Abstract: We use recently proposed tests to extract jumps and cojumps from three types of assets: stock index futures, bond futures, and exchange rates. We then characterize the dynamics of these discontinuities and informally relate them to US macroeconomic releases before using limited dependent variable models to formally model how news surprises explain (co)jumps. Nonfarm payroll and federal funds target announcements are the most important news across asset classes. Trade balance shocks are important for foreign exchange jumps. We relate the size, frequency and timing of jumps across asset classes to the likely sources of shocks and the relation of asset prices to fundamentals in the respective classes.

Abstract: The asset allocation of defined benefit pension plans is a setting where both risk shifting and risk management incentives are likely be present. Empirically, firms with poorly funded pension plans and weak credit ratings allocate a greater share of pension fund assets to safer securities such as government debt and cash, whereas firms with well-funded pension plans and strong credit ratings invest more heavily in equity. These relations hold both in the cross-section and within firms and plans over time. The incentive to limit costly financial distress plays a considerably larger role than risk shifting in explaining variation in pension fund investment policy among U.S. firms.

Abstract: This article investigates a fund manager's risk-taking incentives induced by an increasing and convex relationship of fund flows to relative performance. In a dynamic portfolio choice framework, we show that the ensuing convexities in the manager's objective give rise to a finite risk-shifting range over which she gambles to finish ahead of her benchmark. Such gambling entails either an increase or a decrease in the volatility of the manager's portfolio, depending on her risk tolerance. In the latter case, the manager reduces her holdings of the risky asset despite its positive risk premium. Our empirical analysis lends support to the novel predictions of the model.

Abstract: Accurate appraisal of hedge fund performance must recognize the freedom with which managers shift asset classes, strategies, and leverage in response to changing market conditions and arbitrage opportunities. The standard measure of performance is the abnormal return defined by a hedge fund's exposure to risk factors. If exposures are assumed constant when, in fact, they vary through time, estimated abnormal returns may be incorrect. We employ an optimal changepoint regression that allows risk exposures to shift, and illustrate the impact on performance appraisal using a sample of live and dead funds during the period January 1994 through December 2005.

Abstract: This paper derives optimal equity-bond-annuity portfolios for households who face stochastic capital market returns, differential exposures to mortality risk and uncertain uninsured health expenses, and differential Social Security and defined benefit pension coverage. The results show that the health spending risk drives household portfolios to shift from risky equities to safer assets and enhances the demand for annuities due to their increasing-with-age superiority over bonds in hedging against life-contingent health spending and longevity risks. Households with higher income have a greater incremental demand for life annuities. The safe and higher-return annuities in turn provide a greater leverage for equity investment in the remaining asset portfolios.

Abstract: In risk management it is desirable to grasp the essential statistical features of a time series representing a risk factor. This tutorial aims to introduce a number of different stochastic processes that can help in grasping the essential features of risk factors describing different asset classes or behaviors. This paper does not aim at being exhaustive, but gives examples and a feeling for practically implementable models allowing for stylised features in the data. The reader may also use these models as building blocks to build more complex models, although for a number of risk management applications the models developed here suffice for the first step in the quantitative analysis. The broad qualitative features addressed here are fat tails and mean reversion. We give some orientation on the initial choice of a suitable stochastic process and then explain how the process parameters can be estimated based on historical data. Once the process has been calibrated, typically through maximum likelihood estimation, one may simulate the risk factor and build future scenarios for the risky portfolio. On the terminal simulated distribution of the portfolio one may then single out several risk measures, although here we focus on the stochastic processes estimation preceding the simulation of the risk factors Finally, this first survey report focuses on single time series. Correlation or more generally dependence across risk factors, leading to multivariate processes modeling, will be addressed in future work.

Abstract: We will review the econometrics of non-parametric estimation of the components of the variation of asset prices. This very active literature has been stimulated by the recent advent of complete records of transaction prices, quote data and order books. In our view the interaction of the new data sources with new econometric methodology is leading to a paradigm shift in one of the most important areas in econometrics: volatility measurement, modelling and forecasting. We will describe this new paradigm which draws together econometrics with arbitrage free financial economics theory. Perhaps the two most influential papers in this area have been Andersen, Bollerslev, Diebold and Labys(2001) and Barndorff-Nielsen and Shephard(2002), but many other papers have made important contributions. This work is likely to have deep impacts on the econometrics of asset allocation and risk management. One of our observations will be that inferences based on these methods, computed from observed market prices and so under the physical measure, are also valid as inferences under all equivalent measures. This puts this subject also at the heart of the econometrics of derivative pricing. One of the most challenging problems in this context is dealing with various forms of market frictions, which obscure the efficient price from the econometrician. Here we will characterise four types of statistical models of frictions and discuss how econometricians have been attempting to overcome them.

Abstract: Markowitz (1959) mean-variance (MV) portfolio optimization has been the practical standard for asset allocation and equity portfolio management for almost fifty years. However, it is known to be overly sensitive to estimation error in risk-return estimates and have poor out-of-sample performance characteristics. The Resampled Efficiency™ (RE) techniques presented in Michaud (1998) introduce Monte Carlo methods to properly represent investment information uncertainty in computing MV portfolio optimality and in defining trading and monitoring rules. This paper reviews and updates the literature on estimation error and RE portfolio optimization and rebalancing. We resolve several open issues and misunderstandings that have emerged since Michaud (1998). In particular, we show RE optimization to be a Bayesian-based generalization and enhancement of Markowitz’s solution.

Abstract: Most asset allocation analyses use the mean–variance approach for analyzing the trade-off between risk and expected return. Analysts use quadratic programming to find optimal asset mixes and the characteristics of the capital asset pricing model to determine reasonable optimization inputs. This article presents an alternative approach in which the goal of asset allocation is to maximize expected utility, where the utility function may be more complex than that associated with mean–variance analysis. Inputs for the analysis are based on the assumption of asset prices that would prevail if there were a single representative investor who desired to maximize expected utility.

Abstract: The value of active investment management is traditionally measured by alpha, beta, tracking error, and the Sharpe and information ratios. These are essentially static characteristics of the marginal distributions of returns at a single point in time, and do not incorporate dynamic aspects of a manager's investment process. In this paper, I propose a new measure of the value of active investment management that captures both static and dynamic contributions of a portfolio manager's decisions. The measure is based on a decomposition of a portfolio's expected return into two distinct components: a static weighted-average of the individual securities' expected returns, and the sum of covariances between returns and portfolio weights. The former component measures the portion of the manager's expected return due to static investments in the underlying securities, while the latter component captures the forecast power implicit in the manager's dynamic investment choices. This measure can be computed for long-only investments, long/short portfolios, and asset allocation rules, and is particularly relevant for hedge-fund strategies where both components are significant contributors to their expected returns, but only one should garner the high fees that hedge funds typically charge. Several analytical and empirical examples are provided to illustrate the practical relevance of these new measures.

Abstract: Pairs trading is a popular trading strategy that tries to take advantage of market inefficiencies in order to obtain profit. The idea is simple: find two stocks that move together and take long/short positions when they diverge abnormally, hoping that the prices will converge in the future. From the academic point of view of weak market efficiency theory, pairs trading strategy shouldn’t present positive performance since, according to it, the actual price of a stock reflects its past trading data, including historical prices. This leaves us with a question, does pairs trading strategy presents positive performance for the Brazilian market? The main objective of this research is to verify the performance and risk of pairs trading in the Brazilian financial market for different frequencies of the database, daily, weekly and monthly prices for the same time period. The main conclusion of this simulation is that pairs trading strategy was a profitable and market neutral strategy at the Brazilian Market. Such profitability was consistent over a region of the strategy’s parameters. The best results were found for the highest frequency (daily), which is an intuitive result.

Abstract: This article studies institutional investor allocations to the socially responsible asset class. We propose two elements influence socially responsible institutional investment in private equity: internal organizational structure, and internationalization. We study socially responsible investments from Dutch institutional investments into private equity funds, and compare socially responsible investment across different asset classes and different types of institutional investors (banks, insurance companies, and pension funds). The data indicate socially responsible investment in private equity is 40–50% more common when the decision to implement such an investment plan is centralised with a single chief investment officer. Socially responsible investment in private equity is also more common among institutional investors with a greater international investment focus, and less common among fund-of-fund private equity investments.

Abstract: Economic theory assigns a central role to risk preferences. This paper develops a measure of relative risk tolerance using responses to hypothetical income gambles in the Health and Retirement Study. In contrast to most survey measures that produce an ordinal metric, this paper shows how to construct a cardinal proxy for the risk tolerance of each survey respondent. The paper also shows how to account for measurement error in estimating this proxy and how to obtain consistent regression estimates despite the measurement error. The risk tolerance proxy is shown to explain differences in asset allocation across households.

Abstract: The paper shows that country-specific exchange traded funds (hereafter ETFs) enhance global asset allocation strategies. Because ETFs can be sold short even on a downtick, global strategies that diversify risk across country-specific ETFs generate efficiency gains that cannot be achieved by simply investing in a global index open or closed-end fund. Besides, the benefits of international diversification can be achieved with country-specific ETFs at a low cost, with a low tracking error and in a tax-efficient way. For all these reasons, country-specific ETFs may be considered as serious competitors to traditional country open and closed-end funds.

Abstract: This paper proposes a solution method for the discrete-time long-term dynamic portfolio optimization problem with state and asset allocation constraints. We use the ideas of Model Predictive Control (MPC) to solve the constrained stochastic control problem. MPC is a solution technique which was developed to solve constrained optimal control problems for deterministic control applications. MPC solves the optimal control problem with a receding horizon where a series of consecutive open-loop optimal control problems is solved. The aim of this paper is to develop an MPC approach to the problem of long-term portfolio optimization when the expected returns of the risky assets are modeled using a factor model based on stochastic Gaussian processes. We prove that MPC is a suboptimal control strategy for stochastic systems which uses the new information advantageously and thus is better than the pure optimal open-loop control. For the open-loop optimal control optimization, we derive the conditional portfolio distribution and the corresponding conditional portfolio mean and variance. The mean and the variance depend on future decision about the asset allocation. For the dynamic portfolio optimization problem, we consider constraints on the asset allocation as well as probabilistic constraints on the attainable values of the portfolio wealth. We discuss two different objectives, a classical mean–variance objective and the objective to maximize the probability of exceeding a predetermined value of the portfolio. The dynamic portfolio optimization problem is stated, and the solution via MPC is explained in detail. The results are then illustrated in a case study.

Abstract: Hedge funds sometimes use mathematical techniques to “capture” the short-term volatility of stocks and perhaps other types of securities. This sort of strategy resembles market making and is sometimes considered a form of statistical arbitrage. This study shows that for the universe of large-capitalization U.S. stocks, even quite naive techniques can achieve remarkably high information ratios. The methods used are quite general and should be applicable also to other asset classes.

Abstract: In a financial market with one riskless asset and n risky assets whose prices are lognormal, we solve in a closed form the problem of a pension fund maximizing the expected CRRA utility of its surplus till the (stochastic) death time of a representative agent. We consider a unique asset allocation problem for both accumulation and decumulation phases. The optimal investment in the risky assets must decrease during the first phase and increase during the second one. We accordingly suggest it is not optimal to manage the two phases separately, and outsourcing of allocation decisions should be avoided in both phases.

Abstract: This paper provides cross-country evidence of the link between securitized real estate and stocks, bonds, and direct real estate. First, the behavior of betas in sixteen countries is examined and then the causes of their variation are identified. Second, securitized real estate returns are regressed on "pure" stock, bond, and real estate factors. The betas are generally found to decrease over the 1990-2004 period, but the causes for such decline differ across countries. Securitized real estate returns are found to be positively associated with stock and direct real estate returns, but negatively related to bond returns. Financial assets contribute greatly to the variance of securitized real estate, while the impact of direct real estate is limited. However, a large fraction of the variance is not accounted for by these factors, especially in the United States, which suggests that other factors are at play. (ProQuest: ... denotes formulae omitted.) With a market capitalization estimated at USD 800 billion as of the end of 2005 (Brounen, Ling, and Eichholtz, 2006), the importance of securitized real estate as an asset class has grown considerably. Accordingly, much research has been devoted to studying the behavior and to unmasking the driving factors of publicly traded real estate.1 As for any other asset class, there are many important reasons for studying the return generating process of securitized real estate, such as to examine whether returns can be forecasted (Liu and Mei, 1992; Bharati and Gupta, 1992; and Brooks and Tsolacos, 2003), to ascertain the diversification benefits of the asset class (Mull and Soenen, 1997; and Gordon, Canter, and Webb, 1998), and to analyze the inflationhedging effectiveness of such vehicles (Liu, Hartzell, and Hoesli, 1997; and Adrangi, Chatrath, and Raffiee, 2004). The aims of this paper are twofold. The first objective is to expand the investigation done by Khoo, Hartzell, and Hoesli (1993) on the behavior of real estate investment trust (REIT) betas in the United States by employing a similar procedure to securitized real estate in sixteen countries from 1990 to 2004 and by providing a cross-country analysis of the causes underlying the variations in the betas. Second, this research expands Clayton and MacKinnon's (2003) work on the importance of stock, bond, and real estate ''pure factors'' in explaining securitized real estate returns by doing the analysis for five countries. In sum, this research seeks to expand the literature by depicting the dynamics that underpin different markets and analyze if the previous findings for the U.S. can be generalized for other markets. The paper is organized as follows. First, there is a discussion of related work on securitized real estate's betas and on the hybrid nature of such securities. Second, there is a presentation of the methodologies employed and the data, respectively, followed by a discussion of the results. Finally, the paper closes with concluding remarks. Literature Review An important question addressed by the literature concerning securitized real estate has been whether or not this asset class outperforms other asset classes. Chan, Hendershott, and Sanders (1990), Glascock (1991), and Peterson and Hsieh (1997) find that REITs do not display higher risk-adjusted returns with respect to stocks. On an international basis, this result is confirmed by Ling and Naranjo (2002). Contrasting evidence for the U.S. is provided by Liu and Mei (1992) who show that on a riskadjusted basis, EREITs outperform large caps and small caps, but not bonds. Lying in between and probably settling the differences, Chen, Hsieh, and Jordan (1997) derive a Jensen measure for each EREIT using excess returns and conclude that EREITs outperform other investments during some periods but not always. To better understand the asset class, the analysis of the time-varying nature of securitized real estate betas constitutes another stream of research. …

Abstract: Building models for high dimensional portfolios is important in risk management and asset allocation. Here we propose a novel way of estimating models of time-varying covariances that overcome some of the computational problems which have troubled existing methods when applied to 1,000s of assets. The theory of this new strategy is developed in some detail, allowingformal hypothesis testing to be carried out on these models. Simulations are used to explore the performance of this inference strategy while empirical examples are reported which show the strength of this method.

Abstract: This paper investigates the dynamics of individual portfolios in a unique dataset containing the disaggregated wealth and income of all households in Sweden. Between 1999 and 2002, stockmarket participation slightly increased but the average share of risky assets in the financial portfolio of participants fell moderately, implying little aggregate rebalancing in response to the decline in risky asset prices during this period. We show that these aggregate results conceal strong household-level evidence of active rebalancing, which on average offsets about one half of idiosyncratic passive variations in the risky asset share. Sophisticated households with greater education, wealth, and income, and holding better diversified portfolios, tend to rebalance more aggressively. We also study the decisions to enter and exit risky financial markets. More sophisticated households are more likely to enter, and less likely to exit. Portfolio characteristics and performance also influence exit decisions. Households with poorly diversified portfolios and poor returns on their mutual funds are more likely to exit; however, consistent with the literature on the disposition effect, households with poor returns on their directly held stocks are less likely to exit.

Abstract: A portfolio9s asset allocation determines the portfolio9s risk and return characteristics. To maintain its original risk and return characteristics over time, the portfolio must be rebalanced. This paper identifies the factors that influence a rebalancing strategy. We present a conceptual framework for developing rebalancing strategies that can accommodate changes in the financial market environment and in asset class characteristics, as well as account for an institution9s unique risk tolerance and time horizon. We conduct simulations to analyze how these different factors and different rebalancing guidelines affect a portfolio9s risk and return characteristics. We conclude with a review of practical rebalancing considerations.

Abstract: We investigate the ability of mutual fund managers to successfully rotate between investment styles based on characteristics such as market capitalisation, valuation ratios, and price momentum. We find evidence in favour of market timing among a group of 153 US-based mutual funds with a Morningstar Midcap/Blend investments style. We also find evidence in favour of mutual funds being able to predict the direction of the valuation and momentum style returns, but not their magnitude. Our results indicate that the mutual funds in our sample were not able to rotate successfully between stocks with small and large market capitalisation.

Abstract: Personal preferences and financial incentives make homeownership desirable for most families. Once a family purchases a home they find it impractical (costly) to frequently change their ownership of residential real estate. Thus, by deciding how much home to buy, a family constrains their ability to adjust their asset allocation between residential real estate and other assets. To analyze the impact of this constraint on consumption, welfare, and post-retirement wealth, we first investigate an individual’s optimal asset allocation decisions when they are subject to a “homeownership constraint.” Next, we perform a “thought experiment” where we assume the existence of a market where a homeowner can sell, without cost, a fractional interest in their home. Now the housing choice decision does not constrain the individual’s asset allocations. By comparing these two cases, we estimate the differences in post-retirement wealth and the welfare gains potentially realizable if asset allocations were not subject to a homeownership constraint. For realistic parameter values, we find that the homeowner would require a substantial increase in total net worth to achieve the same level of utility as would be achievable if the choice of a home could be separated from the asset allocation decision. The robustness of the analysis is evaluated with respect to the model’s parameters and initial state variables. We find that changes in the values of the constraint (i.e., the value of the home) and the expected real rate of home value appreciation are the only state variables or parameter that is associated with a large change in asset allocation and/or the burden imposed by the housing constraint. This finding suggests the importance of a detailed examination of the impact of inter-regional differences in home prices and expected rates of appreciation on asset allocation and post-retirement wealth.

Abstract: We consider the problem of optimal funding and asset allocation for a defined benefit pension scheme by assuming that the pension fund can be invested in a risk-free asset and a risky asset whose return follows a jump diffusion process. We extend existing literature which mainly assumes that the risky asset’s return follows a pure diffusion process. In a stochastic analysis of the optimal policies we show that the optimal contribution and asset allocation policies have similar forms as in the pure diffusion approaches, but with a modification for the effect of jumps. These results hold under both constant pension scheme benefit outgo and stochastic pension scheme benefit outgo. Using a sensitivity analysis of the effect of the mean jump magnitude on the asset allocation policy, we show that increasing (in absolute terms) the mean jump magnitude reduces the allocation in the risky asset and increases the allocation in the risk-free asset.

Abstract: This paper studies the strategic asset allocation for an investor with risky liabilities which are subject to inflation and real interest rate risk and who invests in stocks, government bonds, corporate bonds, T-bills, listed real estate, commodities and hedge funds. Using a vector autoregression for returns, liabilities and macro-economic state variables the paper explores the intertemporal covariance structure of assets and liabilities. We find horizon effects in time diversification, risk diversification, inflation hedge and real interest rate qualities. The covariance structures give insights into which asset classes have a term structure of risk that is different from that of stocks and bonds. The alternative assets classes add value for long-term investors. Differences in strategic portfolios for asset-only and asset-liability investors are due to differences in the global minimum variance and liability hedge portfolio. We find that the benefits of long-term investing are larger when there are liabilities.

Abstract: This paper investigates the effect of changes in state prudent trust investment laws on asset allocation in noncommercial trusts. The old prudent‐man rule favored “safe” investments and disfavored “speculation” in stock. The new prudent‐investor rule directs trustees to craft an investment portfolio that fits the risk tolerance of the beneficiaries and the purpose of the trust. Using state‐ and institution‐level panel data from 1986–97, we find that after adoption of the new prudent‐investor rule, institutional trustees held about 1.5–4.5 percentage points more stock at the expense of “safe” investments. Our findings explain roughly 10–30 percent of the overall increase in stock holdings in the period studied. The rest of the increase appears to be attributable to stock market appreciation. We conclude that, even though trust fiduciary laws are nominally default rules, institutional trustees are nonetheless sensitive to changes in those rules.

Abstract: The asset allocation of defined benefit pension plans is a setting where both risk shifting and risk management incentives are likely be present Empirically, firms with poorly funded pension plans and weak credit ratings allocate a greater share of pension fund assets to safer securities such as government debt and cash, whereas firms with well-funded pension plans and strong credit ratings invest more heavily in equity These relations hold both in the cross-section and within firms and plans over time The incentive to limit costly financial distress plays a considerably larger role than risk shifting in explaining variation in pension fund investment policy among US firms