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Journal ArticleDOI

Hedge funds and optimal asset allocation: Bayesian expectations and spanning tests

11 Jan 2012-Financial Markets and Portfolio Management (Springer US)-Vol. 26, Iss: 1, pp 109-141
TL;DR: In this paper, the authors analyzed the contribution of hedge funds to optimal asset allocations between 1993 and 2010 and found that allocations to hedge funds improved the global minimum variance portfolio even after controlling for short-selling restrictions and minimum diversification constraints.
Abstract: This paper analyzes the contribution of hedge funds to optimal asset allocations between 1993 and 2010 The preferences of specific institutional investors are captured by implementing a Bayesian asset allocation framework that incorporates heterogeneous expectations regarding hedge fund alpha Mean-variance spanning tests are used to infer the ability of hedge funds to significantly enhance the mean-variance efficient frontier Further, a novel democratic variance decomposition procedure sheds light on the dynamics in the co-movement of hedge fund returns with a set of common benchmark assets The empirical findings indicate that portfolio benefits of hedge funds are time-varying and strongly depend on investor optimism regarding hedge funds’ ability to generate alpha In general, allocations to hedge funds improve the global minimum variance portfolio even after controlling for short-selling restrictions and minimum diversification constraints However, due to dynamics underlying the composition of the aggregate hedge fund universe, the factor structure of hedge fund returns has become more similar to the benchmark assets over time
Citations
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Journal ArticleDOI
TL;DR: In this paper, the authors analyzed the in-sample and out-of-sample portfolio effects resulting from adding commodities to a stock-bond portfolio for commonly implemented asset allocation strategies such as equally-and strategically-weighted portfolios, risk-parity, minimum-variance as well as reward-to-risk timing, mean variance and Black-Litterman.
Abstract: An essential motive for investing in commodities is to enhance the performance of portfolios traditionally including only stocks and bonds. We analyze the in-sample and out-of-sample portfolio effects resulting from adding commodities to a stock-bond portfolio for commonly implemented asset allocation strategies such as equally- and strategically-weighted portfolios, risk-parity, minimum-variance as well as reward-to-risk timing, mean-variance and Black–Litterman. We analyze different commodity groups such as agricultural and livestock commodities that currently are critically discussed. The out-of-sample portfolio analysis indicates that the attainable benefits of commodities are much smaller than suggested by previous in-sample studies. Hence, in-sample analyses, such as spanning tests, might exaggerate the advantages of commodities. Moreover, the portfolio gains greatly vary between different types of commodities and sub-periods. While aggregate commodity indices, industrial and precious metals as well as energy improve the performance of a stock-bond portfolio for most asset allocation strategies, we hardly find positive portfolio effects for agriculture and livestock. Consequently, investments in food commodities are not essential for efficient asset allocation.

92 citations

Journal ArticleDOI
TL;DR: In this article, the authors analyzed the in-sample and out-of-sample portfolio effects resulting from adding commodities to a stock-bond portfolio for commonly implemented asset-allocation strategies such as equally and strategically weighted portfolios, risk-parity, minimum-variance as well as reward-to-risk timing, mean variance, and Black-Litterman.
Abstract: An essential motive for investing in commodities is to enhance the performance of portfolios traditionally including only stocks and bonds. We analyze the in-sample and out-of-sample portfolio effects resulting from adding commodities to a stock-bond portfolio for commonly implemented asset-allocation strategies such as equally and strategically weighted portfolios, risk-parity, minimum-variance as well as reward-to-risk timing, mean-variance and Black-Litterman. We analyze different commodity groups such as agricultural and livestock com-modities that currently are critically discussed. The out-of-sample portfolio analysis indicates that the attainable benefits of commodities are much smaller than suggested by previous in-sample studies. Hence, in-sample analyses, such as spanning tests, might exaggerate the ad-vantages of commodities. Moreover, the portfolio gains greatly vary between different types of commodities and sub-periods. While aggregate commodity indices, industrial and precious metals as well as energy improve the performance of a stock-bond portfolio for most asset-allocation strategies, we hardly find positive portfolio effects for agriculture and livestock. Consequently, investments in food commodities are not essential for efficient asset allocation.

91 citations

Journal ArticleDOI
TL;DR: In this article, a sample-based version of the Black-Litterman model was proposed and implemented on a multi-asset portfolio consisting of global stocks, bonds, and commodity indices, covering the period from January 1993 to December 2011.
Abstract: The Black–Litterman model aims to enhance asset allocation decisions by overcoming the problems of mean-variance portfolio optimization. We propose a sample-based version of the Black–Litterman model and implement it on a multi-asset portfolio consisting of global stocks, bonds, and commodity indices, covering the period from January 1993 to December 2011. We test its out-of-sample performance relative to other asset allocation models and find that Black–Litterman optimized portfolios significantly outperform naive-diversified portfolios (1/N rule and strategic weights), and consistently perform better than mean-variance, Bayes–Stein, and minimum-variance strategies in terms of out-of-sample Sharpe ratios, even after controlling for different levels of risk aversion, investment constraints, and transaction costs. The BL model generates portfolios with lower risk, less extreme asset allocations, and higher diversification across asset classes. Sensitivity analyses indicate that these advantages are due to ...

67 citations

Journal ArticleDOI
TL;DR: In this article, the authors focus on the following diversification principles: law of large numbers, correlation, capital asset pricing model, and risk contribution or risk parity diversification, which are the DNA of the existing portfolio selection rules and asset pricing theories.
Abstract: Diversification is one of the major components of investment decision-making under risk or uncertainty. However, paradoxically, as the 2007–2009 financial crisis revealed, the concept remains misunderstood. Our goal in writing this paper is to correct this issue by reviewing the concept in portfolio theory. The core of our review focuses on the following diversification principles: law of large numbers, correlation, capital asset pricing model and risk contribution or risk parity diversification principles. These four diversification principles are the DNA of the existing portfolio selection rules and asset pricing theories and are instrumental to the understanding of diversification in portfolio theory. We review their definition. We also review their optimality, with respect to expected utility theory, and their usefulness. Finally, we explore their measurement.

23 citations

Journal ArticleDOI
TL;DR: In this paper, regression-based style analysis and other established methods in the bulk of finance journals literature, using both currency and fixed-income factors, were used to investigate the alpha of global bond funds.
Abstract: The main focus of this paper is the managerial skill or alpha of global bond funds. Analysis of the global bond market shows that both currency and bond-related returns are an integral part of the global fixed-income exposure. The present work deals with regression-based style analysis and other established methods in the bulk of finance journals literature, using both currency and fixed-income factors, and investigates the alpha of the globally invested fixed-income portfolios. There is empirical evidence that, between May 2007 and January 2015, global bond funds delivered significantly positive alpha. There is also an indication that periods of depreciation of the basis currency of the funds (EUR) improves fund performance, and market turmoil and negative events destroy alpha. During the Euro crisis and Fed tapering, the funds generated sustainable positive excess alpha. A division of the sample into two sub-samples gives more insight into the excess return. Additional robustness estimations deliver qualitatively similar results.

4 citations

References
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Journal ArticleDOI
TL;DR: In this article, the authors identify five common risk factors in the returns on stocks and bonds, including three stock-market factors: an overall market factor and factors related to firm size and book-to-market equity.

24,874 citations

Journal ArticleDOI
TL;DR: In this article, the effect of the bid-ask spread on asset pricing was studied and it was shown that market-observed expexted return is an increasing and concave function of the spread.

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Journal ArticleDOI
TL;DR: For example, this paper found that expected returns on common stocks and long-term bonds contain a term or maturity premium that has a clear business-cycle pattern (low near peaks, high near troughs).

4,110 citations

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TL;DR: In this article, the authors investigated whether marketwide liquidity is a state variable important for asset pricing and found that expected stock returns are related cross-sectionally to the sensitivities of returns to fluctuations in aggregate liquidity.
Abstract: This study investigates whether marketwide liquidity is a state variable important for asset pricing. We find that expected stock returns are related cross-sectionally to the sensitivities of returns to fluctuations in aggregate liquidity. Our monthly liquidity measure, an average of individual-stock measures estimated with daily data, relies on the principle that order flow induces greater return reversals when liquidity is lower. From 1966 through 1999, the average return on stocks with high sensitivities to liquidity exceeds that for stocks with low sensitivities by 7.5 percent annually, adjusted for exposures to the market return as well as size, value, and momentum factors. Furthermore, a liquidity risk factor accounts for half of the profits to a momentum strategy over the same 34-year period.

4,048 citations

01 Jan 1986
TL;DR: In this article, the effect of the bid-ask spread on asset pricing was studied and it was shown that market-observed expexted return is an increasing and concave function of the spread.
Abstract: Abstract This paper studies the effect of the bid-ask spread on asset pricing. We analyze a model in which investors with different expected holding periods trade assets with different relative spreads. The resulting testable hypothesis is that market-observed expexted return is an increasing and concave function of the spread. We test this hypothesis, and the empirical results are consistent with the predictions of the model.

2,810 citations