Research Review | 11 Mar 2016 | Portfolio Strategy

Understanding Modern Portfolio Construction
Cullen O. Roche (Orcam Financial Group)
February 22, 2016
Over the last 75 years there have been great strides in modern finance, portfolio theory and asset allocation strategies. Despite this progress the process of portfolio construction remains grounded in many theoretical concepts that can result in inappropriate or unrealistic frameworks. In this paper we provide an overview of the development of these ideas, construct a general foundation for understanding portfolio construction and produce a framework for simplifying, systematizing and streamlining the process in an attempt to establish a realistic and suitable process for portfolio construction.

Return Chasing and Trend Following: Superficial Similarities Mask Fundamental Differences
Victor Haghani (Elm Partners) and Samantha McBride (Elm Partners)
January 29, 2016
Return chasing is often cited as one of the primary behavioral foibles of investors, resulting in sub-par returns. Surprisingly, the literature does not provide a generally accepted and testable description of return chasing. This paper proposes a simple definition. It then describes how return chasing so defined differs from trend following and how return chasing explains the shortfall of the returns of active, market timing investors compared to static asset allocation strategies. Finally, it shows that if the trading flows of return chasers are large enough to impact prices, then return chasing provides a powerful explanation of the positive returns earned by trend following strategies, which alternative descriptions of return chasing, such as it is trend following but with too long of a horizon, do not provide.

Predicting Stock Market Returns Using the Shiller CAPE — An Improvement Towards Traditional Value Indicators?
Norbert Keimling (StarCapital AG)
January 21, 2016
Existing research indicates that it is possible to forecast potential long-term returns in the S&P 500 for periods of more than 10 years using the cyclically adjusted price-to-earnings ratio (CAPE). This paper concludes that this relationship has also existed internationally in 17 MSCI Country indexes since 1979. In addition, the paper also examines the forecasting ability of price-to-earnings, price-to-cash-flow and price-to-book ratio, as well as that of dividend yield and of CAPE adjusted for changes in payout ratios. The results indicate that only price-to-book ratio and CAPE enable reliable forecasts on subsequent returns and market risks. In countries with structural breaks, price-to-book ratio even exhibits some advantages compared to CAPE.
Based on these findings, the long-term equity market potential for various markets is forecasted using CAPE and price-to-book ratio. The current valuation makes it likely that investors with a global portfolio can achieve real returns of 6% over the next 10 to 15 years. Even greater increases can be expected in European equity markets (8%) and in emerging markets (9%). Due to the high valuation of the US stock market, US investors can only expect below-average returns of 4% with a higher drawdown potential.

Invest Like an Endowment
Drew F. Knowles (Berkeley Square Capital Management)
March 1, 2016
This paper studies the investment returns and asset allocation policies of college and university endowments who share annual performance and asset allocation data with the National Association of College and University Business Officers (NACUBO) annual endowment study. In this paper, we review the performance data and asset allocation policies by the size of the endowment assets as set forth by NACUBO. Further, we investigate how an individual investor could replicate the high risk-adjusted returns based on the asset allocation policies of reporting institutions, including Yale University.

Style and Skill: Hedge Funds, Mutual Funds, and Momentum
Mark Grinblatt (UCLA), et al.
January 6, 2016
Institutional investors’ 13F stockholdings reveal stark differences between the investment philosophy and skill of hedge funds and mutual funds. Hedge funds tend to buy stocks with low past returns, while mutual funds tend to be trend followers. The nearly two-thirds of hedge funds that follow contrarian strategies outperform their risk- and characteristic-adjusted benchmarks by 2.4% per year. Hedge funds that follow momentum strategies do not outperform their benchmarks, irrespective of whether these benchmarks control for momentum. By contrast, most mutual funds follow momentum strategies; their managers exploit the momentum anomaly but lack trading skill once we control for the effect of momentum on stock returns. The most profitable trades of contrarian hedge funds are purchases of stocks sold by momentum mutual funds. The superior performance of contrarian hedge funds is persistent and arises from strategies that are more complex than purchasing stocks with low past returns.

The Market Portfolio is NOT Efficient: Evidences, Consequences and Easy to Avoid Errors
Pablo Fernandez (University of Navarra), et al.
March 3, 2016
The Market Portfolio is not an efficient portfolio. There are many evidences that tell us that: the equal weighted indexes have beaten their market-value weighted indexes for many years, many easy-to-build portfolios (some “smart-beta”, “multifactors”) have beaten market-value weighted indexes… We document evidences about seven ‘Equal weighted indexes’ that have had higher returns than the corresponding ‘market-value weighted index’: S&P500, MSCI Emerging Markets, FTSE 100, MSCI World. MSCI, DAX 30 and IBEX 35. However, many finance and investment books still recommend “to diversify in the same relative proportions as in a broad market index such as the Standard & Poor’s 500”, many funds compare their performance with the return of market-value weighted indexes. Without homogeneous expectations, the market portfolio cannot be an efficient portfolio for all investors.

What’s in Your Smart Beta Portfolio? A Fundamental and Macroeconomic Analysis
January 8, 2016
Daniel Ung (CAIA) and Priscilla Luk (S&P Dow Jones Indices)
The demand for transparent, rules-based investing has been one of the secular trends in the asset management industry over recent decades. Within the passive investment arena, alternatively weighted — or smart beta — strategies have witnessed remarkable growth and have amassed over USD 497 billion of assets in exchange-traded products alone. In their broadest sense, smart beta strategies can refer to a swath of strategies that are designed to provide access to a wide array of return-enhancing risk premia (or risk factors). Usually, return derived from these factors is unaccounted for by the basic capital asset pricing model, which embraces market beta as the sole measure of compensated risk. As of yet, there is no agreement on a definitive list of these risk premia in academia or in industry, and this remains the object of continued research and discussion. We have therefore elected to focus only on those factors for which empirical evidence exists to suggest that the factors may provide risk-adjusted returns in multiple markets and over the long run; namely, volatility, momentum, quality, value, dividend yield, and size. One may reasonably expect that methodologies for different indices that target the same factors would be similar, and that any divergence between indices would elicit interest in only academic circles rather than from practitioners or investors.

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