Asness, Clifford S.

An argument can be made that hedge funds, particularly a combination of traditional index funds and hedge funds, represent the future of investment management?but we are not there yet, for a variety of reasons. Some dark sides of hedge fund investing stand in the way. Hedge fund fees remain a contentious issue. Fees must become more rational in terms of paying for alpha versus hedge fund beta versus traditional beta. Other evolutionary changes must occur to make hedge funds more user-friendly, particularly for institutional investors.

De Souza, Clifford; Smirnov, Mikhail

Dynamic leverage as defined here depends on the level of hedge fund volatility, time horizon, and the difference between the fund\'s net asset value and its critical liquidation level. The critical liquidation level is the level of net asset value loss from which the fund manager could not recover and the fund would need to be liquidated to meet margin calls and redemptions. Dynamic leverage may be formalized very generally as a barrier option. At some intermediate critical level (above the liquidation level), efforts to reduce risk have little influence on the chance the fund will hit the critical liquidation level. A constant dynamic leverage portfolio insurance modifies the more traditional classic portfolio insurance.

Waring, M. Barton

Here is an update of the technology for calculating surplus efficient frontiers and surplus asset allocation that separately incorporates both systematic and unsystematic (or beta and alpha) characteristics, and yields an economic view of the liability. This measure of the liability is more relevant to the asset allocation problem than the standard approaches, enabling a better risk control system for pension plans by controlled hedging of the assets against the liability. The framework allows the inclusion of alpha and active risk from active management.

The long-only constraint imposed in traditional portfolios is one of the more severe constraints in terms of its impact on potential value-added, particularly for portfolios benchmarked to a capitalization-weighted benchmark such as the S&P 500; it can reduce the effectiveness of the manager\'s information by 50% or more. This loss can be avoided to a great degree by eliminating the long-only constraint or by creating a market-neutral portfolio with a derivatives overlay to restore market exposure. The information ratio can also be increased considerably using only underlying securities by allowing modest short positions and using the cash generated to purchase an equivalent amount of long positions, thus maintaining full market exposure.

Amenc, Noel; Malaise, Philippe; Martellini, Lionel

Tracking error is not necessarily bad. Good tracking error would be outperformance of a portfolio with respect to the benchmark. If they severely restrict the amounts invested in active strategies as a result of tight tracking error constraints, investors foreclose the opportunity for significant outperformance, especially during market downturns. A new methodology based on an optimal dynamic adjustment of the fractions invested in a passive core versus an active satellite portfolio allows investors to gain full access to good tracking error, while keeping bad tracking error below a given threshold. The method is a natural extension of constant-proportion portfolio insurance techniques.

Idzorek, Thomas M.; Bertsch, Fred

A quantitative measure of style drift measures the variability of a portfolio\'s effective asset mix as determined by return-based style analysis around the portfolio\'s average effective asset mix. A style drift score eliminates examination of countless rolling-window asset allocation graphs and rolling-window style maps; it quantifies the style drift of a portfolio in a single statistic. A style drift score is ideal for screening thousands of portfolios, comparing the style consistency of portfolios, and monitoring drift in a portfolio\'s style.

Levy, Haim; Alisof, Natalie

If investors are rational, firms and fund managers should not worry about the degree of their leverage or investment in the riskless asset—investors can always increase or reduce leverage by borrowing or lending themselves, thus creating their own so-called homemade leverage. The CAPM, the Sharpe ratio, and the Modigliani-Miller theory of capital structure rely on this idea. But are investors capable of effectively employing homemade leverage in their decision-making? When financial practitioners and management students are asked to choose one of several funds that they can mix with a risk-free asset, almost half of them fail to integrate the cash flows from the risky asset and the risk-free asset, and thus choose very inefficient portfolios. When they can choose from mixed funds, which perform the cash flow integration for the subjects, efficient choices are made 98% of the time. Clearly fund managers should carefully consider their funds\' leverage; capital structure may influence firm values by virtue of a clientele effect.

Pedersen, Henrik H.; de Zwart, Gerben J.

Trend-following strategies use past price performance in an attempt to predict future price performance. While widely applied in currency markets with a good track record for major currency pairs, the strategies do not apply universally. Under what conditions does trend-following work or fail to work? A new model created from simulations and later verified on G10 currency pairs assesses trend model profitability from the statistical features of the return distribution of the asset under consideration. The results and examples facilitate the selection of appropriate currencies or assets for inclusion in trend models going forward.

Biglova, Almira; Ortobelli, Sergio; Rachev, Svetlozar; Stoyanov, Stoyan

Some new performance measures may be regarded as alternatives to the most popular criterion for portfolio optimization, the Sharpe ratio. Analysis of some allocation problems here takes into consideration portfolio selection models based on different risk perceptions and sample paths of the final wealth process for each allocation problem. One new performance ratio seems to be suitable for some optimization problems, but we need a thorough classification of the set of performance measures that would be ideal for large classes of financial optimization problems.

Brooks, Robert; Gray, Brian

An analysis of semiannual Wall Street Journal long-term interest rate forecasts made since 1982 by a panel of distinguished economic experts shows that the consensus forecast of long-term U.S. Treasury bond yield changes is poor. A naive forecast is more accurate.