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RESEARCH
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WORK IN PROGRESS
Active Management and Performance by Large Institutions
Hedge Fund Failures, Restarts, and Manager Incentives (joint with Mila Getmansky-Sherman and Hongjun Yan)
What Is the True Cost of Active Management? A Comparison of Hedge Funds and Mutual Funds (joint with Jussi Keppo)
Predicting Stock Returns with the Distribution of Fund Managers' Beliefs
BOOK CHAPTERS
Hedge Funds, Mutual Funds, and ETFs (joint with Stephen Brown and Anthony Lynch) Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance, ed. by Acharya et al., Wiley, 2010, chapter 12:351-366
PUBLICATIONS AND WORKING PAPERS
Inefficiencies in the Pricing of Exchange-Traded Funds (pdf file) August 2011 Winner of INQUIRE Europe Research Grant 2010 Related research report that focuses on market-on-close transactions in ETFs (pdf file)
The prices of exchange-traded funds can deviate significantly from
their net asset values, in spite of the arbitrage mechanism that allows
authorized participants to create and redeem shares for the underlying
portfolios. The deviations are larger in funds holding international or
illiquid securities where net asset values are most difficult to
determine in real time. To control for stale pricing of the underlying
assets, I introduce a novel approach using the cross-section of prices
on groups of similar ETFs. I find that significant ETF mispricings
remain in many asset classes. Active trading strategies exploiting such
inefficiencies produce substantial abnormal returns before transaction
costs.
Active Share and Mutual Fund Performance (pdf file) December 2010
I sort domestic all-equity mutual funds into different categories of
active management using Active Share and tracking error, as suggested
by Cremers and Petajisto (2009). I find that over my sample period
until the end of 2009, the most active stock pickers have outperformed
their benchmark indices even after fees and transaction costs. In contrast,
closet indexers or funds focusing on factor bets have lost to their
benchmarks after fees. The same long-term performance patterns held up over
the 2008-2009 financial crisis. Closet indexing has become more popular
after market volatility started to increase in 2007. Cross-sectional
dispersion in stock returns positively predicts average benchmark-adjusted
performance by stock pickers.
Should Benchmark Indices Have Alpha? Revisiting Performance Evaluation (pdf file) January 2010 (joint with Martijn Cremers and Eric Zitzewitz) Winner of the Commonfund Best Paper Prize at the EFA 2009 Annual Meeting Winner of the Best Paper Award at the FMA 2009 European Conference Winner of the Roger F. Murray Best Paper Prize (3rd place) at the Q-Group 2009 conference Winner of Q-Group Research Grant 2007 NEW: Click here for return data on index-based factors
Standard Fama-French and Carhart models produce economically and
statistically significant nonzero alphas even for passive benchmark
indices such as the S&P 500 and Russell 2000. We find that these
alphas primarily arise from the disproportionate weight the
Fama-French factors place on small value stocks which have performed
well, and from the CRSP value-weighted market index which is
historically a downward-biased benchmark for U.S. stocks. We explore
alternative ways to construct these factors and propose alternative
models constructed from common and easily tradable benchmark indices.
The index-based models outperform the standard models in common
applications such as performance evaluation of mutual fund managers.
How Active Is Your Fund Manager? A New Measure That Predicts Performance September 2009 (joint with Martijn Cremers) (published version) (working paper) Review of Financial Studies, 2009, 22(9):3329-3365 (lead article) Winner of the Best Paper Award at the Financial Research Association 2006 Annual Meeting Top 100 most downloaded paper on SSRN across all time and disciplines Related op-ed piece: "Magellan's Problem: Closet Indexing," November 15, 2005 (pdf file) Selected media coverage Click here for data on Active Share of mutual funds
To quantify active portfolio
management, we introduce a new measure we label Active Share.
It describes the share of portfolio holdings that differ from
the benchmark index. We determine the type of active management
for a portfolio by measuring it in two dimensions using both
Active Share and tracking error volatility. We apply this
approach to the universe of all-equity mutual funds to
characterize how much and what type of active management they
practice. We test how active management is related to fund
characteristics such as size, expenses, and turnover in the
cross-section, and we examine the evolution of active management
over time. Active management also predicts fund performance:
funds with the highest Active Share significantly outperform
their benchmark indexes both before and after expenses, and they
exhibit strong performance persistence even after controlling
for momentum. Non-index funds with the lowest Active Share
underperform.
Why Do Demand Curves for Stocks Slope Down? October 2009 (published version) (working paper) Journal of Financial and Quantitative Analysis, 2009, 44(5):1013-1044 (lead article) An earlier and more comprehensive version, including results on endogeneously arising institutions and optimal institutional structure (pdf file) Separate appendices: Empirical tests (pdf file) and a more elaborate model (pdf file)
Representative agent models
are inconsistent with existing empirical evidence for steep demand
curves for individual stocks. This paper resolves the puzzle by
proposing that stock prices are instead set by two separate classes of
investors. While the market portfolio is still priced by individual
investors based on their collective risk aversion, those individual
investors also delegate part of their wealth to active money managers
who use that capital to price stocks in the cross-section. In
equilibrium the fee charged by active managers has to equal the
before-fee alpha they earn; this endogenously determines the amount of
active capital and the slopes of demand curves. A calibration of the
model reveals that demand curves can indeed be steep enough to match
the magnitude of many empirical findings, including the price effects
for stocks added to (or deleted from) the S&P 500 index.
The Index Premium and Its Hidden Cost for Index Funds March 2011 (published version) (working paper) Journal of Empirical Finance, 2011, 18(2):271-288
This paper empirically investigates the index premium and its implications
from 1990 to 2005. First, we find that the price impact has averaged +8.8%
and +4.7% for additions to the S&P 500 and Russell 2000, respectively, and
-15.1% and -4.6% for deletions. The premia have been growing over time,
peaking in 2000, and declining since then. Second, the implied price
elasticity of demand increases with firm size and decreases with
idiosyncratic risk, supporting theoretical predictions. Third, we
introduce a new concept that we label the index turnover cost, which
represents a hidden cost borne by index funds (and the indexes themselves)
due to the index premium. We illustrate this cost and estimate its lower
bound as 21-28bp annually for the S&P 500 and 38-77bp annually for the Russell 2000.
Selection of an Optimal Index Rule for an Index Fund (pdf file) August 2008 Journal of Financial Markets, revise and resubmit
Several empirical studies document a substantial
price premium for stocks in the S&P 500 index. For index investors this creates a recurring
cost: as the index is updated, they need to buy stocks with the premium and sell stocks without
the premium. Different index rules can produce different index premia due to the different
frequency and criteria of updating. We build a model to investigate the behavior of the
index turnover cost and the portfolio performance of a mechanical index fund under a market-cap
rule, an exogenous random rule, and a deterministic rule. We find that the rational anticipation
of future index composition reflected in prices today eliminates any first-order differences in
index fund performance across the three index rules. As the index investors become a large part
of the market, the non-index investors become less diversified, and this induces hedging motives
which hurt the index investors especially under a market-cap rule.
Laise, Eleanor: "The Return of the Market-Beating Fund Manager," The Wall Street Journal, December 18, 2010
Lee, Samuel: "The Hidden Costs of Indexing," Morningstar, October 27, 2010
"Closet Indexers Make Up One Third of Fund Assets," Reuters TV, October 25, 2010
"SEC Regulation, Volatility Drive Closet Indexing Trend," Reuters TV, October 25, 2010
Leggio, Ryan, and John Coumarianos: "Go Active or Go Home," Morningstar, September 6, 2010
Elston, Peter: "Don't Tar All Actives with the Same Brush," Financial Times, May 30, 2010
Boucher, Christopher, and Bertrand Maillet: "Case for Active Management Is Actually Strong," Financial Times, May 2, 2010
"Closet Index Funds Are Doomed to Underperform," Fidelity Perspective, May, 2010
Whitehead, Marcus: "Genuine Active Managers Can Add Value," Financial Times, January 10, 2010
Mamudi, Sam: "What Are You Paying For?" The Wall Street Journal, December 8, 2009
Little, Pat: "Active versus Passive Equity Managers: Using the "Active Share" Measure," Hammond Associates research note, August, 2009
Solow, Ken: "Compelling Evidence that Active Management Really Works," Advisor Perspectives, June 23, 2009
Laise, Eleanor: "As Firms Boost Analyst Ranks, Here's How to Sort Out Funds," The Wall Street Journal, November 5, 2007
"A Lesson in Pursuing Alpha and Beta," Financial Times, July 23, 2007
Strauss, Lawrence: "When Divergence is Good," Barron's, July 23, 2007
Gangahar, Anuj: "Advantages of Active Investing," Financial Times, July 9, 2007
Marquardt, Katy: "Spot Closet Indexers," Kiplinger.com, July 9, 2007
Wherry, Rob: "Is Your Fund a Closet Indexer?" SmartMoney.com, May 3, 2007
Richards, Matthew: "There Are a Few Skeletons Lurking in the Closets," Financial Times, February 10, 2007
Davis, Jonathan: "A Nugget to Please Active Managers," Financial Times, February 5, 2007
Petajisto, Antti: "How Active Is Your Fund Manager?" Global Investor Magazine, November 2006
Heiskanen, Mirva: "Kaappi-indeksi laskuttaa tyhjästä," Talouselämä, November 6, 2006 (in Finnish)
Wheleham, Barbara: "Index Funds: A Good Driver of Investment Returns," Bankrate.com, October 4, 2006
O'Brian, Elizabeth: "How Active Is Your Fund Manager?" Financial Planning, October 1, 2006
Brown, Jeff: "Indexing Brings Peace of Mind to Mutual Funds," The Philadelphia Inquirer, September 5, 2006
Möttölä, Matias: "Aktiivisimmat menestyvät," Helsingin Sanomat, September 3, 2006 (in Finnish)
Hanson, Tim: "A Warning for Investors," The Motley Fool, August 30, 2006
Mossman, Laura: "Alpha Superheroes," Financial Times Investment Adviser, August 23, 2006
"Yale Study: A Third of Mutual Funds Are 'Closet Indexers,'" Institutional Investor, August 22, 2006
"More Actively Managed Funds Tied to Indexes," Money Management Executive, August 21, 2006
Lauricella, Tom: "Professors Shine a Light into 'Closet Indexes,'" The Wall Street Journal, August 18, 2006
"Index Hugging," Financial Times Investment Adviser, July 31, 2006
"Research Sorts Index Huggers from Active," Financial Times Investment Adviser, July 31, 2006
Montier, James: "Come Out of the Closet, or, Show Me the Alpha," Dresdner Kleinwort Global Equity Strategy research report, July 19, 2006
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