Benchmark Returns Research Articles

Investing in mutual funds when returns are predictable

This paper forms investment strategies in US domestic equity mutual funds, incorporating predictability in (i) manager skills, (ii) fund risk loadings, and (iii) benchmark returns. We find predictability in manager skills to be the dominant source of investment profitability—long-only strategies that incorporate such predictability outperform their Fama-French and momentum benchmarks by 2 to 4%/year by timing industries over the business cycle, and by an additional 3 to 6%/year by choosing funds that outperform their industry benchmarks. Our findings indicate that active management adds significant value, and that industries are important in locating outperforming mutual funds.

Investing in Mutual Funds when Returns are Predictable

This paper analyzes the performance of portfolio strategies that invest in no-load, open-end U.S. domestic equity mutual funds, incorporating predictability in (i) manager skills, (ii) fund risk-loadings, and (iii) benchmark returns. Predictability in manager skills is found to be the dominant source of investment profitability -- long-only strategies that incorporate such predictability considerably outperform prior-documented hot-hands and smart-money strategies, and generate positive and significant performance with respect to the Fama-French and momentum benchmarks. Specifically, these strategies outperform their benchmarks by 2-4% per year through their ability to time industries over the business cycle. Moreover, they choose individual funds that outperform their industry benchmarks to achieve an additional 3-6% per year. Overall, our findings indicate that industries are important in locating outperforming mutual funds, and that active management adds much more value than documented by prior studies.

The Timing Ability of Fixed Income Mutual Funds

This paper evaluates the ability of US fixed income mutual funds to time common factors related to bond markets. We control for potential non-timing-related sources of nonlinearity in the relation between fund returns and common factors. Such nonlinearities may arise from dynamic trading strategies or derivatives, funds' responses to public information, they may appear in the underlying assets held by the fund, or they may be related to systematic patterns in stale pricing. Controlling for these effects we find that funds returns are more typically concave than convex, in relation to benchmark returns, which suggests negative timing ability. Thus, the evidence is similar to what previous studies have found for equity funds.

Dividing gains between a client and her agent

A client(she) contracts with an agent(him), who has limited liability, as follows: she lends him one dollar at time 0 and he uses the money to trade in a security market. As return, he promises to give her a fixed amount \(e^{r_0T}\) at the final time T; in addition, if the real return rate of the strategy is larger than \(r_0\), she can also get a fixed proportion \((1-\alpha)\) of the “excess profit” and he will take the rest. Assume that the market is complete and the agent aims to maximize the risk-neutral value of his profit subject to some expected shortfall constraint. The reasonable benchmark return rate \(r_0\) and the proportion \(\alpha\) are explicitly worked out.

On the Existence of Visual Technical Patterns in the UK Stock Market

The aim in this paper is to replicate and extend the analysis of visual technical patterns by Lo et al. (2000) using data on the UK market. A non‐parametric smoother is used to model a nonlinear trend in stock price series. Technical patterns, such as the ‘head‐and‐shoulders’ pattern, that are characterised by a sequence of turning points are identified in the smoothed data. Statistical tests are used to determine whether returns conditioned on the technical patterns are different from random returns and, in an extension to the analysis of Lo et al. (2000), whether they can outperform a market benchmark return. For the stocks in the FTSE 100 and FTSE 250 indices over the period 1986 to 2001, we find that technical patterns occur with different frequencies to each other and in different relativities to the frequencies found in the US market. Our extended statistical testing indicates that UK stock returns are less influenced by technical patterns than was the case for US stock returns.

Cross-Industry, Cross-Country Allocation

Recent empirical evidence has demonstrated that both global industry factors and country factors are important determinants of equity prices. In light of this evidence, we describe a cross-industry, cross-country allocation framework for making active global equity investment decisions. We present a forecasting approach to predicting the relative performance of industries in each of 22 developed country equity markets and demonstrate that a blend of style signals provides an effective way to predict the return performance of these assets. The out-of-sample portfolio performance of investment strategies based on these forecasts for the 1991–2001 period would have provided annual gross returns in excess of the world benchmark return of 400 bps a year with one-way turnover of 50 percent. Conventional global risk models cannot explain this outperformance. Thus, explaining this “anomaly” is a challenge for the investment and academic communities.

Incentives, Discretion, and Asset Valuation in Closed–End Mutual Funds

This paper studies earnings management using 363 closed–end mutual fund firm–years of data. Closed–end fund assets consist of unrestricted and restricted securities, and realized and unrealized income. While unrestricted securities are not subject to earnings management, restricted security values are largely discretionary. Managerial valuation of restricted securities is modeled as contingent on unrestricted returns relative to a performance benchmark. Four unrestricted performance regions are identified. Known multi–period compensation incentives become the basis for hypothesizing earnings management behaviors in the regions in the form of restricted security valuation. Across several benchmarks, the results are consistent with multi–period maximization rather than simpler single–period compensation maximization or income smoothing. Funds with extreme unrestricted performance show relatively larger income–decreasing earnings management, and funds with slightly–below benchmark returns show relatively larger income–increasing earnings management than those slightly above. These results clarify the relationship between complex earnings management behavior and managerial incentives.

Closed-End Funds and Turnover Restrictions

Past studies have found that investors can earn higher returns than a benchmark by purchasing shares of closed-end funds with discounts or selling shares with premiums. These studies either ignored the impact of transaction costs or used equally weighted portfolio strategies without controls on turnover or transaction costs. We examined whether constraining the holdings of individual funds and turnover has any bearing on the excess returns earned by closed-end equity funds over a benchmark return. We found that when transaction costs were low, portfolios with frequent rebalancing and loose turnover constraints outperformed the benchmark and other portfolios in the period we studied. We found, in contrast, that when transaction costs were moderate to high, portfolios with less-frequent rebalancing and tight turnover constraints outperformed the benchmark and other portfolios. The implication for the portfolio manager is that excess returns may be achieved in a variety of trading-cost environments with the proper mix of policy variables.

Mutual fund performance and seemingly unrelated assets

Estimates of standard performance measures can be improved by using returns on assets not used to define those measures. Alpha, the intercept in a regression of a fund's return on passive benchmark returns, can be estimated more precisely by using information in returns on nonbenchmark passive assets, whether or not one believes those assets are priced by the benchmarks. A fund's Sharpe ratio can be estimated more precisely by using returns on other assets as well as the fund. New estimates of these performance measures for a large universe of equity mutual funds exhibit substantial differences from the usual estimates.

The Pricing of Relative Performance Based Incentives for Executive Compensation

Since 1995, more than 50 percent of the firms in the FTSE‐100 have granted rewards to their senior executives, the payoffs of which are contingent on the firm’s stock return relative to a bench mark return over a given period (hereafter, relative performance incentives). This paper investigates and derives closed‐form solutions for a class of relative performance incentives that have a positive payoff if, in addition to the traditional contingencies, the firm’s stock return is higher than the market return times a threshold. Results suggest that UK firms, in practice, when relative performance incentives (RPI’s) substitute absolute performance incentives (API’s) tend to (i) decrease the cost of their compensation packages; (ii) undertake more risky capital‐investment projects; and (iii) avoid providing so high‐powered incentives to increase shareholder wealth.

Smoothing in Commercial Property Valuations: Evidence from Individual Appraisals

We explore the causes and extent of appraisal smoothing, defined as a temporal lag bias in appraisals, by analyzing how appraisers use the transaction price data available to them. We test the empirical validity of the partial adjustment model that underlies the traditional “unsmoothing” of benchmark return indexes. We reject the no‐lag null hypothesis and find that the extent of bias‐inducing behavior appears to vary over time in the manner suggested by rational appraisal behavior as the quantity and quality of contemporaneous transaction information changes. We find evidence that appraisers valuing the same property in consecutive periods anchor onto their previous appraised values, resulting in more lagging than first‐time appraisals. An implied policy prescription is for investment managers to rotate appraisers so as not to allow the same appraisal firm to consecutively value the same property.

Mutual Fund Performance and Seemingly Unrelated Assets

Estimates of standard performance measures can be improved by using returns on assets not used to de?ne those measures. Alpha, the intercept in a regression of a fund's return on passive benchmark returns, can be estimated more precisely by using information in returns on non-benchmark passive assets, whether or not one believes those assets are priced by the benchmarks. A fund's Sharpe ratio can be estimated more precisely by using returns on other assets as well as the fund. New estimates of these performance measures for a large universe of equity mutual funds exhibit substantial dierences from the usual estimates.

The ordered mean difference as a portfolio performance measure

The ordered mean difference (OMD) function is a running mean of the difference between returns on a given fund or security and a benchmark such as the market portfolio, ordered by values of the benchmark. The expectation of this function, conditional on the observed series of benchmark returns, can be used as a portfolio performance measure. Such a formulation is the financial counterpart of the equivalent variation of welfare economics, which in the present context can be regarded as the resource rental value of the manager's market timing ability. The conditional ordered mean difference (COMD) is related to a number of recent approaches to the principles of performance measurement. It can be estimated either by using the OMD as a non-parametric estimate, or else by fitting the conditional expectation by least squares.

A Portfolio Performance Index

Fund managers may sensibly be averse to earning a time-averaged portfolio return that is less than the average return of some designated benchmark. When a portfolio is expected to earn a higher average return than the benchmark return, the probability that it will not approaches zero asymptotically at a computable exponential decay rate. The probability decay rate is thus proposed here as a new portfolio “performance index.” In the widely analyzed special case in which returns are normally distributed, the new performance-index-maximizing portfolio is the same as the popular Sharpe-ratio-maximizing portfolio. The results of the two approaches generally differ, however, because of nonnormal levels of skewness and/or kurtosis in the portfolio attributable to large asymmetrical economic shocks or investments in options and other derivative securities. An illustrative example will show that the new index is easy to implement and, consistent with empirical evidence on portfolio choice, favors investments with positively skewed returns.

Alpha, Alpha… Who's Got the Alpha?

Hedge funds have also been called “Absolute Return” strategies given their supposed ability to achieve positive returns in a wide range of market environments. In addition, performance is often based on their ability to obtain a return in excess of the risk free rate. However, the ability to obtain alpha (i.e., return above the risk free rate) is not indicative of managerial ability. In fact, any strategy that has volatility should use a benchmark return above the risk free rate. In this article, various forms of alpha determination are discussed. Moreover, the article emphasizes the problem of using Sharpe ratios to compare return/risk performance of two dissimilar strategies, especially when these strategies would be added to a predetermined portfolio.

Portfolio Performance and Agency

The evaluation and compensation of portfolio managers is an important problem for practitioners. Optimal compensation will induce managers to expend effort to generate information and to use it appropriately in an informed portfolio choice. Our general model points the way towards analysis of optimal performance evaluation and contracting in a rich model. Optimal contracting in the model includes an important role for portfolio restrictions that are more complex than the sharing rule. The agent's compensation gives the agent approximately to benchmark return plus an incentive fee equal to a portfolio measure that is approximately the excess of return above the benchmark. This measure is often used by practitioners but is simpler than the Jensen measure and other measures commonly recommended in the academic literature. In addition to the excess return above the fixed benchmark, the manager is given some additional incentive to take a position that deviates from the benchmark to remove an incentive to tend towards being a closet indexer. Efficient contracting involves restrictions on what portfolio strategies can be pursued, and prior communication of the information gathered.

The Performance of Actively Managed International Mutual Funds

International mutual funds allow individual investors to diversify abroad at a reasonable cost. This paper tests whether international funds that actively engage in country and security selection outperform passive global benchmarks. We apply a mean-variance efficiency test that incorporates the practical prohibition against short sales of open-end mutual funds. Our tests reject the efficiency of the world equity market portfolio over the sample period, and our funds as a group outperform the inefficient world index. However, we find no evidence of security selectivity ability using a 12-country benchmark. We do find that active international funds provide global diversification benefits. Tests using the Positive Period Weight (PPW) measure of Grinblatt and Titman (1989), which is robust to nonlinearity in fund and benchmark returns, yield similar results.

Issues in Measuring Performance of Commingled Real Estate Funds

Executive Summary. This study analyzes the performance of non-securitized real estate investments in relation to two phenomena—the effect of asset management fees and the persistence of the returns. This is done using data from the Townsend Real Estate Universe on CREFs. Cumulative returns and Jensen's alpha are used for seventy-two CREFS. The NCREIF Index is used as the benchmark return. The results indicate that performance rankings are not effected by asset management fees and that the choice of a risk-adjusted performance measure (Jensen's alpha) or a non-risk-adjusted performance measure (the cumulative return) have a significant impact.

Residual Risk

Excess returns are deviations between actual returns and benchmark returns, and residual risk is the volatility of these returns. The authors use a framework based on the information ratio, defined as the excess returns to residual risk, to examine the effects of using arbitrary constraints to control residual risk. They find that these constraints may lead to suboptimal behavior by investors and portfolio managers.

A STATISTICAL MODEL OF CHANGES IN ASSET PRICES EMPLOYING INTRADAY DATA: A RECURSIVE APPROACH

This paper develops a statistical model of changes in asset prices employing intraday data. The procedure proposed in this paper is an alternative to the Hausman, Lo, and MacKinlay (1992) ordered probit model. Similar to the ordered probit model, our model also contains the linear regression model as a special case. However, compared to the ordered probit model, our specification is parsimonious. Parsimony does come at a cost, but for certain applications where, for example, a benchmark return is needed in intraday studies, there is value in terms of the computational effort required and the method's robustness to various empirical microstructure phenomena. The parsimony is achieved when statistical implications arising from intraday structural changes, which may due to such factors as concentrated trading patterns, are incorporated into a statistical model.