Optimal Asset Allocation in Asset Liability Management

We study the impact of regulations on the investment decisions of a defined benefits pension plan. We assess the influence of ex ante (preventive) and ex post (punitive) risk constraints on the gains to dynamic, as opposed to myopic, decision making. We find that preventive measures, such as Value-at-Risk constraints, tend to decrease the gains to dynamic investment. In contrast, punitive constraints, such as mandatory additional contributions from the sponsor when the plan becomes underfunded, lead to very large utility gains from solving the dynamic program. We also show that financial reporting rules have real effects on investment behavior. For example, the current requirement to discount liabilities at a rolling average of yields, as opposed to at current yields, induces grossly suboptimal investment decisions.

Measuring Skill in the Mutual Fund Industry

Using the value that a mutual fund extracts from capital markets as the measure of skill, we find that the average mutual fund has used this skill to generate about $3.2 million per year. Large cross-sectional differences in skill persist for as long as ten years. Investors recognize this skill and reward it by investing more capital with better funds. Better funds earn higher aggregate fees, and a strong positive correlation exists between current compensation and future performance. The cross-sectional distribution of managerial skill is predominantly reflected in the cross-sectional distribution of fund size, not gross alpha

Optimal Decentralized Investment Management

We study a decentralized investment problem in which a CIO employs multiple asset managers to implement and execute investment strategies in separate asset classes. The CIO allocates capital to the managers who, in turn, allocate these funds to the assets in their asset class. This two-step investment process causes several misalignments of objectives between the CIO and his managers and can lead to large utility costs on the part of the CIO. We focus on i) loss of diversification ii) different appetites for risk, iii) different investment horizons, and iv) the presence of liabilities. We derive an optimal unconditional linear performance benchmark and show that this benchmark can be used to better align incentives within the firm. The optimal benchmark substantially mitigates the utility costs of decentralized investment management. These costs can be further reduced when the CIO can screen asset managers on the basis of their risk appetites. Each manager%u2019s optimal level of risk aversion depends on the asset class he manages and can differ substantially from the CIO%u2019s level of risk aversion.

Journal of Financial Economics

We propose a new method of testing asset pricing models that relies on quantities rather than just prices or returns. We use the capital flows into and out of mutual funds to infer which risk model investors use. We derive a simple test statistic that allows us to infer, from a set of candidate models, the risk model that is closest to the model that investors use in making their capital allocation decisions. Using our method, we assess the performance of the most commonly used asset pricing models in the literature

Equity Yields

We study a new data set of prices of traded dividends with maturities up to 10 years across three world regions: the US, Europe, and Japan. We use these asset prices to construct equity yields, analogous to bond yields. We decompose these yields to obtain a term structure of expected dividend growth rates and a term structure of risk premia, which allows us to decompose the equity risk premium by maturity. We find that both expected dividend growth rates and risk premia exhibit substantial variation over time, particularly for short maturities. In addition to predicting dividend growth, equity yields help predict other measures of economic growth such as consumption growth. We relate the dynamics of growth expectations to recent events such as the financial crisis and the earthquake in Japan.

Predictive Regressions: A Present-value Approach

We propose a latent variables approach within a present-value model to estimate the expected returns and expected dividend growth rates of the aggregate stock market. This approach aggregates information contained in the history of price-dividend ratios and dividend growth rates to predict future returns and dividend growth rates. We find that returns and dividend growth rates are predictable with R-squared values ranging from 8.2% to 8.9% for returns and 13.9% to 31.6% for dividend growth rates. Both expected returns and expected dividend growth rates have a persistent component, but expected returns are more persistent than expected dividend growth rates.

The Cost of Debt

We estimate firm-specific marginal cost of debt functions for a large panel of companies between 1980 and 2007. The marginal cost curves are identified by exogenous variation in the marginal tax benefits of debt. The location of a given company’s cost of debt function varies with characteristics such as asset collateral, size, book-to-market, asset tangibility, cash flows, and whether the firm pays dividends. By integrating the area between benefit and cost functions we estimate that the equilibrium net benefit of debt is 3.5% of asset value, resulting from an estimated gross benefit of debt of 10.4% of asset value and an estimated cost of debt of 6.9%. We find that the cost of being overlevered is asymmetrically higher than the cost of being underlevered and that expected default costs constitute approximately half of the total ex ante cost of debt.

Financial Valuation of PBGC Insurance with Market-Implied Default Probabilities

In this paper, we use financial valuation techniques to measure the unfunded liabilities associated with the Pension Benefit Guaranty Corporation (PBGC) single-employer pension insurance program. This is an alternative approach to the calculations of expected future PBGC payouts in the PBGC exposure reports. The PBGC insurance is akin to an exchange option, a financial instrument that allows a party to exchange one risky asset for another. Calculating the value of this option for each PBGC-covered plan provides a measure of the fair market price of the PBGC guarantee that is consistent with the finance principles of risk-neutral pricing. That is, the market valuation method reflects the fact that bad outcomes tend to coincide with times when losses are particularly painful. The valuation we perform also reflects the fact that PBGC insurance is triggered only in the case of bankruptcy by drawing on the default probabilities implied by the credit ratings of insured plans. Under the baseline parameters, the PBGC’s insurance of the unfunded liabilities has a financial value of $358 billion, net of the estimated present value of PBGC premiums

On the Timing and Pricing of Dividends

We present evidence on the term structure of the equity premium. We recover prices of dividend strips, which are short-term assets that pay dividends on the stock index every period up to period T and nothing thereafter. It is short-term relative to the index because the index pays dividends in perpetuity. We find that expected returns, Sharpe ratios, and volatilities on short-term assets are higher than on the index, while their CAPM betas are below one. Short-term assets are more volatile than their realizations, leading to excess volatility and return predictability. Our findings are inconsistent with many leading theories

Matching Capital and Labor

We establish an important role for the firm by studying capital reallocation decisions of mutual fund firms. The firm\u27s decision to reallocate capital among its mutual fund managers adds at least $474,000 a month, which amounts to over 30% of the total value added of the industry. We provide evidence that this additional value added results from the firm\u27s private information about the skill of its managers. The firm captures this value because investors reward the firm following a capital reallocation decision by allocating additional capital to the firm\u27s funds