Robert Ferguson

A Comparative Analysis of Several Popular Term Structure Estimation Models

Fixed-income analysis begins with the term structure. Issues arise as to the methodology for estimating a term structure. Practitioners seem to want a method that is easy to implement, reliable, accurate, and appropriate for their particular niche (e.g., hedging, mortgage-backed, trading, or valuation). Our analysis addresses estimation methodology by using simulations to examine six methods of deriving a cross-sectional discount function.

The trouble with performance measurement

Performance measurement consists of assigning numbers to portfolios. This does not matter if there is only one available portfolio to invest in, because then you have no choice. It does not matter if there is more than one available portfolio to invest in, either. But in that case it is not quite so clear why. A few diehards still use return as a measure of performance. This is correct if all they care about is the portfolio’s expected return. Since the expected returns of stocks differ, one stock will have the highest expected return. The implication is that a one-stock portfolio is the proper choice. Most of the time,. people who use return as a measure of performance do not have one-stock portfolios. This may be because they have a fragmented personality, or possible worse. I try to stay away from these people; they could be dangerous. But perhaps I arn being too hard on return. What about using long-term return as a measure of performance? I suppose the point is arguable if you are going to be around forever.’ Some people argue that long-term return is the proper definition of portfolio attractiveness for pension funds and other possibly immortal investors. I disagree for two reasons. First, there are no immortal investors * My second reason is the important one. Only living people make decisions, and I believe that they try to make decisions that make them happy. The utility functions whose expected values are maximized in all of the textbooks are ours, not those of hypothetical people yet to be born. We place great importance on the short-term availability of funds for consumption and bequests. Show me a pension fund manager who will take a 99% chance of losing almost everything in a year in order to maximize really long-term return and I will show you someone without a job. The sophisticated measures of portfolio at trac-

Trading Strategy on EVA and MVA: Are They Reliable Indicators of Future Stock Performance?

The positive risk-adjusted return of the winner group is found when adjusted-MVA is designated as the ranking variable. This return is higher than the one in the loser group. However, both returns are at an insignificant level. The p-values for each factor loading as well as the F-values are all significant, while the adjusted R-squares range between 0.5578–0.8801. Hence, the authors suspect that the adjusted-MVA variable may be a weak alternative indicator of earnings momentum. At the same time, the authors conclude that the Fama-French model successfully captures the return components.

Portfolio Composition and the Investment Horizon Revisited

any articles show how portfolio composition depends on the investment horizon. Typically, they conclude that portM folio composition changes in a simple way as the investment horizon lengthens. Gunthorpe and Levy [1994] is a superior example. It presents the case for a simple relationship clearly, and the authors express concern that the relationship may not always be as simple as they represent it. The authors’ concern is well-founded. There is no reliable simple relationshp. The real message is that portfolio composition depends on the investment horizon, not how. This article builds on the Gunthorpe and Levy work to show how treacherous is any simple characterization of the relationshp.

An Intuitive Procedure to Approximate Convertible Bond Hedge Ratios and Durations

A simple and intuitive model to approximate convertible bond hedge ratios and durations can help investors understand how these securities can be hedged and how more complex models work.

Making the Dividend Discount Model Relevant for Financial Analysts

The traditional dividend discount model (DDM) depends on dividend forecasts that are highly uncertain. The DDM can be restated in terms of projected abnormal earnings, however, which provide a much sounder basis for pricing equities. The author shows how the restated DDM can be programmed into a spreadsheet and used as a practical pricing tool by financial analysts. He uses the spreadsheet to demonstrate the behavior of a firm’s theoretical price-to-book ratio and P/E under various scenarios and illustrates the advantages of external equity financing when a firm has abnormally profitable business opportunities.

What to do, or not do, about the markets

T here has been considerable finger pointing cause more harm than good. since the Crash, much of it devoted to the tail wagging the dog idea. This concept may be typical of many that will influence regulators and exchanges as they decide what new measures to adopt to prevent another Crash. It is wrong and it misses the point. The wide pre-October use of futures and options demonstrates that investors want them. All the same, their future is in the hands of these regulators and exchanges. I do not know what the future of the markets is, because I do not know what measures the regulators and exchanges will adopt. The outlook, however, is poor to the extent that deleterious measures are implemented.’ l4

The Danger of Leverage and Volatility

High expected returns are attractive but are associated with high risk. Ultimately, risk shows up as volatility. Volatility is a fundamental feature of a business but can be increased through firm or investor leverage. Volatility without leverage significantly reduces long term return. Leverage and volatility combined can turn moderately poor returns into disasters and reduce long term return far more than is generally appreciated. Many investments with high expected returns have disappointing long term returns or appreciable chances of disaster.

Chicken Little Gets It Wrong Again

Many investors see little opportunity for active portfolio managers to exploit relative returns in environments with high return correlation. Contrary to what current-day Chicken Littles believe, the authors empirically find a positive relation between the S&P 500’s average constituent stock relative-return volatility and its average between-constituent return correlation. Moreover, the S&P 500’s index-return variance, average between-constituent return correlation, average constituent relative-return variance, and average constituent residual-return variance are all positively related to a statistically significant degree. The authors also provide a theoretical foundation for these empirical findings.

Market Diversity and the Performance of ActivelyManaged Portfolios

Agapova, Ferguson, and Greene examine a theoretically motivated measure of the “size effect” known as market diversity and link it to the relative returns of institutional actively managed portfolios. Market diversity reflects how disperse or concentrated capital is across firms in the market, with changes in market diversity reflecting movement of capital between relatively large firms to relatively small firms. Changes in market diversity explain a statistically and economically significant amount of variation in the relative returns of actively managed institutional large-cap strategies. The authors estimate that an increase (decrease) in market diversity of 1% leads to an average increase (decrease) in relative returns of approximately 30 basis points, with higher tracking error strategies showing relatively more sensitivity. They find that another measure of the size effect, the Fama–French small-minus-big factor, explains less of the variation in actively managed large-cap strategies’ relative returns and is rejected in favor of changes in market diversity as the underlying explanatory variable for actively managed strategies’ relative returns. The authors suggest that market diversity provides academics and practitioners an important measure of market conditions when evaluating the performance of actively managed portfolios.