Do ADRs enhance portfolio performance for a domestic portfolio? Evidence from the 1990s

American depository receipts (ADRs) represent an increasingly popular and convenient mechanism for international investing. We analyze ADRs traded throughout the 1990s and find that these securities offer a diversification and portfolio performance benefit when combined with a domestic portfolio (proxied by the S&P 500). While we find that emerging market ADRs are effective instruments for reducing portfolio risk, they do not improve portfolio performance as measured by the Sharpe ratio. Developed market ADRs do improve portfolio performance as measured by the Sharpe ratio. The asset allocation which maximizes the Sharpe ratio is 84 percent domestic stocks, 16 percent developed ADRs, and 0 percent emerging ADRs. Further, due to problems in defining an appropriate market index for ADRs, the Sharpe ratio is viewed to be the preferred performance measure. Other measures such as Jensen’s alpha and the Treynor measure are susceptible to being “gamed” to distort portfolio performance.     

Asset allocation using flexible dynamic correlation models with regime switching

The asset allocation decision is often considered as a trade-off between maximizing the expected return of a portfolio and minimizing the portfolio risk. The riskiness is evaluated in terms of variance of the portfolio return, so that it is fundamental to consider correctly the variance of its components and their correlations. The evidence for the heteroskedastic behaviour of the returns and the time-varying relationships among the portfolio components have recently shifted attention to the multivariate GARCH models with time varying correlation. In this work we insert a particular Markov Switching dynamics in some Dynamic Correlation models to consider the abrupt changes in correlations affecting the assets in different ways. This class of models is very general and provides several specifications, constraining some coefficients. The models are applied to solve a sectorial asset allocation problem and are compared with alternative models.     

Optimal and Simple,Nearly Optimal Rules for Minimizing the Probability Of Financial Ruin in Retirement

Abstract

The increasing risk of poverty in retirement has been well documented; it is projected that current and future retirees’ living expenses will significantly exceed their savings and income. In this paper, we consider a retiree who does not have sufficient wealth and income to fund her future expenses, and we seek the asset allocation that minimizes the probability of financial ruin during her lifetime. Building on the work of Young (2004) and Milevsky, Moore, and Young (2006), under general mortality assumptions, we derive a variational inequality that governs the ruin probability and optimal asset allocation. We explore the qualitative properties of the ruin robability and optimal strategy, present a numerical method for their estimation, and examine their sensitivity to changes in model parameters for specific examples. We then present an easy-to-implement allocation rule and demonstrate via simulation that it yields nearly optimal ruin probability, even under discrete portfolio rebalancing.     

Do Savings Associations Have a Special Commitment to Housing?

In this paper, we investigate whether elimination of the savings association charter might reduce lending to nontraditional mortgage borrowers. We present a theoretical model of lender portfolio choice, in which nontraditional lenders have some market power and traditional lenders are price takers in the mortgage market. The comparative statics indicate differences between nontraditional and traditional lenders in terms of their asset allocation responses to changes in borrower income and house prices. Empirical tests indicate the absence of such differences between savings associations and commercial banks, suggesting that elimination of the savings association charter would not impair lending to nontraditional mortgage borrowers.     

Interest rate management in LDC's

The McKinnon argument that higher Time Deposit rates raise output and lower inflation in the short run and increase medium-term growth by raising the savings rate are shown to depered crucially on the assumption that portfolio shifts into TD's come out of an asset providing less intermediation than the banking system. We show that if instead the shift is out of an asset providing more intermediation (e.g., loans on a curbmarket), raising TD rates is contractionary in the short run, may have negative impacts on growth and can lead to more rather than less inflation in the short run.     

Overreaction in the Hong Kong stock market

Overreaction reported in the equity markets of the United States, Spain, and Brazil is also observed in the Hong Kong stock market. The “loser” portfolios of the 33 stocks in the Hang Seng Index (HSI), on average, outperform the “winner” portfolios by 9.9% 1 year after the formation periods. Besides its emphasis on the importance of the Hong Kong market in international investment, this paper is unique in some special features related to the overreaction study. Hong Kong has markets for index futures and stock futures. Only three stocks are used in the portfolios. All the stocks in the HSI have large market capitalization and liquidity and can be shorted with no up-tick rule. Unlike other studies in international stock markets, the “arbitrage” portfolio of buying the loser portfolio and shorting the winner portfolio can actually be formed with minimum cost and easy execution, which makes the overreaction phenomena in this study very powerful.     

On the Out-of-Sample Importance of Skewness and Asymmetric Dependence for Asset Allocation

Recent studies in the empirical finance literature have reportedevidence of two types of asymmetries in the joint distributionof stock returns. The first is skewness in the distributionof individual stock returns. The second is an asymmetry in thedependence between stocks: stock returns appear to be more highlycorrelated during market downturns than during market upturns.In this article we examine the economic and statistical significanceof these asymmetries for asset allocation decisions in an out-of-samplesetting. We consider the problem of a constant relative riskaversion (CRRA) investor allocating wealth between the risk-freeasset, a small-cap portfolio, and a large-cap portfolio. Weuse models that can capture time-varying moments up to the fourthorder, and we use copula theory to construct models of the time-varyingdependence structure that allow for different dependence duringbear markets than bull markets. The importance of these twoasymmetries for asset allocation is assessed by comparing theperformance of a portfolio based on a normal distribution modelwith a portfolio based on a more flexible distribution model.For investors with no short-sales constraints, we find thatknowledge of higher moments and asymmetric dependence leadsto gains that are economically significant and statisticallysignificant in some cases. For short sales-constrained investorsthe gains are limited.     

Portfolio implications of systemic crises

Systemic crises can have grave consequences for investors in international equity markets, because they cause the risk-return trade-off to deteriorate severely for a longer period. We propose a novel approach to include the possibility of systemic crises in asset allocation decisions. By combining regime switching models with Merton [Merton, R.C., 1969. Lifetime portfolio selection under uncertainty: The continuous time case. Review of Economics and Statistics 51, 247–257]-style portfolio construction, our approach captures persistence of crises much better than existing models. Our analysis shows that incorporating systemic crises greatly affects asset allocation decisions, while the costs of ignoring them is substantial. For an expected utility maximizing US investor, who can invest globally these costs range from 1.13% per year of his initial wealth when he has no prior information on the likelihood of a crisis, to over 3% per month if a crisis occurs with almost certainty. If a crisis is taken into account, the investor allocates less to risky assets, and particularly less to the crisis prone emerging markets.     

Benefits of international diversification with investment constraints: An over-time perspective

This paper investigates the benefits and asset allocation of the optimal international diversification for the U.S.A. investor while considering various portfolio constraints. Although the global financial market is becoming more integrated, the findings suggest that adding lower and upper weighting bounds reduces, but does not completely eliminate, the potential economic value of international investment. The addition of investment constraints makes asset allocation more feasible and decreases the volatility in portfolio return. The time-variation in the optimal asset allocation implies that fund managers should rebalance international portfolios dynamically. The out-of-sample test suggests that the Markowitz model with constraints realizes trivial improvement in mean-variance efficiency but still demonstrates significant reduction in risk.     

Dynamic correlations and volatility effects in the Balkan equity markets

This paper investigates the presence of time-varying comovements, volatility implications and dynamic correlations in major Balkan and leading mature equity markets, in order to provide quantified responses to international asset allocation decisions. Since asset returns and correlation dynamics are critical inputs in asset pricing, portfolio management and risk hedging, emphasis is placed on the respective (constant and dynamic) equity market correlations produced by alternative multivariate GARCH forms, the Constant Conditional Correlation and the Asymmetric Dynamic Conditional Correlation models. The Balkan stock markets are seen to exhibit time-varying correlations as a peer group, although correlations with the mature markets remain relatively modest. In conjunction with sensitivity analysis on the asymmetric variance–covariance matrix, active portfolio diversification to the Balkan equity markets indicates to potentially improve investors’ risk-return trade-off.     

Linear predictability vs. bull and bear market models in strategic asset allocation decisions: evidence from UK data

Most papers in the portfolio choice literature have examined linear predictability frameworks based on the idea that simple but flexible Vector Autoregressive (VAR) models can be expanded to produce portfolio allocations that hedge against the bull and bear dynamics typical of financial markets through careful selection of predictor variables that capture business cycles and market sentiment. Yet, a distinct literature exists that shows that non-linear econometric frameworks, such as Markov switching, are also natural tools to compute optimal portfolios arising from the existence of good and bad market states. This paper examines whether and how simple VARs can produce portfolio rules similar to those obtained under a simple Markov switching, by studying the effects of expanding both the order of the VAR and the number/selection of predictor variables included. In a typical stock-bond strategic asset allocation problem for UK data, we compute the out-of-sample certainty equivalent returns for a wide range of VARs and compare these measures of performance with those of non-linear models. We conclude that most VARs cannot produce portfolio rules, hedging demands or (net of transaction costs) out-of-sample performances that approximate those obtained from simple non-linear frameworks.     

Do commodities add value in multi-asset portfolios? An out-of-sample analysis for different investment strategies

An essential motive for investing in commodities is to enhance the performance of portfolios traditionally including only stocks and bonds. We analyze the in-sample and out-of-sample portfolio effects resulting from adding commodities to a stock-bond portfolio for commonly implemented asset allocation strategies such as equally- and strategically-weighted portfolios, risk-parity, minimum-variance as well as reward-to-risk timing, mean-variance and Black–Litterman. We analyze different commodity groups such as agricultural and livestock commodities that currently are critically discussed. The out-of-sample portfolio analysis indicates that the attainable benefits of commodities are much smaller than suggested by previous in-sample studies. Hence, in-sample analyses, such as spanning tests, might exaggerate the advantages of commodities. Moreover, the portfolio gains greatly vary between different types of commodities and sub-periods. While aggregate commodity indices, industrial and precious metals as well as energy improve the performance of a stock-bond portfolio for most asset allocation strategies, we hardly find positive portfolio effects for agriculture and livestock. Consequently, investments in food commodities are not essential for efficient asset allocation.     

The 4% strategy revisited: a pre-commitment mean-variance optimal approach to wealth management

In contrast to single-period mean-variance (MV) portfolio allocation, multi-period MV optimal portfolio allocation can be modified slightly to be effectively a down-side risk measure. With this in mind, we consider multi-period MV optimal portfolio allocation in the presence of periodic withdrawals. The investment portfolio can be allocated between a risk-free investment and a risky asset, the price of which is assumed to follow a jump diffusion process. We consider two wealth management applications: optimal de-accumulation rates for a defined contribution pension plan and sustainable withdrawal rates for an endowment. Several numerical illustrations are provided, with some interesting implications. In the pension de-accumulation context, Bengen (1994)’s [J. Financial Planning, 1994, 7, 171–180], historical analysis indicated that a retiree could safely withdraw 4% of her initial retirement savings annually (in real terms), provided that her portfolio maintained an even balance between diversified equities and U.S. Treasury bonds. Our analysis does support 4% as a sustainable withdrawal rate in the pension de-accumulation context (and a somewhat lower rate for an endowment), but only if the investor follows an MV optimal portfolio allocation, not a fixed proportion strategy. Compared with a constant proportion strategy, the MV optimal policy achieves the same expected wealth at the end of the investment horizon, while significantly reducing the standard deviation of wealth and the probability of shortfall. We also explore the effects of suppressing jumps so as to have a pure diffusion process, but assuming a correspondingly larger volatility for the latter process. Surprisingly, it turns out that the MV optimal strategy is more effective when there are large downward jumps compared to having a high volatility diffusion process. Finally, tests based on historical data demonstrate that the MV optimal policy is quite robust to uncertainty about parameter estimates.     

TACTICAL ASSET ALLOCATION: CAN IT WORK?

Market events of the past ten years have sparked an interest in tactical asset allocation. In the current study we develop and test a model that incorporates currently available information into the tactical asset allocation process. The model provides an estimate of the probabilities that the upcoming market period will be bullish or bearish. Logit analysis is employed to determine which of the various timely and readily available data significantly affect these probabilities. These estimated probabilities are used to suggest the optimal allocations of funds over time between the risk-free asset and the market portfolio. Then, several timing strategies are compared with a buy-and-hold portfolio. An asset allocation strategy based on the probabilities assigned by the logit model appears to achieve greater terminal wealth with less variability of returns. Similar results are obtained for both an initial sample (1962–76 in our model) and a holdout sample (1977–88).     

Asset restructuring strategies in bank acquisitions: Does distance between dealing partners matter?

One of the most lively-debated effects of banking acquisitions is the change in lending and asset allocation of the target bank in favour of transaction-based products, at the expense of small and informationally opaque borrowers. These changes may be the result of two distinct restructuring strategies pursued by the acquirer with respect to the asset portfolio of the acquired bank: a cleaning strategy (CS), in which the acquirer makes a clean sweep of all the negative net present value activities in the portfolio of the acquired bank, and a portfolio strategy (PS), in which the acquiring bank permanently changes the portfolio allocation of the acquired bank. In this paper we focus on Italian bank acquisitions and test which asset restructuring strategy was predominantly pursued over the period 1997–2003. Moreover, we distinguish acquisitions according to their geographic diversifying character and to the physical and cultural distances that separate acquiring from acquired banks. When we look at the mean value, we do not find clear evidence of a primacy either of CSs or PSs. When we separate in-market from out-of-market bank acquisitions, however, results show that the CSs prevail only in the former type of deals, while in the latter the portfolio of acquired banks is subject to PSs. Finally, we find that differences in asset restructuring strategies can be explained by differences in corporate culture and the workplace environment of the dealing partners.     

The impact of deposit insurance on S&L shareholders' risk/return trade-offs

This article empirically examines how savings and loan associations' (S&Ls') stock returns respond to asset mix changes. When deposit insurance is underpriced, increases in financial leverage and the riskiness of the asset portfolio should lead to increases in expected return on common stock. In particular, changes in asset components which increase the volatility of an institution's portfolio should lead the stock market to upwardly revalue S&L equity. This hypothesis is examined using data for the July 1984–December 1989 period. Increases in commercial mortgage loans, acquisition and development loans, and investments in service corporations appear to cause higher return for shareholders of poorly capitalized, failing S&Ls. Similar increases appear to have little impact on the common stock returns of well-capitalized S&Ls.     

Properties of the Margrabe Best-of-two strategy to tactical asset allocation

The Margrabe Best-of-two (MBo2) strategy is a rule-based dynamic investment solution for the two-asset allocation problem. Its typical implementation involves yearly rebalancing the portfolio weights to 50–50 between a low-risk and high-risk asset. It uses intra-year weight adjustments to chase the momentum of the best performing asset by replicating the Margrabe formula for the value of a European option to exchange an asset for another asset at year-end. In practice, this means that the Margrabe portfolio allocation benefits from the upside potential of the high-risk asset and the downside protection from the low-risk asset. The MBo2 allocation depends on the assets' prices, their return volatilities, and correlation, as well as the remaining time until year-end. In this paper, we derive analytical formulae and use simulations to provide insights into the sensitivity of the strategy's weights and performance to these input parameters. We also report the results of an extensive out-of-sample evaluation for the MBo2 strategy applied to the bond–equity, real estate–equity, and world equity–emerging market equity portfolio allocation problems.     

What is the impact of wealth shocks on asset allocation?

I test the assumption of constant relative risk aversion using U.S. macroeconomic data and analyse the role of wealth shocks in generating transitory changes in asset portfolio composition. I show that the risky asset share exhibits cyclical behavior and it is significantly (and positively) affected by unexpected variation in wealth. Therefore, the empirical evidence suggests that risk aversion is counter-cyclical. I also find that the portfolio share of housing wealth falls when the agent is faced with a positive wealth shock, i.e. housing is a hedge against unfavorable wealth fluctuations. Finally, considering a variety of wealth definitions, the results show that: (i) wealth effects are stronger for direct holdings of risky assets than for indirect holdings, which highlights that investors do not typically trade some assets such as pension or mutual funds; (ii) although significant, wealth effects on asset allocation are mainly temporary as agents quickly rebalance the asset portfolio composition (i.e. there is weak evidence of inertia or slow adjustment in asset allocation); and (iii) changes in expected returns partially explain the variation in risky asset allocation.     

Investment Horizon Effects

Abstract:   Boudry and Gray (2003) have documented that the optimal buy‐and‐hold demand for Australian stocks is not necessarily increasing in the investment horizon when returns are predictable. Such finding is in contrast with Barberis (2000) who shows that positive monotonic horizon effects predominate for US stocks. Using a closed‐form approximation to the asset allocation problem, this paper relates the return dynamics to the investor's portfolio choice for different investment horizons. In the special case of a single risky asset, it is shown that return predictability under stationarity may induce both positive and negative horizon effects in the optimal allocation to the risky asset. The paper extends previous empirical results by solving for the optimal portfolio when two risky assets with predictable returns are available for investment.     

An analysis of the impact of timberland, farmland and commercial real estate in the asset allocation decisions of institutional investors

We examine the effects of including timberland, farmland and commercial real estate in a mixed asset portfolio with stocks, government bonds and T-Bills. Using both smoothed and unsmoothed returns (as per Geltner [Geltner, D. (1993). Estimating market values from appraised values without assuming an efficient market. Journal of Real Estate Research, 8, 25-345.]) and both constrained and unconstrained allocation assumptions (as per Eichhorn, Gupta and Stubbs [Eichhorn, D., Gupta, F., & Stubbs, E. (1998). Using constraints to improve the robustness of asset allocation. Journal of Portfolio Management, Spring, 41-48.]), we employ Markowitz portfolio optimization and find widely varying allocation outcomes. However, timberland entered nearly all portfolios, accounting for large percentages in several scenarios, while farmland entered only low-risk portfolios. At lower risk levels, commercial real estate dominates the real estate allocation but as acceptable risk levels rise, timberland supplants commercial real estate as the primary component of the portfolio's real estate allocation.