End the Charade: Replacing the Efficient Frontier with the Efficient Range

**Meir Statman (Santa Clara University) and Joni Clark | July 2013**

● Imprecise estimates are one source of gaps between optimized mean-variance portfolios and portfolios that investors prefer. Investor preferences beyond high mean and low variance is the other source. Both sources of gaps call for investor judgment.

● Harry Markowitz, who introduced mean-variance portfolio theory and its optimizer, noted that judgment plays an essential role in the proper application of mean-variance analysis.

● The charade of the efficient frontier involves “massaging” the estimates of the mean-variance parameters until they yield the efficient frontier and portfolios we prefer.

● This paper offers the “efficient range,” the location of portfolios that acknowledge imprecise estimates of mean-variance parameters and accommodate investor preferences beyond high mean and low variance, as a replacement for the “efficient frontier.”

Factor Investing

**Andrew Ang (Columbia Business School) | June 10, 2013**

Factor investing asks: how well can a particular investor weather hard times relative to the average investor? Answering helps her reap long-run factor premiums by embracing risks that lose money during bad times, but make up for it the rest of the time with attractive rewards. When factor investing can be done cheaply, it raises the bar for active management.

The Value of Stop-Losses and Stop-Gains in Enhancing Risk-Adjusted Return

**Austin Shelton (University of Arizona) | July 2, 2013**

Asset allocation strategies which utilize stop-loss and stop-gain rules may dramatically decrease risk and even increase long-term return relative to passive investing. I introduce an asset allocation strategy which shifts portfolio weights based on simplistic stop rules. The two-asset (S&P mutual fund and bond mutual fund) strategy tested from 1990-2012 produces an annual geometric return of 8.45% vs. 7.50% for the underlying S&P 500 Index fund, with 50% less volatility (9.41% annualized standard deviation of return vs. 18.76% for the S&P index fund). The strategy’s strong results are robust to changes in the user-specified parameters, such as the level and number of stop placements. Hence, further development and refinement of asset allocation and trading strategies which incorporate stop-loss and stop-gain rules may be a valuable area of future research.

Asset Valuations and Safe Portfolio Withdrawal Rates

**David Blanchett (Morningstar Investment Management), et. al | June 27, 2013 **

Bond yields today are well below and stock market valuations are well above their historical average. There are no historical periods in the United States where comparable low bond yields and high equity valuations have occurred simultaneously. Both current bond yields and stock values have been shown to predict near-term returns. Portfolio returns in the first decade of retirement have an outsize impact on retirement income strategies. Traditional Monte Carlo simulation approaches generally do not incorporate market valuations into their analysis. In order to simulate how retirees will fare in a low return environment for both stocks and bonds, we incorporate the predictive ability of current valuations to simulate its impact on retirement portfolios.

We estimate bond returns through an autoregressive model that uses an initial bond yield value where yields drift in the future. We use the cyclically adjusted price-to-earnings (NYSEARCA:CAPE) ratio as an estimate of market valuation to predict short-run stock performance. Our simulations indicate that the safety of a given withdrawal strategy is significantly affected by the initial bond yield and CAPE value at retirement, and that the relative impact varies based on the portfolio equity allocation. Using valuation measures current as of April 15, 2013, which is a bond yield of 2.0% and a CAPE of 22, we find the probability of success for a 40% equity allocation with a 4% initial withdrawal rate over a 30 year period is approximately 48%. This success rate is materially lower than past studies and has sobering implications on the likelihood of success for retirees today, as well as how much those near retirement may need to save to ensure a successful retirement.

Frontier Markets: The Last Tide

**Vishal Mhaiskar (EDHEC Business School) | Dec. 1, 2012**

Historically, investors constantly look at newer avenues to unlock value. They relentlessly search for an investment story that most others have neglected. Imagine investing in a country like China or India in the 1980’s. The Indian Equity Index (SENSEX: INDEX) had a base value of 100 in 1979 and has risen to around 17,000 times until the present day, giving 50% annualized return for the past 34 years. So if you invested U.S. $10,000 in the year 1979, your investment would have earned you U.S. $1.7 million by the year 2012. What if there is a similar opportunity today with markets that will be considered tomorrow’s emerging markets? That even today lays an opportunity that existed a decade back? The awareness of the risks of investing in these markets would definitely be higher than they were decades back. Equity research analysts are constantly on the look for company stories. The stocks universe itself is so big that it is impossible to do justice at a global level and, hence, the need for sector and country specialists. This study intends to use a top’s down approach. If a country index can give a 17,000 times return, the individual stocks that form that index are bound to have much more potential. Hence, a macro level conclusion is appropriate to this thesis objective. Equity has been the asset class that can be defined as a wealth creator. The thesis intends to probe further into the smaller intricacies of investing into the frontier markets, and conclude if there still lays a risk worth taking with these markets and if investing does bring in the diversification benefits, aptly rewarding an investor for each unit of risk taken. Emerging markets today forms a part of most Investor’s portfolios. This thesis study will try to explore all facets of investments that would help an investor make an informed decision about whether or not a frontier market too should form a part of his global allocation in the portfolio.

Does it Pay to Invest in Art? A Selection-Corrected Returns Perspective

**Arthur Korteweg (Stanford Graduate School of Business), et. al | June 16, 2013 **

This paper shows the importance of correcting for sample selection when investing in illiquid assets with endogenous trading. Using a large sample of 20,538 paintings that were sold repeatedly at auction between 1972 and 2010, we find that paintings with higher price appreciation are more likely to trade. This strongly biases estimates of returns. The selection-corrected average annual index return is 7 percent, down from 11 percent for traditional uncorrected repeat-sales regressions, and Sharpe Ratios drop from 0.4 to 0.1. From a pure financial perspective, passive index investing in paintings is not a viable investment strategy, once selection bias is accounted for. Our results have important implications for other illiquid asset classes that trade endogenously.