PORTFOLIO MANAGEMENT FEES: ASSETS OR PROFITS BASED COMPENSATION?

This paper compares assets-based portfolio management fees to profits-based fees. Whilst both forms of compensation can provide appropriate risk incentives, fund managers´ limited liability induces more excess risk-taking under a profits-based fee contract. On the other hand, an assets-based fee is more costly to investors. In Spain, where the law explicitly permits both forms of retribution, assets-based fees are observed far more frequently. Under this type of compensation, the paper provides some insights into how management fees should be determined in order to solve the principal´s trade-off between providing better risk incentives and incurring a lower cost of compensation.

OPTIMAL DEMAND FOR LONG-TERM BONDS WHEN RETURNS ARE PREDICTABLE

This paper further explores the horizon effect in the optimal static and dynamic demand for risky assets under return predictability as documented by Barberis (2000). Contrary to the case of stocks, the optimal demand for long-term Government bonds of a buy-and-hold investor is not necessarily increasing in the investment horizon, and may in fact be decreasing for some initial levels of the predicting variable. The paper provides an analytical explanation based on the dependence of the mean variance ratio on the investor´s time horizon. Under stationarity of the predicting variable, unusually high or unusually low levels of the predictor tend to dissapear over time inducing the mean of cumulative returns to grow less or more than linearly as the investment horizon increases. If this effect dominates that on the variance, optimal demands can either be increasing or decresing in the investment horizon. On the other hand, the solution to the investor´s dynamic allocation problem in the presence of bonds indicates that long-term Government bonds do not provide a good hedge for adverse changes in the investor´s opportunity set: optimal dynamic demands for bonds do not differ from static portfolio choices at any horizon.

A nonparametric dimension test of the term structure

This paper addresses the problem of conducting a nonparametric test of the dimension of the state variable vector in a continuous-time term structure model. The paper shows that a bivariate diffusion function of the short rate process is a sufficient condition for the term structure to be driven by two stochastic factors. Using an easy-to-implement kernel smoothing method the number of state variables can be tested under very unrestrictive assumptions. The results suggest that continuous-time models for the US interest rates should contain at least two stochastic factors

When cheaper is better: fee determination in the market for equity mutual funds

In this paper, we develop a model of the market for equity mutual funds that captures three key characteristics of this market. First, there is competition among funds. Second, fund managers' ability is not observed by investors before making their investment decisions. And third, some investors do not make optimal use of all available information. The main results of the paper are that 1) price competition is compatible with positive mark-ups in equilibrium; and 2) worse-performing funds set fees that are greater or equal than those set by better-performing funds. These predictions are supported by available empirical evidence

A NONPARAMETRIC DIMENSION TEST OF THE TERM STRUCTURE

This paper addresses the problem of conducting a nonparametric test of the dimension of the state variable vector in a continuous-time term structure model. The paper shows that a bivariate diffusion function of the short rate process is a sufficient condition for the term structure to be driven by two stochastic factors. Using an easy-to-implement kernel smoothing method the number of state variables can be tested under very unrestrictive assumptions. The results suggest that continuous-time models for the US interest rates should contain at least two stochastic factors.

Nonparametric estimation of conditional beta pricing models

We propose a new procedure to estimate and test conditional beta pricing models which allows for flexibility in the dynamics of assets' covariances with risk factors and market prices of risk (MPR). The method can be seen as a nonparametric version of the two-pass approach commonly employed in the context of unconditional models. In the first stage, conditional covariances are estimated nonparametrically for each asset and period using the time-series of previous data. In the second stage, time-varying MPR are estimated from the cross-section of returns and covariances, using the entire sample and allowing for heteroscedastic and cross-sectionally correlated errors. We prove the desirable properties of consistency and asymptotic normality of the estimators. Finally, an empirical application to the term structure of interest rates illustrates the method and highlights several drawbacks of existing parametric models

Market imperfections, discount factors and stochastic dominance: an empirical analysis with oil-linked derivatives

Oil-linked derivatives are becoming very important in Modern Investment Theory. Accordingly, the analysis of Pricing Techniques and Portfolio Choice Problems involving these securities is a major topic for both managers and researchers. We focus on both the No-Arbitrage Approach and Stochastic Discount Factor (SDF) based methods in order to study oil-linked derivatives available at The New York Mercantile Exchange, Inc, one of the world's largest markets in energy and precious metals. First, we generalize some theoretical properties of the SDF in order to capture the effects induced by the bid-ask spread when analyzing dominated/efficient portfolios. Secondly, we apply our findings and empirically analyze the existence of dominated assets and portfolios in the oil derivatives market. Our results reveal the systematic presence of dominated prices, which should be taken into account by traders when composing their portfolios. Additionally, the test yields pricing and portfolio choice methods as well as new strategies that may allow brokers to outperform their service for their clients. It is worth to point out that the conclusions of the test have two important characteristics: On the one hand, they are very precise since we draw on perfectly synchronized bid/ask prices, as provided by Reuters. On the other hand, they are robust in the sense that they do not depend on any assumption about the underlying asset price dynamics. Finally, despite the empirical test focuses on oil derivatives, the methodology is general enough to apply to a broad range of markets

A Non-Parametric Dimension Test of the Term Structure

Published as an article in: Studies in Nonlinear Dynamics & Econometrics, 2004, vol. 8, issue 3, article 6.

YET ANOTHER PUZZLE? THE RELATION BETWEEN PRICE AND PERFORMANCE IN THE MUTUAL FUND INDUSTRY

Gruber (1996) drew attention to the puzzle that investors buy actively-managed funds even though, on average, they underperform index funds. We uncover another puzzling fact about the market for actively-managed equity mutual funds: funds with worse before-fee performance charge higher fees. We then conduct a series of robustness checks and find that the apparently anomalous fee-performance relation survives all of them. Finally, we show that this relation may be explained as the outcome of strategic fee setting by mutual funds in the presence of investors with different degrees of sensitivity to performance.

When cheaper is better: Fee determination in the market for equity mutual funds.

In this paper, we develop a model of the market for equity mutual funds that captures three key characteristics of this market. First, there is competition among funds. Second, fund managers’ ability is not observed by investors before making their investment decisions. Third, some investors do not make optimal use of all available information. The main results of the paper are that (1) price competition is compatible with positive mark-ups in equilibrium, and (2) worse-performing funds set fees that are greater or equal to those set by better-performing funds. These predictions are supported by available empirical evidence.Mutual fund fees; Mutual fund performance; Product quality; Asymmetric information; Bounded rationality;