Today, high-quality research exists that demonstrates the investment approaches that are most likely to work in the future, as well as those approaches that are unnecessarily risky. There is overwhelming data about how impossible it is to pick stocks, trade in and out of them, and fare as well as the market. Likewise, the notion that there is a system by which one can consistently profit by timing the purchase and/or sale of securities has been proven false. The data on this is crystal clear and has been compiled by Nobel laureates and other highly acclaimed thinkers and academics who have created a consensus over the past two decades.
Nevertheless, many investment and financial advisers pay no attention to the evidence and instead follow a pre-scientific model. Their conventional investment approach assumes that investing amounts to speculation and forecasting and that the goal is to use “special” knowledge to achieve returns that are greater than the market as a whole. This “conventional approach” perpetuates because millions of year of evolution leaves us all hard wired to believe mankind can find patterns, trends and predict outcomes; contrary to the evidence. It is easier to sell products and investment solutions with a good story; investors want and expect this. Evidenced based investment solutions are ironically harder for people to accept such is the power of our nature and nurture (see Behavioural Finance).
Below you will find a collection of articles and papers which form the bulk of the scientific evidence. It is by no means complete; however we think many of the most important works are included along with, articles that discuss practical implementation.
Please bear in mind that most of the research was undertaken in the US which represents nearly half the world’s capital markets. Consequently many of the documents are written by Americans academics, journalists and financial advisers. Unfortunately suitable funds to enable implementation of many of the strategies advocated by this body of work were not available in the UK until 2004, indeed the worlds largest provider of low cost institutional asset class funds; Vanguard, still does not see a market big enough in the UK or Europe to warrant launching funds (as of 2008). Thus there has been relatively little research undertaken by UK institutions.
Academic papers are often very difficult for the laymen to read. We have included many for the benefit of professionals and academics visiting our site and these are indicated by the following symbol.
Articles we feel lay people should be able to understand are labelled 'easy', those that may require deeper knowledge are labeled 'tough'.
Asset allocation is a term used to refer to how an investor distributes his or her investments among various classes of investment vehicles. At the highest level, this refers to a split between stocks and bonds. Many more finely defined sub-asset allocations are also common.
Easy "The Nature of Commodity Index Returns," Robert J. Greer,Journal of Alternative Investments, Summer 2000. The data from 1970 to the present indeed support the risk and return benefits of commodity index investing:
Dimensional Fund Advisors (DFA)
Many of our recommended funds are provided by DFA. However, you may never have heard of them because they do no advertising to the public. Here are some good articles on DFA.
“Indexing Goes Hollywood,” Don Phillips, Managing Director
"How the REALLY smart money INVESTS: Nobel Prize winners entrust their nest eggs to DFA, where investing is a science, not a spectator sport," Shawn Tully, Fortune, July 6 1998. An excellent article. Perhaps the best introduction to DFA in the popular press.
"So You Think Stock Picking Is a Fool's Game," Robert Barker, Business Week, November 18 2002. An extremely brief basic introduction to DFA.
"Going Their Own Way," Raymond Fazzi, Financial Advisor, March 2001.
"The Best Fund Family You've Never Heard of — and Why It Doesn't Want Your Money," Beverly Goodman, TheStreet.com, August 26 2002.
"'Investment Porn' Panned by DFA Funds Preaching Fama's Gospel," Seth Lubove, Bloomberg.com, March 27 2007.
"Dear Dagen: What's a Good Substitute for the Exclusive DFA Funds," Dagen McDowell, TheStreet.com, July 8 1999.
"DFA funds hard to buy, easy to own," Timothy Middleton, CNBC Money Central, June 4 2002.
"Brain Trust: With a host of noted academics minding the store, Dimensional Fund Advisors has attracted a loyal following among fee-only advisors," Lynn O'Shaughnessy, Bloomberg Wealth Manager, November 2002.
"The Dimensions of a Pioneering Strategy," Joanna L. Ossinger, The Wall Street Journal, November 6 2006.
"Dimensional's 'Passive' Course Pays Off," Tom Petruno, Los Angeles Times, December 30 2005.
"Ditching the Monkey," Eric J. Savitz, Barron's, January 9 2006.
"Taking a Market's Measure," Barbara Mlotek Whelehan, Mutual Funds, August 2001.
"The Index Insurgents," Scott Woolley, Forbes, October 30 2006.
"Global Investment Solutions," Dimensional Fund Advisors, 2002. DFA's
brochure.
“Putting Theory into Practice”, Jennifer Vanasco, originally appeared in GSB Chicago, Vol. 21 No. 4, Autumn 1999. How the founders of DFA came together.
Dimensional Fund Advisors UK, web site.
Diversification refers to the idea that your investments ought to be spread out amongst many investments. On average, a diversified portfolio will have the same expected return (but less risk/volatility) as a less diversified portfolio with similar characteristics. When put that way, it is easy to see why diversification is beneficial — why have a more risky portfolio if you can't expect higher returns in exchange for taking on that additional risk?
"Diversification is your buddy." — Merton Miller, winner of the Nobel Memorial Prize in Economic Sciences, 1990
"How Many Stocks Do You Need to be Diversified?" Daniel J. Burnside, Donald R. Chambers, and John S. Zdanowicz, AAII Journal, July 2004. An excellent article.
"Have Individual Stocks Become More Volatile? An Empirical Investigation of Idiosyncratic Risk," John Y. Campbell, Martin Lettau, Burton G. Malkiel, and Yexiao Xu, Journal of Finance, February 2001. This paper finds that, while several decades earlier, it may have been true that adequate diversification could be had with 15-20 stocks, it is no longer true. The paper finds that, while volatility of the stock market as a whole has remained relatively steady, the volatility of individual stocks has increased. This implies that correlations between stocks have decreased, which is confirmed by the paper's empirical results. Thus, the benefits of diversification have increased, along with the need to hold more stocks to achieve those benefits. This confirms the prudence of holding highly diversified collective investment funds instead of individual stocks.
"How much Diversification is Enough?" Meir Statman, Santa Clara University Working Paper, September 2002. "Lack of diversification is costly. Investors who hold only 4 stocks in their portfolios forego the equivalent of a 3.3% annual return relative to investors who hold the 3,444 stocks of the Vanguard Total Index Stock Market Index fund. Why do investors forego the benefits of diversification?"
"Dispersion, correlation, and the benefits of diversification," Meir Statman and Jonathan Scheid, Santa Clara University Working Paper, May 2004. "Correlation is the common measure of the benefits of diversification but it is deficient for two reasons. First, the benefits of diversification depend not only on correlations but on standard deviations as well. Dispersion combines both effects. Second, dispersion, unlike correlation, provides an intuitive measure of the benefits of diversification. It is best to set aside correlation when we assess the benefits of diversification and focus on dispersion."
"The Truth About Diversification by the Numbers," Ronald J. Surz and Mitchell Price, Journal of Investing, Winter 2000. This paper challenges the conventional wisdom that a randomly chosen portfolio of 15-20 stocks gives nearly all the diversification benefit of the market. "Fifteen-stock portfolios, on average, achieve only 75%-80% of available diversification, not the 90%-plus typically believed. Even 60-stock portfolios achieve less than 90% of full diversification." This confirms the prudence of avoiding individual stocks in favour of highly diversified collective investment funds.
The Efficient Market Hypothesis is a controversial and often-disputed theory that states that fundamental and technical analysis does not lead to excess market returns. This is because markets are fully efficient and as such incorporate all relevant information about every security.
"Random Walks in Stock Market Prices," Eugene F. Fama, Chicago School of Business Selected Paper Series. This is the seminal paper where Dr. Fama coined the term "Efficient Market." "In an efficient market, competition among the many intelligent participants leads to a situation where, at any point in time, actual prices of individual securities already reflect the effects of information based both on events that have already occurred and on events which, as of now, the market expects to take place in the future. In other words, in an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value."
"The Behaviour of Stock Market Prices," Eugene F. Fama, Journal of Business, January 1965. This paper is the technical version of Dr. Fama's doctoral dissertation summarised above.
"The Development, Accomplishments and Limitations of the Theory of Stock Market Efficiency," Ray Ball, Managerial Finance, 1994. A good summary of the research into stock market efficiency. This is only a discussion of this paper.
"A brief history of market efficiency," Elroy Dimson and Massoud Mussavian, European Financial Management, March 1998. An excellent, highly readable history of the efficient market hypothesis.
"The Efficient Market Hypothesis and Random Walk Theory," Investor Home, 1999. An outstanding summary of the subject matter.
"Market Efficiency, Long-Term Returns, and Behavioural Finance," Eugene F. Fama, Journal of Financial Economics, September 1998.
"Efficient Capital Markets: A Review of Theory and Empirical Work," Eugene F. Fama, Journal of Finance, May, 1970. A comprehensive review of the literature on this topic.
"Efficient Capital Markets: II," Eugene F. Fama, Journal of Finance, December 1991. Here's a good summary. A (somewhat less comprehensive) review of the literature twenty years after his first review.
"The Efficient Market Hypothesis and its Critics," Burton G. Malkiel, Journal of Economic Perspectives, 2003. "This survey examines the attacks on the efficient-market hypothesis and the relationship between predictability and efficiency. I conclude that our stock markets are more efficient and less predictable than many recent academic papers would have us believe."
"Efficient Markets Hypothesis Bibliography," Martin Sewell, University College London. An excellent bibliography of this topic.
Emerging markets refers to stock markets of economies which are developing (e.g., China, Brazil, Argentina, Mexico, etc.). Investing in emerging markets is often done with a small portion of one's portfolio in order to get the diversification benefits offered by this asset class.
"Active Management's Failure to Deliver in Emerging Markets: A View from the New Economy," David G. Booth, Institute for Fiduciary Education, July 1 2000. This article points out that, compared with passively managed funds, actively managed funds haven't faired particularly well in emerging markets. This is contrary to the conventional wisdom, which suggests that less efficient markets are more amenable to active management.
"Predictable Risk and Returns in Emerging Markets," Campbell R. Harvey, Review of Financial Studies, Autumn 1995. "... inclusion of emerging market assets in a mean-variance efficient portfolio will reduce portfolio volatility and increase expected returns."
The "Equity Premium" refers to how much stock returns are higher than bond returns. There are many good reasons to believe that the equity premium in the future will be much less than the equity premium in the recent past. It is prudent to have realistic expectations of what stock returns are likely to be in the future. Therefore, macroscopic estimates thereof are quite important for investors.
"The Investment Implications of Lower Stock Return Prospects," William Reichenstein, AAII Journal, October 2001. An excellent, readable article with very pragmatic advice.
"What Do Past Stock Market Returns Tell Us About the Future?" William Reichenstein, Journal of Financial Planning, July 2002. This may be the best summary of recent studies in this area.
"Stocks versus Bonds: Explaining the Equity Risk Premium," Clifford S. Asness, Financial Analysts Journal, March/April 2000. This paper presents a model for long term stock dividend yield which suggests that the difference between stock yields and bond yields is driven by the long-run difference in volatility between stocks and bonds.
"What Rate of Return Can You Reasonably Expect ... or What Can the Long Run Tell Us about the Short Run?" Peter L. Bernstein, Financial Analysts Journal, March/April 1997. "A strange and unexpected conclusion emerges. Stocks are fundamentally less risky than bonds, not only because their returns have been consistently higher than those of bonds over the long run but also because less uncertainty surrounds the long-term return investors can expect on the basis of past history. Equity investors have at least some notion of what the long run has provided to owners of equities and at least a few hints as to whether stocks are high or low relative to their long-run performance. Investors in the bond market, even with 195 years of history to look back on, can make no statement at all about a basic return; they can make no judgments beyond the duration of the particular instrument they happen to be holding at any given moment."
"How Risky Is the Risk Premium?" Peter Coy, Business Week, December 25 2000.
"Risk and Return in the 20th and 21st Centuries," Elroy Dimson, Paul Marsh, and Mike Staunton, Business Strategy Review, Summer 2000. This is basically a longer version of the short article below.
"New evidence puts risk premium in context," Elroy Dimson, Paul Marsh, and Mike Staunton, Corporate Finance, March 2003. “Our work results in a set of forward-looking, geometric risk premia for the United States, United Kingdom, and for the world of around 2.5 to 4.0 per cent." "... this corresponds to arithmetic mean risk premia of around 3.5 to 5.25 per cent."
"Global Evidence on the Equity Risk Premium," Elroy Dimson, Paul Marsh, and Mike Staunton, Journal of Applied Corporate Finance, Autumn 2003.
"The Equity Premium," Eugene F. Fama and Kenneth R. French, CRSP Working Paper No. 522, April 2001.
"A Comprehensive Look the Empirical Performance of Equity Premium Prediction," Amit Goyal and Ivo Welch, National Bureau of Economic Research Working Paper No w10483, May 2004. This paper tests whether various empirical means of predicting near-term equity premiums have been useful in the past. "... we find that, for all practical purposes, the equity premium has not been predictable, and any belief about whether the stock market is now too high or too low has to be based on theoretical prior, not on the empirically [sic] variables we have explored."
"The Supply of Stock Market Returns," Roger G. Ibbotson and Peng Chen, Ibbotson Associates. June 2001.
"Expected Returns on Stocks and Bonds: Investors must moderate their expectations," Antti Ilmanen, Journal of Portfolio Management, Winter, 2003. A survey of the issues affecting expected returns.
"The Declining U.S. Equity Premium," Ravi Jagannathan, Ellen R. McGrattan, and Anna Scherbina, Federal Reserve Bank of Minneapolis Quarterly Review, Autumn, 2000. A good discussion of this issue.
"Is Equity Risk Premium Still Thriving, or a Thing of the Past?" Mimi Lord, Journal of Financial Planning, April 2002. Ms. Lord interviews Roger Ibbotson and Robert Arnott.
"Average Debt and Equity Returns: Puzzling?" Ellen R. McGrattan and Edward C. Prescott, Federal Reserve Bank of Minneapolis Research Dept Staff Report 313, January, 2003. An interesting look at the "equity premium puzzle" (i.e., why have returns on equity in the US been so much higher than predicted?). After correcting for taxes, regulatory constraints, and diversification costs, and focusing on long-term rather than short-term savings instruments, they find that there really is no equity premium puzzle.
"Views of Financial Economists on the Equity Premium and on Professional Controversies," Ivo Welch, Journal of Business, 2000.
"The Equity Premium Consensus Forecast Revisited," Ivo Welch, Cowles Foundation Discussion Paper No. 1325, September, 2001. An update to his earlier work, using a survey taken three years after the first.
"Great Expectations," The Economist, July 15, 2000. Explains the Fama/French paper's conclusions in layman's terms.
"Equity Risk Premium Forum," November 8, 2001. The record of an outstanding discussion led by several preeminent academics.
Bibliography on Equity Risk Premium, November 8, 2001. An excellent bibliography on this topic
Exchange Traded Funds are similar to conventional index mutual funds, but they are purchased like a stock. Blackstone uses ETFs to access certain asset classes such as property and commodities, which do not have a suitable unit trust or OEIC available. ETFs are not without their problems; such as fixed dealing charges, which can be very costly for regular purchases or rebalancing. Blackstone consequently pays a lot of attention to trades and tries wherever possible to mitigate the trading costs by aggregating many trades together which usually leaves each trade only bearing pennies of cost.
"The ETF vs. Open-End Index-Fund Shootout," William J. Bernstein, Efficient Frontier, Autumn 2001. Although William’s research uses Vanguard’s funds for comparison (not available in the UK), it never the less provides a good insight into some of the pros and cons of ETF.
"It's the Execution, Stupid!" William J. Bernstein, Efficient Frontier, Winter, 2004. This article finds that the best index funds have tended to outperform "equivalent" ETFs even without considering the costs of bid-ask spreads and commissions which apply to ETFs, but not index funds.
"Exchange-Traded Funds Not for Everyone," Wilfred L. Dellva, Journal of Financial Planning, April 2001. an excellent paper which compares ETFs with the best index mutual funds.
“Are ETFs right for you?" Christopher J. Traulsen, CFA,
ETFZone.com An excellent web site with a great deal of information on ETFs.
Exchangetradedfunds.com A good place for quotes on ETFs.
Fama/French Three-Factor Model
These papers explore the intellectual underpinnings for the idea that tilting a stock portfolio towards small and value stocks will tend to result in higher long-term expected returns (at the expense of somewhat higher short-term volatility).
"The Cross-Section of Expected Stock Returns," Eugene F. Fama and Kenneth R. French, Journal of Finance, Vol XLVII No 2 June 1992. This is the seminal paper that first provided proof that exposure to market risk, market capitalisation, and book to price ratio almost completely explained (variations in) the level of stock returns.
"Common Risk Factors In The Returns On Stocks And Bonds," Eugene F. Fama and Kenneth R. French, Journal of Financial Economics, 33 1993. This paper extends the three factor model, which explains variation in stock returns, to five factors, which also explain variation in bond returns (the additional factors, only applicable to bonds, are default risk and term risk (i.e., maturity/duration)). Note that explanatory powers for the two risk factors are only applicable to high-quality bonds. Lower quality bonds are also affected by the equity factors.
"Fama French Three Factor Model," Frank Armstrong, Investor Solutions, 2001. An outstanding, very readable introduction to the three factor model.
"Size and Book-to-Market Effects: Evidence from Emerging Equity Markets," Christopher B. Barry, Elizabeth Goldreyer, Larry Lockwood, Mauricio Rodriguez, Emerging Markets Review. This paper finds a value premium in emerging markets. It finds much less evidence in support of a small premium.
"The Cross-Section of Expected Stock Returns: A Tenth Anniversary Reflection," William J. Bernstein, Efficient Frontier, Summer 2002. A very readable retrospective ten years after the original Fama/French paper on the subject.
"Value and Growth Investing: A Review and Update," Louis K. C. Chan and Josef Lakonishok, Financial Analysts Journal, January/February 2004. "The evidence suggests that ... value investing generates superior returns. Common measures of risk do not support the argument that the return differential is due to the higher riskiness of value stocks. Instead, behavioural considerations and the agency costs of delegated investment management lie at the root of the value-growth spread."
"The Dimensions of Stock Returns: 2002 Update," Truman A. Clark, Dimensional Fund Advisors, April 2002.
"The Dimensions of Stock Returns: 2007," Truman A. Clark, Dimensional Fund Advisors, September 2007.
"Characteristics, Covariances, and Average Returns: 1929-1997," James L. Davis, Eugene F. Fama, and Kenneth R. French, February 1999, Centre for Research in Security Prices Working Paper No. 471. This paper more than doubles the sample size of returns analysed, with the same conclusions as the original Fama/French paper (the original paper only used data from 1962-1989).
"Is There Still Value in the Book-to-Market Ratio?" James L. Davis, Dimensional Fund Advisors, January 2001. Addresses whether BTM ratio has been superseded by other measures of value, such as Price/Earnings ratio and others. The bottom line is that BTM remains in several pragmatic ways the optimal measure of the "value-ness" of a stock.
"Explaining Stock Returns: A Literature Survey," James L. Davis, Dimensional Fund Advisors, December 2001. An excellent survey of literature on this subject.
Elroy Dimson, Stefan Nagel, and Garrett Quigley, "Capturing the Value Premium in the U.K.1955-2001," Financial Analysts Journal, November/December 2003. “... we find a strong value premium in the UK for the period 1955-2001. The value premium exists within the small-cap as well as the large-cap universe." "However, managers attempting to capture the value premium in the small-cap segment should pay particular attention to rebalancing-induced portfolio turnover and market illiquidity in small-value stocks. Compared to the U.S., the U.K. market for small-cap stocks is relatively illiquid. Trading costs are therefore an even more crucial determinant of overall performance. This is likely to be the case in other non-U.S. markets as well." This suggests that it is important to implement strategies that sacrifice tracking accuracy in favour of reducing trading needs and lowering trading costs.
“Value vs. Growth: The International Evidence,” Eugene F. Fama and Kenneth R. French, SSRN Working Paper 2358. This paper examines non-US markets for the "value premium" and finds it in nearly every other country studied.
"Engineering Portfolios for Better Returns," Eugene Fama, Jr., Senior Consultant, May 1998. Dr. Fama's son discusses the practical implications of the Fama/French Three-Factor model.
"Risk and Return: Professor Ken French on the Cross Section of Expected Returns," Bob Hansen, Tuck Today, Winter 2004. An outstanding interview with Professor Ken French.
"The Cross Section of Common Stock Returns: A Review of the Evidence and Some New Findings," Gabriel Hawawini and Donald B. Keim, The Wharton School of the University of Pennsylvania, 1998.
"Growth Vs. Value Investing: And the Winner Is...," Roger G. Ibbotson and Mark W. Riepe, Journal of Financial Planning, June 1997.
"Contrarian Investment, Extrapolation, and Risk," Josef Lokonishok, Andrei Shleifer, and Robert W. Vishny, NBER Working Paper number W4360.
Investing internationally with a portion of one's portfolio is often recommended in order to achieve diversification benefits.
"International Index Funds and the Investment Portfolio," Scott Aiello and Natalie Chieffe, Financial Services Review, 8 1999. "This study urges caution for those investors who seek to maximise returns. However, it does suggest that the diversification one can gain from international index funds is significant and important."
"Do World Markets Still Serve as a Hedge?" Claude B. Erb, Campbell R. Harvey, and Tadas E. Viskanta, Journal of Investing, Autumn 1995. "Do world markets still serve as a hedge? The answer is affirmative."
"On the relative importance of industrial factors in international stock returns," Dušan Isakov and Frédéric Sonney, University of Geneva, January 2002. This study analyses whether international diversification across countries or across industries gives more diversification benefit. It concludes that, on average, the country effect continued to dominate during the period studied. However, the industry effect is increasing in importance and may dominate the country effect now. It remains to be seen if this is a temporary or permanent effect.
"Long-Term Investing and International Diversification," Mattias Persson, SSRN Abstract #302682, March 2002. This paper finds that "investors gain more from internationally diversified portfolios if the investment horizon is longer, that is, the [optimal] weight in the international assets are significantly higher for long investment horizons compared to the one-year horizon."
Hedge Funds are similar to mutual funds, but they are more risky, less regulated, less liquid, and dramatically more expensive (not only do they have annual expense ratios of about 2%, but they typically take 20% or more of all gains as well). Indeed a Hedge fund –fund of funds can be as high as 35 and 30%!! Do .
"If you want to waste your money, it's a good way to do it." "If you want to invest in something where they steal your money and don't tell you what they're doing, be my guest." — Dr. Eugene Fama, commenting on the prudence of investing in hedge funds
"If there's a license to steal, it's in the hedge fund arena." — Dr. Burton Malkiel, commenting on the high costs of hedge funds
"It takes about 35 years of returns to say with any statistical confidence that stocks have a higher expected return than the risk-free rate. Think about a hedge fund that has equity-like volatility. If the manager’s alpha was as large as the market risk premium — which would be huge — it would also take about 35 years to be confident the manager has any value added — and that’s before his fees of '2 and 20.' Even if that phenomenal manager is out there, is he likely to stick around long enough for us to be able to figure out he wasn’t just lucky?" — Dr. Kenneth French, commenting on the probability of being able to determine that any particular hedge fund manager had ANY skill
"Multi-Period Performance Persistence Analysis of Hedge Funds," Vikas Agarwal and Narayan Y. Naik, London Business School Working Paper, February 2000. This study concludes that there may be some very short term persistence, but it is primarily the poor performers whose performance appears to persist — persistence among good performers is dramatically less. This suggests that it may not make sense to pick a Hedge Fund based on past performance (but it may make sense to avoid those with particularly poor past performance).
If it doesn't make sense to choose a hedge fund based on past performance, how would one do it? By minimising fees? Virtually all hedge funds have fees ranging from "much too high" to "truly outrageous."
"Do Hedge Funds Hedge?" Clifford Asness, Robert Krail, and John Liew, Journal of Portfolio Management, Autumn 2001. This excellent paper looks at the risk-adjusted performance of Hedge Funds. It notes that illiquidity of underlying investments, among other effects, tends to distort performance numbers. Specifically, it notes that hedge fund performance tends to lag the performance of the market. After taking that effect into account, it doesn't appear that Hedge Funds are very good at "hedging".
"The Statistical Properties of Hedge Funds Index Returns and Their Implications for Investors," Chris Brooks and Harry M. Kat, The University of Reading, October 31 2000. "Sharpe Ratios will substantially overestimate the true risk-return performance of (portfolios containing) hedge funds. Similarly, mean-variance analysis will over-allocate to hedge funds and overestimate the attainable benefits from including hedge funds in an investment portfolio."
"Hedge Fund Investing For Dummies," Bernard Condon, Forbes, May 14 2004. "Warning to hedge fund investors: You would do better giving your money to a monkey." You may have to register (for free) to read this article.
"A Critical Look at the Case for Hedge Funds: Lessons from the Bubble," Richard M. Ennis and Michael D. Sebastian, The Journal of Portfolio Management, Summer 2003, pp. 103-112. "Notwithstanding evident market timing skill — at least during the extraordinary period covered here — the performance of hedge funds has not been good enough to warrant their inclusion in balanced portfolios. The high cost of investing in funds of funds contributed to this result. Many practitioners believe markets are imperfectly efficient, providing astute investors an opportunity to exploit security mispricing. This may well be true. One wonders, though, how realistic it is to expect funds of hedge funds to realise competitive returns for their investors after costs upward of 5% per year."
"Introduction to Hedge Funds - Part One," "Introduction to Hedge Funds - Part Two: Advantages and Questions," David Harper, Investopedia.com, December 10 2003. A good discussion of Hedge Funds for laypeople.
"Hedge Funds Aren't Beautiful," William Jahnke, Journal of Financial Planning, February 2004. "Hedge funds are a great product for the hedge fund industry and its support apparatchik ... but are likely, on average, to produce a negative return contribution relative to a benchmark consisting of stocks, bonds, and cash." A scathing review of the utility (or lack thereof) which hedge funds might have for investors.
"Hedge Funds: Risk and Return," Burton Malkiel and Atanu Saha, Financial Analysts Journal, November/December 2005. "We conclude that hedge funds are far riskier and provide much lower returns than is commonly supposed."
"An Alternative Look at Hedge Funds," Alejandro Murguía and Dean T. Umemoto, Journal of Financial Planning, January 2004. An outstanding, frank discussion of hedge funds. "Advisors relying on simple return data and traditional evaluation measures presented in many hedge fund tear sheets will be vulnerable to inaccurate conclusions and possibly expose their clients’ investments to an inappropriate amount of risk." "Although this [hedge fund] manager may seem to be providing excess returns, a multifactor model that incorporates the dynamic trading strategy of the fund will indicate that the fund manager is essentially creating these returns by taking on more risk through the specific trading strategy and not necessarily through alpha."
"Until further advances are made [in empirical research on what drives hedge fund returns], advisors may be better served by diversifying their clients’ portfolios with other un-represented asset classes traded on major exchanges such as emerging markets or international small cap stocks. These different asset classes have traditionally been very effective portfolio diversifiers. Additionally they allow advisors a degree of liquidity and transparency not currently present in hedge funds."
"Why Hedge Funds Make Sense," Michael W. Peskin, Michael S. Urias, Satish I. Anjilvel, and Bryan E. Boudreau, Morgan Stanley Dean Witter, November 2000. This often-cited paper concludes that Hedge Funds are beneficial for institutional investors. However, before going out and buying any Hedge Funds, be sure to view the other studies listed here.
"A Reality Check on Hedge Funds Returns," Nolke Posthuma and Pieter Jelle Van Der Sluis, Working Paper, July 8 2003. This paper finds that backfill bias causes Hedge Fund return databases to systematically overstate actual realised returns by about four percent per annum. This brings into serious question any and all studies which might conclude that hedge funds are beneficial.
"What are you Really Getting When You Invest in a Hedge Fund?" William Reichenstein, AAII Journal, July 2004. "... a review of the historical returns of hedge funds and other alleged advantages finds them suspect."
"Understanding Hedge Fund Performance: Research Results and Rules of Thumb for the Institutional Investor,” Thomas Schneeweis, Hossein Kazemi, and George Martin, Centre for International Securities and Derivatives Markets, University of Massachusetts, November 2001. An outstanding discussion of various topics surrounding Hedge Funds.
"The Sleaziest Show On Earth," Neil Weinberg and Bernard Cohen, Forbes, May 24 2004. "Hedge funds will suck in $100 billion this year from an ever-broader swath of investors. Pretty good for a business rife with exorbitant fees, phony numbers and outright thievery." You may have to register (for free) to read this article.
"The Dangers of Historical Hedge Fund Data," Andrew B. Weisman and Jerome D. Abernathy. This paper presents a means of describing performance characteristics of Hedge Fund managers. It also points out two troubling biases which tend to be present in the data. It calls these biases "Short-Volatility Bias" and "Illiquidity Bias." These biases tend to cause Hedge Fund performance data to understate the actual risk/volatility of the funds (and therefore overstate risk-adjusted performance).
Martin Sewell's Hedge Fund Bibliography. An excellent bibliography of relevant papers on this topic — most with full text!
Index weighting refers to how a stock market index is weighted by the market capitalisation of each stock in the index. In such a weighting scheme, larger companies account for a greater portion of the index. Most indexes are constructed in this manner, for example the FTSE 100. In the USA there has been a debate for some time suggesting indexes should be constructed by alternative criteria; dividends, employees, economic footprint. ETF funds exist in the UK to gain exposure to what are commonly called “Fundamental Indexes”, although the average investor has little or no knowledge of such funds. Back testing data and creating an investment strategy based on the findings can prove problematic as the anomalies it seeks to exploit may no longer exist. Fundamental index funds essentially overweight towards value stocks, something Blackstone does via specific allocation to value funds.
"Fundamental Indexation," Robert D. Arnott, Jason C. Hsu, and Philip Moore, Financial Analysts Journal, March/April 2005. This was the paper that most spurred interest in this topic. "In this paper, we examine a series of equity market indexes weighted by fundamental metrics of size, rather than market capitalisation. We find that these indexes deliver consistent and significant benefits relative to standard capitalisation-weighted market indexes."
"Fundamental Indexing and the Three-Factor Model," William J. Bernstein, Efficient Frontier, May 2006. "Fundamental indexing is a promising technique, but its advantage over more conventional cap-weighted value-oriented schemes, to the extent that it exists at all, is relatively small." "Even assuming that fundamental indexation produces returns in excess of its factor exposure, caution should be used in the practical application of this methodology. Differences in the expenses, fees, and transactional costs incurred in the design and execution of real-world portfolios can easily overwhelm the relatively small marginal benefits of any one value-oriented approach. The prospective shareholder needs to consider not only the selection paradigm used, but just who is executing it."
"Fundamentals-Weighted Indexing Offers New Insight on Value Investing," Eric Brandhorst, State Street Global Advisors, December 22, 2005. A good discussion of the topic.
"Quieting The Noise," Matthew Hougan, Journal of Indexing, September/October 2007.
"Cap-Weighted Portfolios are Sub-Optimal Portfolios," Jason C. Hsu, Social Science Research Network paper #647001, December 2004. This working paper was the unpublished predecessor to the important Arnott/Hsu/Moore paper above.
"New Frontiers in Index Investing," Jason C. Hsu and Carmen Campollo, Journal of Indexes, January/February 2006. Makes a compelling case for weighting based on fundamentals
Market timing refers to an attempt to time investing decisions so as to invest in assets which are expected to go up in the near term and divest from assets which are expected to go down in the near term. The evidence is; this is a fruitless and expensive activity.
"The long, sad history of market timing is clear: Virtually nobody gets it right even half the time. And the cost of getting it wrong wipes out the occasional gain of getting it right. So the average investor's experience with market timing is costly. Remember, every time you decide to get out of the market (or get in), the investors you buy from and sell to are the best of the big professionals. (Of course, they're not always right, but how confident are you that you will be 'more right' more often than they will be?) What's more, you will incur trading costs or mutual fund sales charges with each move—and, unless you are managing a tax-sheltered retirement account, you will have to pay taxes every time you take a profit." — Charles Ellis, Winning the Loser's Game- One of our favourite books.
"Market timing ability and volatility implied in investment newsletters' market timing recommendations," John R. Graham and Campbell R. Harvey, Journal of Financial Economics, December 1996. This paper examines whether investing newsletters exhibit market timing ability. Such newsletters are not so popular in the UK, but there is a valuable lesson to be learned for those that listen to market pundits. "We find no evidence that letters systematically increase equity weights before market rises or decrease weights before market declines."
"Market-Timing Futility," Robert Sheard, Motley Fool, July 1 1998. This article supports disciplined periodic investment. It suggests that, since the long-term return difference between making periodic investments with perfect timing and with perfectly imperfect timing is small, the important thing is to be making the periodic investments, not to try to time the markets. "...for a genuine long-term investor/saver ... it makes precious little difference when you invest."
“Black Swans and Market Timing: How Not to Generate Alpha,” Javier Estrada, IESE Business School, Spain, November, 2007. Are investors likely to successfully predict the best days to be in and out of the market? Should investors attempt to time the market? “On average across all 15 markets, missing the best 10 days resulted in portfolios 50.8% less valuable than a passive investment; and avoiding the worst 10 days resulted in portfolios 150.4% more valuable than a passive investment. Given that 10 days represent less than 0.1% of the days considered in the average market, the odds against successful market timing are staggering. Of the countless strategies that academics and practitioners have devised to generate alpha, market timing seems to be one very unlikely to succeed. Much like going to Vegas, market timing may be an entertaining pastime, but not a good way to make money.”
Modern Portfolio Theory refers to the idea that each investment ought to be selected in consideration of how it will interact with other assets in one's portfolio. Modern Portfolio Theory is the basis for Mean Variance Optimisation.
"Portfolio Selection," Harry Markowitz, Journal of Finance, March 1952. This paper laid the groundwork for Modern Portfolio Theory, which earned Dr. Markowitz a Nobel Prize. The paper suggests that, instead of asking the question, "What is a good investment?", you ought to be asking, "What is a good investment for my portfolio?" It turns out that the answer is heavily dependent on what else happens to be in your portfolio. All else being equal, it is more beneficial (from the standpoint of maximising your risk-adjusted return) to take on an investment which is likely to have low correlations with other elements of your portfolio than to take on an investment which is likely to have high correlations with other elements of your portfolio. Thus, investment selection should involve getting maximum diversification benefit (with respect to the rest of the portfolio) from each investment.
"The Appropriate Use of the Mean Variance Optimiser," William J. Bernstein, Efficient Frontier, January 1998. An excellent discussion of how this tool can be used and (as is more usual) misused. "Can you use an MVO to help you shape your portfolio? Yes, but you've got to be very careful. An MVO is like a chainsaw. Used appropriately, it is a powerful tool for clearing your backyard. Used inappropriately it will send your local surgeon's kids to college. Same thing with MVOs. Want to wind up in the financial version of intensive care? Just throw in some historical (or even plausible) returns and believe what comes out the other end." "So, what use is the thing? Well, first and foremost an MVO is a superb teaching tool. Play around with one for a few hours and you will begin to acquire a grasp of the rather counterintuitive way in which real portfolios behave." "... you have to realise that the chances of your allocation, no matter how skilfully chosen, winding up exactly on the future efficient frontier are zero."
"Modern Portfolio Theory and Quantum Mechanics," Gregory Curtis, Journal of Wealth Management, Autumn 2002. An interesting discussion of the limits of MPT.
"Portfolio Theory Creates New Investment Opportunities," Paula H. Hogan, Journal of Financial Planning, January 1994. A very basic summary of MPT.
"Is MPT the Solution — or the Problem?" Malcolm Mitchell, Investment Policy, July 2002. A bit long, but this paper is a very readable critique of Modern Portfolio Theory.
"Strategic Asset Allocation: Make Love, Not War," John Rekenthaler, Journal of Financial Planning, September 1999. This article criticises blindly following Mean Variance Optimiser (MVO) outputs during strategic asset allocation decision-making. We agree with the criticism. MVO is an interesting tool, but the results are extremely sensitive to the inputs. The inputs are either guesses about the future or facts about the past. Either way, we know that the data inputs are extremely imperfect predictors of the future, which causes decision-making based on them to be significantly less optimal than may appear to be the case. Dr Eugene Fama on optimisers: "They're junk. You're wasting your time with an optimiser, but if you have a lot of time to waste, go ahead."
Mutual Fund (Unit Trust and OEICs) Persistence
Mutual Fund Persistence refers to the question of whether past performance of a mutual fund has any positive correlation with future performance. The lack of persistence in mutual funds (and pension funds, etc.) is a large part of the empirical argument for passive management.
The root of this issue is whether it is possible for ANY actively-managed mutual fund to consistently achieve superior risk-adjusted returns. This is an important question. If the answer is no, then it implies that actively managed funds should be avoided (because they tend to be more expensive). If the answer is yes, then it inspires a separate, but equally important, question of whether it is possible to identify the few funds which will consistently outperform in advance. We believe that, while it is possible for an actively managed fund to occasionally achieve superior returns through good luck or even through skill, it is impossible to identify these fund managers in advance. The majority of well-done studies tend to support a lack of persistence for all but the worst performing equity mutual funds.
Investor Timing and Fund Distribution Channels,” Mercer Bullard, Geoff Friesen, & Travis Sapp, SSRN Resources, December 2007. “This study examines the investment timing performance of equity mutual fund investors and its relationship to the distribution arrangement of the fund. We find that investors who transact through investment professionals using conventional distribution arrangements experience substantially poorer timing performance than investors who purchase pure no-load funds. Investors in all three principal load-carrying retail share classes (A, B, and C) significantly underperform a buy-and-hold strategy. Among all load funds, Class B investors suffer from the poorest cash flow timing, underperforming a buy-and-hold strategy by 2.28% annually, compared with annual underperformance of 0.78% for investors in pure no-load funds. No-load index funds are the only funds found to show no evidence of poor investor timing. Although investors are ultimately responsible for their own investment choices, these findings question the value being added by investment professionals who sell mutual fund shares through conventional distribution arrangements.
“Past Imperfect? The performance of UK equity managed funds,” Mark Rhodes, Financial Services Authority Occasional Paper 9, August 2000 “The weight of evidence is that information on past performance cannot be exploited usefully by retail investors.”
"The Performance of UK Equity Unit Trusts," Garrett Quigley and Rex A. Sinquefield, Institute for Fiduciary Education, October 1 1999. This paper also appeared in Journal of Asset Management, February 2000. This provides a look at mutual fund persistence in the United Kingdom. "Does performance persist? Yes, but only poor performance."
"On Persistence in Mutual Fund Performance," Mark M. Carhart, Journal of Finance, March 1997. This may be the best and most authoritative study of persistence. The study concludes that there is virtually no persistence, except for the worst performing mutual funds (which is explainable either by their having high fees, poor strategies, and/or tax-loss harvesting by investors).
"Performance Persistence," Stephen J. Brown and William N. Goetzmann, Journal of Finance, June 1995. This paper concludes that some persistence does seem to exist among mutual funds, but it is mostly due to poor performers (i.e., poor performance persists, but good performance doesn't). This paper's conclusions confirm the prudence of a passive strategy of investing in low cost index mutual funds.
"Staying the Course: Mutual Fund Investment Style Consistency and Performance Persistence," Keith C. Brown and W. Van Harlow, University of Texas Working Paper, April 2 2004. This paper tests and finds support for each of the following hypotheses:
A negative relationship exists between a fund's style consistency and portfolio turnover.
A positive relationship exists between a fund's style consistency and the future actual and relative returns it produces.
A positive relationship exists between the consistency of a portfolio's investment style and the persistence of its performance over time.
"Explaining Persistence in Mutual Fund Performance," F. Larry Detzel and Robert A. Weigand, Financial Services Review, 1998. This paper found that there was virtually no persistence that could not be explained by market risk, expense ratios, market capitalisation, and book to market ratio.
"Does Historical Performance Predict Future Performance?" Ronald N. Kahn and Andrew Rudd, BARRA Newsletter, Spring 1995. This paper finds no persistence in stock funds, but some persistence in bond funds. However, the persistence in bond funds still points to a passive strategy because the small benefit of being able to pick winning (active) bond funds is more than cancelled out by the disadvantage of higher expense ratios associated therewith.
"Eliminating Biases in Evaluating Mutual Fund Performance from a Survivorship Free Sample," Jenke R. Ter Horst, Theo E. Nijman, and Marno Verbeek, October 1998. "Our results are in accordance with the persistence pattern found by Carhart [1997], and do not support the existence of a hot hand phenomenon in mutual fund performance."
The question of whether to invest in actively or passively managed mutual funds is an important one. Passive is perceived, in part because of the other meanings associated with the word passive, to be dull, unexciting and was once suggested to be “guaranteed mediocrity”. Its unfortunate there is not a more exciting word to describe the strategy. However, passive investment strategies should be thought of more like shooting par at golf, always. Few can do it an almost no one can continue to do it in the long run.
"Why Does the Law of One Price Fail? An Experiment on Index Mutual Funds,” James J. Choi, Yale University and NBER. David Laibson, Harvard University and NBER. Brigitte C. Madrian Harvard University and NBER, March 6, 2008. Subjects in their experiment were asked to allocate $10,000 across four index funds that track the S&P 500. The 730 subjects' rewards were tied to the future performance of their portfolio. They were given fund prospectuses that differed in an important way: annualised historical returns for the four index funds were covered different periods of time (e.g., Fund A had an annualised return of 18% between x and y; Fund B had a 15% return between a and b). Assuming all funds had similar tracking errors versus the S&P 500 Index (which wasn't reported, though these are typically small), the optimal decision in this experiment was to invest all the money in the fund that had the lowest expense ratio, as that would maximise realised returns. Yet almost none of the subjects made this choice, and most of them identified the differing reported historical returns for the funds as one of the top three factors that affected their allocation decision (apparently, few people realised the implications of the differing time periods). Amazing and depressing.
“Treasury - Minutes of Evidence,” House of Commons, Minutes of Evidence which were ordered by the House of Commons to be printed 18 May 2006. Witnesses: Mr Clive Briault, Managing Director, Retail Markets, and Mr Dan Waters, Director, Retail Policy, Financial Services Authority, gave evidence. Questions 146 through to 154 are very insightful. Here we have the government questioning two senior officials of the FSA as to the cost & value of active fund management. The later questions read like a sketch from Bremner, Bird, and Fortune.
“What are Stock Investors' Actual Historical Returns? Evidence from Dollar-Weighted Returns,” Ilia D. Dichev, University of Michigan School of Business, December 2004. “This paper suggests a new and more accurate measure of stock investors’ historical returns, which involves dollar-weighting of the returns and properly reflects the effect of investors’ timing. The empirical results indicate that aggregate dollar-weighted returns are systematically lower than buy-and hold returns.” This is actually a very important fact of investing which only serves to dupe the poor investor into making poor investment choices. For example; a fund has £1 in and the fund doubles in value in a year – a 100% return. Next year sees one million more investors invest £1 each. However for the next two years the fund value stands still. The three year performance of this fund would be still 100% or approx 26% compound per annum over 3 years. However the majority of investors have seen no return at all. See also
“An exploration of the persistence of UK unit trust performance,” Jonathan Fletcher, David Forbes, Journal of Empirical Finance, 2002, “This paper has examined the persistence in performance of UK unit trusts between January 1982 and December 1996. Consistent with the prior research of mutual funds and unit trusts, the paper finds evidence of significant persistence in the relative rankings of unit trusts in annual excess returns. This persistence is generally robust to alternative performance measures. However, when the rankings of the trusts depend upon performance compared to an absolute benchmark, then the significant persistence is driven by repeat underperformance.”
“Are UK fund investors achieving fund rates of return? An examination of the differences between UK fund returns and UK Investors’ returns.”
Do high or low Total Expense Ratios correlate with fund performance? Standard & Poor’s, 20 October 2003. "If we look at three, five and 10 year performance figures for UK unit trusts and OEICs investing in UK equities, there is little correlation between performance and TERs. No discernible pattern linking performance and management costs exists.”
“Performance Persistence in Mutual funds,” Professor David Blake PhD, Professor Allan Timmermann PhD, An Independent Assessment of the Studies Prepared by Charles River Associates for the Investment Management Association, FSA, April 2002. The original Charles River Associates (CRA) paper asserted that funds with good past performance did indeed repeat. We do not believe that CRA’s decision to conduct their analysis of performance persistence using raw returns is justified. The absence of risk adjustment in the performance study means that performance persistence figures are likely to divide mutual funds according to their levels of risk exposure and not according to the degree of fund manager skill or value-added. High-risk funds are more likely to be top performers (particularly in the long run), while low-risk funds are more likely to be among the worst performers. Performance figures based on raw returns are likely to induce investors to hold more mutual funds with high risk and fewer mutual funds with low risk, regardless of whether the returns generated by these funds are justified by their level of risk exposure.
"The Arithmetic of Active Management," William F. Sharpe, Financial Analysts Journal, January/February 1991. "If 'active' and 'passive' management styles are defined in sensible ways, it must be the case that (1) before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar and (2) after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar. These assertions will hold for any time period."
"Index and Enhanced Index Funds," David G. Booth, Dimensional Fund Advisors, April 2001. "In summary, logic and empirical evidence overwhelmingly favour an investment approach based on index funds. The returns are higher and the fees are lower. The returns of an asset class are assured. The discipline keeps the portfolio fully invested, thereby avoiding the adverse timing pitfall inherent in investment committees and active managers."
"Passive Management: It's Not an Oxymoron," Beverly Goodman, TheStreet.com, August 19 2002. A very readable article.
"Active Mismanagement: The Case for Index Funds," Beverly Goodman, TheStreet.com, August 12, 2002.
"The Difficulty of Selecting Superior Mutual Fund Performance," Thomas P. McGuigan, The Journal of Financial Planning, February 2006. An interesting study. They conclude that the overwhelming majority of actively managed funds underperform passive alternatives. While they concede that there have been a very small minority of actively managed funds which have consistently outperformed passive alternatives, it is "difficult" to identify them in advance.
"Measuring the True Cost of Active Management by Mutual Funds," Ross M. Miller, SUNY Albany, June 2005. This interesting paper derives a method for allocating fund expenses between active and passive management and constructs a simple formula for finding the cost of active management. Computing this “active expense ratio” requires only a fund’s published expense ratio, its R-squared relative to a benchmark index, and the expense ratio for a competitive fund that tracks that index. At the end of 2004, the mean active expense ratio for the large-cap equity mutual funds tracked by
"Indexed Investing: A Prosaic Way to Beat the Average Investor," William F. Sharpe, a speech presented at the Spring President's Forum, Monterey Institute of International Studies, May 1 2002. Written by a Nobel Prize winner.
"Active vs. Passive Management," Rex A. Sinquefield, Dimensional Fund Advisors, October 1995. A speech given during a debate on the merits of active vs. passive management.
"The Inefficient Markets Argument for Passive Investing,"
"I don't know, I don't care," Jason Zweig, CNNmoney, August 29, 2001. The benefits of passive investing.
Pound Cost Averaging or as it is often referred to in these articles “Dollar Cost Averaging” (however exactly the same maths at work) refers to a procedure whereby an equal amount is invested each period on an ongoing basis.
"Does Dollar-Cost Averaging Work for Bonds?" Peter W. Bacon, Richard E. Williams, and M. Fall Ainina, Journal of Financial Planning, June 1997. This article compares lump-sum investment in bonds vs. doing it gradually over time. "Does dollar-cost averaging work for bonds? Based on historical evidence, the major conclusion of our study is that an investor is better off, in terms of return and risk-adjusted performance, investing the lump sum immediately."
"A Note on the Sub optimality of Dollar-Cost Averaging as an Investment Policy," George M. Constantinides, Journal of Financial and Quantitative Analysis, June 1979. An outstanding theoretical discussion of the issue.
"Mathematical Illusion: Why Dollar-Cost Averaging Does Not Work," John G. Greenhut, Journal of Financial Planning, October 2006. This article examines the oft-cited reason to use dollar-cost averaging — that this causes the average price per share to be lower than the average share price. "We found instead that the price variations that would be expected for fundamentally valued stocks is precisely the pattern that negates the advantage DCA commonly has been illustrated to hold. .... Whether DCA is practiced by investors should be based on their psychological makeup (for example, aversion to regret) and their outlook for stocks, not on an overly simplistic and misleading representation of how stock prices vary."
"Nobody Gains from Dollar Cost Averaging: Analytical, Numerical, and Empirical Results," John R. Knight and Lewis Mandell, Financial Services Review. "Our results strongly imply that the additional cost and effort associated with Dollar Cost Averaging cannot be justified for any investor, regardless of degree of risk aversion. With the possible exception of its promoters, nobody gains from Dollar Cost Averaging."
"Does loss aversion explain dollar cost averaging?" Karyl B. Leggio and Donald Lien, Financial Services Review 2001. Perhaps the premier reason that some advocate dollar cost averaging is its ability to avoid the regret that might come from investing a lump sum "at the worst possible time." This paper concludes that even taking this into account, DCA results in sub-par performance when compared to lump sum investing.
"Comparing Alternative Investment Strategies Using Risk-Adjusted Performance Measures," Karyl B. Leggio and Donald Lien, Journal of Financial Planning, January 2003. This paper compares dollar cost averaging to lump sum investing using three different measures of risk-adjusted return: Sharpe Ratio, Sortino Ratio, and Upside Potential Ratio. "...performance metrics that more accurately reflect investor risk and return such as the Sortino ratio and the UPR also fail to consistently support DCA as a preferred investing strategy."
"Lump Sum Beats Dollar Cost Averaging," Richard E. Williams and Peter W. Bacon, Journal of Financial Planning, April 1993. This article compares lump-sum investment in the stock market vs. doing it gradually over time. "... the odds strongly favour investing the lump sum immediately [as opposed to spreading it out over equal instalments]."
Real Estate Investment Trusts (REITs)
Real Estate Investment Trusts (REITs) are companies whose business is to own and operate Commercial Property. The company stock trades just like any other stock. Equity REITs are an excellent means to get exposure to the Real Estate asset class.
“Do REITS Behave More Like Real Estate Now,” I Chun Tsai, Ming-Chi Chen and Tien Foo Sing, working paper, November 2007. The authors find that they do, "because investors are better able to price the underlying [real estate] assets the longer REIT assets are securitised."
"Location, Location, Location: REITs in Your Portfolio," Scott Burns, The Dallas Morning News, June 19 2001.
"The Great Diversifier: REITs' Strong Returns in a Down Market are Attracting Attention," Raymond Fazzi, Financial Advisor, April 2002.
"REITs: Providing Core Real Estate Exposure," Devin I. Murphy, Ted Bigman, and Kevin G. Midwinter, Institute for Fiduciary Education, 2003. This paper includes some useful analysis of European REITS and their correlation with direct property markets and relative poor correlation with stocks and bonds. “The evidence continues to build to demonstrate that pension funds can use a portfolio of real estate stocks in order to provide their core real estate allocation. This conclusion is based upon a survey of the listed property markets throughout the world and the preliminary data available for this relatively new secto.r”
“Real Estate Investment Trusts: Review and Outlook," Munder Funds, 2004. A good review of the benefits of REITs. Although entirely based on US data, the conclusions should not change are entirely valid for the UK. Here's a paraphrased summary of why to invest in a REIT fund rather than directly in Real Estate:
Geographic diversification.
Property type diversification.
Liquidity.
Small capital outlay.
Professional management.
In many cases, REIT stocks are trading at discounts to prices in which private real estate transactions are occurring.
Ease of investment.
Limited liability.
Rebalancing refers to periodically restoring a portfolio's asset allocation to its target proportions. If you don't rebalance, the portfolio naturally drifts from its target allocation. This either increases or decreases your portfolio's risk profile, neither of which is desirable (assuming that the risk profile is optimal in the first place).
"Opportunistic Rebalancing: A New Paradigm for Wealth Managers," Gobind Daryanani, Journal of Financial Planning, January 2008. An excellent article.
"Rebalancing: Why? When? How Often?" Robert D. Arnott and Robert M. Lovell, Jr., Journal of Investing, Spring 1993. An excellent discussion of the benefits of rebalancing and a comparison of various rebalancing routines.
"The Rebalancing Bonus," William J. Bernstein, Efficient Frontier, Autumn 1996. This paper presents a formula which quantifies the benefits of rebalancing.
"Case Studies in Rebalancing," William J. Bernstein, Efficient Frontier, Autumn 2000. So, what can we conclude from all this?
Monthly rebalancing is too frequent.
There are small rewards to increasing one's rebalancing frequency from quarterly up to several years, but this comes at the price of increased portfolio risk.
You makes your choice and you takes your chances, but don't sweat this one too much. The returns differences among various rebalancing strategies are quite small in the long run
"Rebalancing for Taxable Accounts," Mark W. Riepe and Bill Swerbenski, Journal of Financial Planning, April 2007. "Tips When Rebalancing a Taxable Account:
Exert more care when rebalancing in taxable accounts.
Avoid generating rebalancing trades by directing new money into underweighted asset classes.
When sensible, execute trades to generate tax losses that can then be used to offset any capital gains generated by rebalancing trades.
Be patient and wait until eligible for long-term capital gains treatment.
If taxable and tax-deferred accounts are both allocated toward the same goal, have the tax-deferred account bear as much of the rebalancing load as possible."
"Guidelines for Rebalancing Passive-Investment Portfolios," Bert Stine and John Lewis, Journal of Financial Planning, April 1992. "... in most cases, the investor would be advised to rebalance only when the portfolio reaches a predetermined level of risk exposure rather than to make the adjustment on a calendar basis."
"Portfolio Rebalancing in Theory and Practice," Yesim Tokat, Vanguard Investment Counselling & Research, February 15 2006. A good discussion of the issue."
"Rebalancing Diversified Portfolios of Various Risk Profiles," Cindy Sin-Yi Tsai, Journal of Financial Planning, October 2001. "Portfolios should be periodically rebalanced. This paper shows that neglecting rebalancing produces the lowest Sharpe ratios." "However... it does not matter much which [rebalancing] strategy they adopt."
Reversion to the mean is the phenomenon whereby a stock's average performance (or a mutual fund's, or many other non-investing statistics) tend to become more average (i.e., less extreme) over time. If true, this implies that recent good performers are perhaps somewhat more likely than average to be below average performers in the future (and vice versa). This idea is supported by much of the research.
"Bogle on Investment Performance and the Law of Gravity: Reversion to the Mean—Sir Isaac Newton Comes to Wall Street," John C. Bogle, speech given at MIT Lincoln Laboratory on January 29 1998. "... RTM is a rule of life in the world of investing—in the relative returns of equity mutual funds, in the relative returns of a whole range of stock market sectors, and, over the long-term, in the absolute returns earned by common stocks as a group."
"Reversion-to-the-Mean is not a Glide Path Phenomenon," Bob Bronson, December 14 2000. This commentator notes that mean reversion doesn't mean that an investment's future performance is likely to gradually approach some asymptote. Rather, it is likely to cycle to the other extreme (i.e., good performance is likely to be followed by bad performance, and vice versa), which over time will cause the average performance to approach some asymptote.
"Mean Reversion in Short-Horizon Expected Returns," Jennifer Conrad and Gautam Kaul, Review of Financial Studies, Vol 2 Number 2, 1989.
"Does the Stock Market Overreact?," Werner F.M. De Bondt and Richard Thaler, Journal of Finance, July 1985. This paper suggests a Behavioural explanation for observed mean reversion: overreaction. It suggests that "loser stocks" tend to subsequently outperform "winner stocks" because the "loser stocks" became loser stocks to an extent that exceeded rational justification (i.e., they were previously bid down lower than justified by rational expectations). Likewise, the "winner stocks" were previously bid up higher than justified by rational expectations. Over time, those expectations become more rational and the overreactions disappear, causing a reversion to the mean.
"Permanent and Temporary Components of Stock Prices," Eugene F. Fama and Kenneth R. French, Journal of Political Economy, 96, 1988. "A slowly mean-reverting component of stock prices tends to induce negative autocorrelation in returns." "In tests for the 1926-1985 period, large negative autocorrelations for return horizons beyond a year suggest that predictable price variation due to mean reversion accounts for large fractions of 3-5 year return variances. Predictable variation is estimated to be about 40 percent of 3-5 year return variances for portfolios of small firms. The percentage falls to about 25 percent for portfolios of large firms."
"Temporary Movements in Stock Prices," Jonathan W. Lewellen, MIT Sloan School Working Paper, May 2001. "Mean reversion in stock prices is stronger than commonly believed. ... The reversals are also economically significant. The full-sample evidence suggests that 25% to 40% of annual returns are temporary, reversing within 18 months. The percentage drops to between 20% and 30% after 1945. Mean reversion appears strongest in larger stocks and can take several months to show up in prices."
"Reversion in Action," Bill Schultheis, 1999. A great explanation of this concept for lay people.
"Reversion to the Mean," Tony Weisstein. An excellent brief formal mathematical description of this generic concept.
Easy "The Case for Commodities as an Asset Class," Goldman, Sachs, & Co., June 2004. A good discussion of the issues. This is an easy-to-follow PowerPoint presentation.