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RESEARCH
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PUBLICATIONS AND WORKING PAPERS
Underperformance of Concentrated Stock Positions June 2023 (working paper)
Contrary to standard investment advice, many high-net-worth investors hold concentrated positions in single stocks, which may constitute 10-20% or more of their total portfolio assets. While most investors recognize that lack of diversification increases the volatility of portfolio returns, they may not understand that concentrated stock positions usually contribute negatively to portfolio returns. Since 1926, the median ten-year return on individual U.S. stocks relative to the broad equity market is –7.9%, underperforming by 0.82% per year. For stocks that have been among the top 20% performers over the previous five years, the median ten-year market-adjusted return falls to –17.8%, underperforming by 1.94% per year. Since the end of World War II, the median ten-year market-adjusted return of recent winners has been negative for 93% of the time. The case for diversifying concentrated positions in individual stocks, particularly in recent market winners, is even stronger than most investors realize.
Inefficiencies in the Pricing of Exchange-Traded Funds January 2017 (published version) (working paper) Financial Analysts Journal, 2017, 73(1):24-54 (lead article) Winner of the Graham and Dodd Top Award (best FAJ paper in 2017) Winner of INQUIRE Europe Research Grant 2010 Related video appearance on CNBC (link) 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, on average fluctuating within a band of about
200 basis points, 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 a group
of similar ETFs. Nevertheless, the average pricing band remains
economically significant at about 100 basis points, with even larger
mispricings in some asset classes. Active trading strategies exploiting
such inefficiencies produce substantial abnormal returns before
transaction costs, providing further proof of short-term mean-reversion
in ETF prices.
What Is the True Cost of Active Management? A Comparison of Hedge Funds and Mutual Funds September 2014 (joint with Jussi Keppo) (published version) (working paper) Journal of Alternative Investments, 2014, 17(2):9-24
On the surface, hedge funds seem to have much higher fees than actively
managed mutual funds. However, the true cost of active management should be
measured relative to the size of the active positions taken by a fund
manager. A mutual fund combines active positions with a passive position in
the benchmark index, which can make the active positions expensive. A hedge
fund takes both long and short positions and uses leverage, which makes the
active positions cheaper, but this can be offset by the expected incentive
fees, especially for more volatile funds. We investigate the trade-offs from
the perspective of a fund investor choosing between a mutual fund and a hedge
fund, examining the impact of leverage, volatility, Active Share, nominal
fees, and alpha for a realistic range of parameter estimates. Our calibration
shows that a moderately skilled active manager is approximately equally
attractive to investors as a mutual fund manager or as a hedge fund manager,
showing that both investment vehicles can coexist as efficient alternatives
to investors. Further, our model explains documented empirical findings on
career development of successful fund managers and on hedge funds' risk
taking. Finally, we show that our findings are quite robust with respect to a
jump risk in the hedge fund returns.
Global Return Premiums on Earnings Quality, Value, and Size (pdf file) November 2012 (joint with Max Kozlov)
We investigate the return premium on stocks with high earnings quality
using a broad and recent global dataset covering all developed markets
from 7/1988 to 6/2012. We find that a simple strategy that is long
stocks with high earnings quality and short stocks with low earnings
quality produces a higher Sharpe ratio than the overall market or
similar strategies betting on value or small stocks. This result holds
both in the overall sample as well as in the more recent time period
since 2005. Because the global earnings quality portfolio has a negative
correlation with a value portfolio, an investor wishing to invest in both
exposures can achieve significant diversification benefits.
Active Share and Mutual Fund Performance July 2013 (published version) (working paper) Financial Analysts Journal, 2013, 69(4):73-93 Winner of the Graham and Dodd Scroll Award My response to AQR's article on Active Share, FAJ, July 2016 (published) (draft) Selected media coverage Click here for data on Active Share of mutual funds
I sort domestic all-equity mutual funds into different categories of
active management using Active Share and tracking error. 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, and they also hold
within market cap styles. Closet indexing increases in volatile and bear
markets and has become more popular after 2007. Cross-sectional
dispersion in stock returns positively predicts average benchmark-adjusted
performance by stock pickers.
Should Benchmark Indices Have Alpha? Revisiting Performance Evaluation July 2013 (joint with Martijn Cremers and Eric Zitzewitz) (published version) (working paper) Critical Finance Review, 2013, 2:1-48 (lead article) 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 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.
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
MARKET COMMENTARY
Treasury Bond Supply and Demand under Fed Tapering (article) June 2013
Many market participants expect Treasury bonds to collapse once the Fed ends its QE program because the Fed has been such a large buyer. However, I find that this scenario is highly unlikely: the combination of rapidly declining Federal deficits and persistently large purchases by the foreign official sector mean that the private sector will not have to start buying new long-term Treasury bonds even after the Fed ends QE.
Who Has Been Buying U.S. Treasuries? (pdf file) March 2012
When evaluating the impact of Treasury bond supply on long-term rates, most market observers seem to have overlooked two key issues: the large role of the foreign official sector (it is not all about the Fed), and the distinction between all Treasuries vs. only long-term Treasuries. Despite large issuance due to the $1.3 trillion federal budget deficit, private investors were actually net sellers of long-term Treasuries in 2011.
Mauboussin, Michael: "Seeking Portfolio Manager Skill," Legg Mason investment strategy report, February 24, 2012
"Mutual Fund Investors Should Crack Down on Closet Indexers," Bloomberg, February 8, 2012
Laise, Eleanor: "Can Anyone Steer This Ship?" The Wall Street Journal, April 23, 2011
Lallos, Laura: "What You Need to Know about Active Fund Managers," Money Magazine, April 8, 2011
"Active Share: Predicting Alpha and Risk," Wellington Management Solutions, April, 2011
Byrt, Frank: "Top Stocks Picked by S&P 500 Slayers," The Street, March 16, 2011
Morgan, Sarah: "When Fund Managers Fake It," SmartMoney Magazine, February 28, 2011
Laise, Eleanor: "The Return of the Market-Beating Fund Manager," The Wall Street Journal, December 18, 2010
Korteila, Maria: "Volatiliteetti tekee salkunhoitajista vellihousuja," Arvopaperi, December 1, 2010 (in Finnish)
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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