on two estates of equal size at death will be less when a significant part of the assets are in tax-sheltered plans, but this is not a fair comparison because if all other factors (e.g., income and consumption during the accumulation period, pre-tax rates of return, etc.) are held constant, the estate associated with the tax-sheltered investment will unequivocally be larger at the time of death. It is also shown that saving in tax-sheltered plans during the early years of the lifecycle, followed by saving in a taxable account in the later years, will generate a maximum after-tax transfer to heirs.

Maximizing Long-Term Cumulative Returns

Abstract: Maximizing long-term returns is widely ignored by mainstream financial theory, which focuses mainly on mean variance optimization. To maximize long-term cumulative returns, investors need only maximize the geometric expected return of their portfolio. It is a virtual certainty that over the long-term the geometric expected return will provide an extremely accurate estimate of the annualized cumulative return. A simple mathematical proof is described. Some counter intuitive consequences for investing are illustrated using simple numerical examples. Basic directions to apply the strategy to real life investing are included. Although little known, the cumulative return maximization strategy will likely appeal to down-to-earth investors, due to its sound mathematical foundation, and its meaningful, tangible results.

Charitable Giving: Noblesse Oblige, “The Gospel of Wealth,” and Other Shibboleths

Abstract: The author starts with the observation that charitable giving is a big business, especially in the United States, where as much as $120 billion a year is estimated as the total of charitable contributions by individuals. She then questions what really motivates wealthy families to give to charities at all. Listing and discussing the various motivations frequently offered, she begs to disagree and submits that the true motivation for most family giving programs is instinctive and sympathetic. She concludes that, at the heart or foundation of charitable giving, we see an urge to help others to whom we can relate—whether in the neighborhood or around the globe—and suggests that this urge is instinctive and emotional. When we give in the best sense we give from a love of mankind.

Performance of the Largest CTAs in Negative S&P 500 Months and Extreme Market Events

Abstract: Since the early 1990s Commodity Trading Advisors (CTAs) have done well, but in recent extreme market events and negative S&P 500 months, they have significantly outperformed hedge funds and market indices. The authors conclude that the trend by pension fund managers as well as wealthy individuals toward increasing their exposure to CTAs as complementary alternative investment vehicles in traditional stock, bond, and hedge fund portfolios makes sense, suggesting that they have understood the diversification benefits inherent in these strategies.

Great Expectations: Challenge and Opportunity for Today's Wealth Manager

Abstract: Demographics, industry consolidation, and the increasing complexity and interdependence of different types of financial services are creating a growing demand for wealth managers—those advisors who can offer a broad spectrum of estate planning and wealth management in addition to sophisticated investment management services.