CFA Institute Pubs

Pensions are the focus of this issue, which includes descriptions of the problems confronting defined-benefit and defined-contribution plans and thoughtful, creative solutions to the problems.

Volatility of GDP has fallen dramatically over the last 20–30 years in most industrialized economies. In the G–7 countries (Canada, France, Germany, Italy, Japan, the United Kingdom, and the United States) and Australia, the magnitude of this so-called moderation was similar but the timing was not. The moderation appeared as early as the early 1970s (e.g., Germany) and as late as the late 1980s (e.g., Canada). The author examines three possible explanations in this eight-country sample. These explanations include better monetary policy, structural changes in inventory management, and a fortuitous yet random period of few economic shocks.

The authors present trends in credit protection terms of loan portfolios secured by commercial property, called commercial mortgage-backed securities (CMBS). They argue that declining interest rates and strong credit performance have increased the attractiveness of CMBS to investors. Because few attractive alternatives exist, credit spreads have decreased and investors have made concessions on loan terms.

The S&P 500 Index is continually updated, with approximately 20 companies added each year and an equal number dropped. In the study reported here, the returns to all 500 of the original S&P 500 companies and returns to the companies subsequently added to the index were calculated from March 1957 through 2003. Contrary to earlier research, this study found that the buy-and-hold returns of the 500 original companies have been higher than the returns to the continually updated S&P 500 and with lower risk. Furthermore, the original companies in 9 of the 10 industry sectors outperformed the new companies added to the index.

Financial planners and advisors increasingly recognize that human capital must be taken into account when building optimal portfolios for individual investors. But human capital is not simply another pre-endowed asset class; it contains a unique mortality risk in the form of the loss of future income and wages in the event of the wage earner's death. Life insurance hedges this mortality risk, so human capital affects both optimal asset allocation and demand for life insurance. Yet, historically, asset allocation and life insurance decisions have been analyzed separately. This article develops a unified framework based on human capital that enables individual investors to make these decisions jointly.

Several surveys conducted in the United States reveal that most investors believe rating agencies are too slow in adjusting their ratings to changes in corporate creditworthiness. It is well known that agencies achieve rating stability by their through-the-cycle methodology. This study provides quantitative insight into this methodology from an investor's point-in-time perspective and quantifies the effects of the methodology on three, somewhat conflicting, objectives: rating stability, rating timeliness, and performance in predicting defaults. The results can guide the search for an optimal balance among these three objectives.

The author studies the investment performance of all types of institutional investors in the United States from 1981 to 2002. The results indicate that institutional investors in general have been successful in managing client money. Institutional investors have added significant value by generating excess returns after controlling for underlying portfolio risk factors. Most of the returns generated can be attributed to the investment style choice, but institutional investors also displayed significant stock selection skills during the period.

The author presents evidence that the money supply has a major effect on GDP and stock prices. This conclusion is drawn from observing the effect on nominal GDP (for which the proxy is M2 or equivalent) and the stock market (for which the proxy is the S&P 500 Index) during three notable boom/bust periods in the United States and Japan. All three of these time periods were sparked by significant technological change and exhibited a long period of economic growth followed by an economic decline and stock market crash. He concludes that the subsequent economic and market recovery is directly correlated to the monetary policy during the post-boom period.

The authors contend that an additional set of global market factors can be used to further diversify a global portfolio's risk exposure. Global portfolios are formed based on exposures to fundamental factor characteristics of markets within asset classes. The authors illustrate the use of such a factor-based framework to provide diversification benefits but note that changing factor exposures over time can cause implementation difficulties.

The author reports a negative relationship between per capita income growth and real equity returns and then presents arguments that even future economic growth is irrelevant in predicting equity returns. After making the case that economic growth supported by technological change does not benefit existing shareholders, the author concludes that earnings yield is what really matters in predicting future equity returns.

The authors investigate whether the ratio of book value to market value serves as a suitable risk measure when using a leverage-based model instead of traditional asset-pricing models. They believe the book-to-market ratio should measure risk because it affects the relationship between financial risk and capital structure. For the base sample composed of companies with positive book values, the authors find that the book-to-market ratio (B/M) not only has the same explanatory power for average returns as financial leverage but also contains some small additional amount of risk information. They find no relationship between average returns and B/M for all-equity-financed companies but an inverse relationship for companies with negative book value of equity.

The paper seeks to determine whether Taiwanese investors exhibit behavioral investing patterns consistent with overconfidence. It finds that trading volume increases following bullish market moves, consistent with the theory. The paper also points to modest shifts toward riskier stocks following bullish moves.

Although it is the centerpiece of modern finance, the capital asset pricing model (CAPM) poorly explains cross-sectional U.S. and U.K. stock returns. By extending the standard CAPM beyond its traditional mean–variance framework to include skewness and kurtosis, U.K. stock return predictability can be improved, though this result could be specious, owing to excessive use of model parameters.

The author proposes an asset/liability model to predict the optimal allocation of a pension plan to both privately held and publicly listed real estate. This model includes the impact of such variables as the funding status of the plan, the industry of the plan's sponsor, and the covariance of real estate returns with changes in plan liabilities. The resulting allocations to real estate—which are subdivided by industry and adjusted by funding status—are lower in absolute terms than most traditional mean–variance models suggest and are also closer to empirically observed plan allocations to real estate.

Current macroeconomic factors as well as recent academic studies support treating commodities as an asset class. Passive index investing in commodities may be difficult because major indices differ considerably and suffer from inherent limitations. The author presents a benchmark index of active commodity futures investors and another including hedfe fund commodity investors. Both active indices outperform passive indexing.