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18 The Importance of Asset Allocation Roger G. Ibbotson

22 The Equal Importance of Asset Allocation and Active

Management James X. Xiong, CFA,

Roger G. Ibbotson,

Thomas M. Idzorek, CFA, and

Peng Chen, CFA

31 In Defense of Optimization: The Fallacy of 1/Af Mark Kritzman, CFA,

S?bastien Page, CFA, and

David Turkington, CFA

40 Capital Gains Overhang and

fm|! the Earnings Announcement Volume Premium Wonseok Choi, Kenton Hoyem, and

Jung-Wook Kim

||g 54 The Shrinking Merger Arbitrage Spread: Reasons and Implications Gaurav Jetley AND XlNYU Jl

69 Hidden Survivorship in

Hedge Fund Returns Rajesh K. Aggarwal and

Philippe Jorion

available online at www.cfapubs.org

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Contents Vol. 66, No. 2 <?>- March/April 2010

Guest Editorial < 8

Letters to the Editor 11

PERSPECTIVES

The Importance of Asset Allocation 18 Roger G. Ibbotson

This article discusses the impact on performance of the long-term asset allocation policy relative

to the impact of active management. Most of

the variation in time-series returns for a typical fund comes from general market movement. The

remaining variation comes about equally from

asset allocation policy and active management.

PORTFOLIO MANAGEMENT

The Equal Importance of Asset Allocation and Active Management 22 James X. Xiong, CFA, Roger G. Ibbotson,

Thomas M. Idz?rek, CFA, and Peng Chen, CFA

What is the relative importance of asset alloca

tion policy versus active portfolio management in

explaining variability in performance? Consider

able confusion surrounds both time-series and

cross-sectional regressions and the importance of

asset allocation. Cross-sectional regressions natu

rally remove market movements; therefore, the

cross-sectional results in the literature are equiva lent to analyses of excess market returns even

though the regressions were performed on total

returns. In contrast, time-series analyses of total

returns do not naturally remove market move

ments. Time-series analyses of excess market

returns and cross-sectional analyses of either

total or excess market returns, however, are con

sistent with each other. With market movements

removed, asset allocation and active management are equally important in determining portfolio return differences within a peer group. Finally, an

examination of period-by-period cross-sectional

results reveals why researchers using the same

regression technique can get widely different results.

In Defense of Optimization: The

Fallacy of MN 31 Mark Kritzman, CFA, S?bastien Page, CFA, and

David Turkington, CFA

Previous research has shown that equally weight ed portfolios outperform optimized portfolios, which suggests that optimization adds no value

in the absence of informed inputs. This article

argues the opposite. With naive inputs, optimized

portfolios usually outperform equally weighted portfolios. The ostensible superiority of the 1/N approach arises not from limitations in optimi zation but, rather, from reliance on rolling short

term samples for estimating expected returns. This

approach often yields implausible expectations.

By relying on longer-term samples for estimating

expected returns or even naively contrived yet

plausible assumptions, optimized portfolios out

perform equally weighted portfolios out of sample.

EQUITY INVESTMENTS

Capital Gains Overhang and the

Earnings Announcement Volume Premium 40

Wonseok Choi, Kenton Hoyem, and Jung-Wo ok Kim

This study examined why stocks that experience

high abnormal trading volume around earn

ings announcements earn high returns. The high returns of high-volume stocks appear to be asso

ciated with selling pressure that is independent of fundamentals and that comes from a subset of

investors who base their selling decisions on the

magnitude of unrealized capital gains or losses.

Supplementary evidence based on account-level

data from a U.S. brokerage firm suggests extra

selling pressure for stocks with large capital losses

around earnings announcements. These patterns also suggest that the conventional interpretation of the disposition effect may not hold for stocks

with large, unrealized capital losses around earn

ings announcements.



Redefining Quantitative Research

otrvai i tin re :,

/ BACKTESTIN^ / OPTIMIZATION / PORTFOLIO ATTRIBUTION



j ~ f ~ t -~ i ~ I.- a **i ~. ~A aa .a 1

Par a a a aa~a~ *a~

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4 - U * 4 4 4.4 4 44 4~ - 4 4~ ~.44'4.~ '4 4 4 4~'~ t44~s 4~



ALTERNATIVE INVESTMENTS

The Shrinking Merger Arbitrage Spread: Reasons and Implications 54 Gaurav Jetley and Xinyu Ji

The merger arbitrage spread has declined by more than 400 bps since 2002. This decline, which is both economically and statistically sig nificant, corresponds to the decline in aggregate returns of merger arbitrage hedge funds, as well

as increased inflows into merger arbitrage hedge funds. Part of the decline in the arbitrage spread

may be explained by increased trading in the

targets7 stocks following the merger announce

ment, reduced transaction costs, and changes in

risk related to merger arbitrage. These findings

suggest that some of the decline is likely to be

permanent; therefore, investors seeking to invest

in merger arbitrage hedge funds should focus on

returns since 2002.

Hidden Survivorship in Hedge Fund Returns 69 Rajesh K. Aggarwal and Philippe Jorion

This study identifies a previously unreported bias in the TASS database. Owing to a merger with the Tremont database, 60 percent of the

funds added to the TASS database between April 1999 and November 2001 are likely to be sur

vivors (i.e., funds that were selected only from

funds that were live as of 31 March 1999). The

resulting survivorship bias is substantial, aver

aging more than 5 percent a year. What would

normally be termed the backfill period actually

represents hidden survivorship. A sorting algo rithm to exclude these fund histories is proposed.

Book Reviews 75

In the Future 80 Rodney N. Sullivan, CFA

f?<T7\ I j*j , Articles in this publication qualify for CE credit under the guidelines of the CFA Institute Continuing ^f^FrV institute Education Program. Articles each qualify for 1 CE credit; Global Financial Crisis and Perspectives pieces

CE Qualified Activity each qualify for 0.5 CE credit.



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EXECUTIVE EDITOR Richard M. Ennis, CFA, Ennis Knupp + Associates EDITOR Rodney N. Sullivan, CFA, CFA Institute

ADVISORY COUNCIL

John C. Bogle The Vanguard Group, Inc.

Gary R Brinson, CFA GP Brinson Investments

Kenneth R. French Dartmouth College

Martin S. Fridson, CFA Fridson Investment Advisors FAJ Book Review Editor

Roger G. Ibbotson Yale School of Management

Bruce I. Jacobs Jacobs Levy Equity Management

Dean LeBaron, CFA

Virtualquest

Martin L. Leibowitz Morgan Stanley

William F. Sharpe Stanford University Graduate School of Business

Jack L. Treynor Treynor Capital Management, Inc.

^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^ Clifford S. Asness AQR Capital Management, LLC

Jean L.R Brunei, CFA Brunei Associates, LLC

Jianguo Chen Massey University

Peng Chen, CFA Ibbotson Associates

Harindra de Silva, CFA Analytic Investors, LLC

William N. Goetzmann Yale School of Management

Richard Grinold Barclays Global Investors

Campbell R. Harvey Duke University

Joanne M. Hill ProShares ETFs and ProFunds

Marianne M. Jennings Arizona State University

Josef Lakonishok University of Illinois at

Urbana-Champaign

Jean-Fran?ois L'Her, CFA Caisse de D?p?t et Placement du Qu?bec

Jinliang Li, CFA Tsinghua University

Andrew Lo MIT Sloan School of Managemen

Francis Longstaff, CFA University of California,

Los Angeles

John J. Nagorniak, CFA Foxstone Financial Inc.

Andr? F. Perofd Harvard Business School

Ludovic Phalippou University of Amsterdam

Richard Roll UCLA Anderson Graduate School of Management

Richard W. Sias Washington State University

Laurence B. Siegel WiImette, Illinois

Vijay Singal, CFA Virginia Tech

Bruno Solnik HEC Paris and HKUST

Meir Statman Santa Clara University

Richard H. Thaler University of Chicago

Kai Chong Tsui, CFA SIM University

M. Barton Waring Barclays Global Investors

H CFA INSTITUTE STAFF ̂ ^^^^^H John D. Rogers, CFA President and CEO

Robert R. Johnson, CFA Senior Managing Director

Tom Robinson, CFA

Managing Director, Education

Rodney N. Sullivan, CFA

Head, Publications

Stephen Smith Editor

David L. Hess Assistant Editor

Mary Whalen Publications Assistant

Jen ine A. Kaznowski

Director, Corporate Sales

Cindy Maisannes

Publishing Technology Specialist

Lois A. Carrier Production Specialist

Cover Design Brent Nultemeier

Cover Photo Boston Skyline Boston, Massachusetts

Photo Credit ?Abeloff dreamstime

Financial Analysts Journal?, Vol. 66, No. 2, March/April 2010. ?2010 CFA Institute. CFA?, Chartered Financial Analyst?, AIMR-PPS?, GIPS?, and Financial Analysts Journal? are just a few of the trademarks owned by CFA Institute. CFA Institute is a not-for-profit corporation devoted to the advancement of investment management and security analysis. To view a list of the CFA Institute trademarks and a guide for the use of the CFA Institute marks, please visit our website at www.cfainstitute.org. Financial Analysts Journal? (USPS 571-200; CPM 4003 14-55; ISSN 0015-198X) is published bimonthly by CFA Institute, 560 Ray C. Hunt Drive, P.O. Box 3668, Charlottesville, Virginia 22903. The FAJ mission, standards, and policies are published on cfapubs.org. Neither CFA Institute nor its publication's editorial staff is responsible for facts and opinions contained in articles therein. Printed in the U.S.A. Indexed in the Business Periodicals Index. Periodicals postage paid at the Post Office in

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Sunday, 16 may OPENING SESSION: Predictably Irrational: Hidden Forces That Shape Our

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monday, 17 may MORNING PLENARY SESSIONS: Understanding Financial Crises Why African Markets Are More Profitable Than You Think Bailouts, Ballyhoo, and New Betas: Managing Portfolio Risks and Rewards

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tuesday, 18 may MORNING PLENARY SESSIONS: The U.S. SEC s Investor-Focused

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The Power of Negative Thinking: A Short-Seller s Perspective Lessons from

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Wednesday 19 may MORNING PLENARY SESSIONS: Animal Spirits and the Economy The

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CFA Institute: Upcoming Events

April THE OXFORD INTERNATIONAL INVESTMENT PROGRAMME 19-22 April 2010 Oxford, United Kingdom In partnership With Said Business School, University of Oxford

ALTERNATIVE INVESTMENTS 2010* 21-22 April 2010 London, United Kingdom In partnership with the Chartered

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INTERNATIONAL FIXED INCOME AND DERIVATIVES (IFID) CERTIFICATE 25 April-1 May 2010 Barcelona, Spain In partnership with the International Capital Markets Association

May INTERNATIONAL WEALTH AND TAX PLANNING SEMINAR 3-7 May 2010 Lucerne, Switzerland In partnership with Swiss Finance Institute

QUANTITATIVE EQUITY PORTFOLIO MANAGEMENT INTERNATIONAL PROGRAM 11-14 May 2010

Milan, Italy In partnership with SDA Bocconi School of Management

RESEARCH FOR THE PRACTITIONER IX 16 May 2010 Boston, Massachusetts, USA

2010 CFA INSTITUTE ANNUAL CONFERENCE* 16-19 May 2010 Boston, Massachusetts, USA

ADVANCES IN ASSET ALLOCATION SEMINAR 18-20 May 2010 Singapore In partnership with EDHEC-Risk Institute

LEVERAGED CREDIT, WORKOUTS, AND DISTRESSED DEBT 24-27 May 2010 Charlottesville, Virginia, USA In partnership with Mclntire School of Commerce, University of Virginia

June GLOBAL INVESTORS WORKSHOP 7- 11 June 2010 Fontainebleau, France In partnership with INSEAD

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THE OXFORD PRIVATE EQUITY PROGRAMME 28 June-1 July 2010 Oxford, United Kingdom In partnership with Said Business School -University of Oxford

Use promotional code FAJ-0310 for a US$50 (or equivalent) discount on these events.

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N S T1TUT E



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CFA INSTITUTE BOARD OF GOVERNORS 2009-2010

Chair Thomas B. Welch, CFA Wells Capital Management Minneapolis, Minnesota

Wee Chair Margaret E. Franklin, CFA

Toronto, Ontario, Canada

CFA Institute President and CEO John D. Rogers, CFA CFA Institute Charlottesville, Virginia

Saeed M. Al-Hajeri, CFA Abu Dhabi Investment Authority Abu Dhabi, United Arab Emirates

Mark J.P. Anson, CFA Nuveen Investments

Chicago, Illinois

Kay Ryan Booth Harrison, New York

Pierre Cardon, CFA Bank for International Settlements

Basel, Switzerland

Samuel B. Jones, Jr., CFA

Carlisle, Massachusetts

Stanley G. Lee, CFA

Neuberger Berman The Greene Group New York, New York

Jeffrey D. Lorenzen, CFA American Equity Investment

Life Insurance Co. West Des Moines, Iowa

Daniel S. Meader, CFA

Trinity Advisory Group South lake, Texas

Alan M. Med er, CFA Duff & Phelps Investment Management Co.

Chicago, Illinois

Jane Shao, CFA

Beijing, China

Brian D. Singer, CFA

Singer Partners, LLC

Winnetka, Illinois

Roger Urwin MSG Barra

London, United Kingdom

Charles J. Yang, CFA

Tokyo, Japan



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