Papers Cited in IFA's Investment Policy Statement



At Index Funds Advisors, Inc. we take an academic approach to investing. This means that we rely on objective and peer-reviewed research, so that our clients will have the highest probability of a successful investment experience. While any Wall Street firm can publish a "research report" that makes an unsubstantiated claim (e.g., Apple's share price will hit $1,000 by the end of the year), academic research is held to a completely different standard: the peer review process. This process ensures that no academic article is published unless it has withstood a high level of scrutiny by qualified members of the profession within the relevant field. In contrast to a Wall Street "research report" that can be authored and published in a matter of days, academic papers often take years before they see the light of day. Below is a selection of papers utilized by IFA in the formulation of its approach to investing.


1. Harry Markowitz, "Portfolio Selection," Journal of Finance (1952)

This Nobel Prize-winning paper introduced the now widely accepted notion that when putting together a portfolio, it is not sufficient to focus on returns alone, but risk must be considered as well. Specifically, if we have assumptions about expected returns, variances, and correlations of different securities (or asset classes), we can form a portfolio that maximizes return for a given level of risk or minimizes risk for a given level of required return. The set of portfolios that meets these criteria is known as "the efficient frontier." While IFA relies on Modern Portfolio Theory (MPT) in the construction of its portfolios by starting from a default market portfolio and successively adding asset classes that either increase expected returns or reduce risk, IFA does not utilize an "optimizer" in the construction of its portfolios. The reason is that the resulting asset allocations are extremely sensitive to the assumptions, and IFA does not consider it prudent to be in the position of forecasting future returns, risks, and correlations for different asset classes. While the efficient frontier is easily found in hindsight, it is unknowable in advance. IFA's Step 2: Nobel Laureates highlights the importance of investors following the advice of academics rather than Wall Street professionals.


2. William Sharpe, "Capital Asset Prices - A Theory of Market Equilibrium under Conditions of Risk," Journal of Finance (1964)

This Nobel Prize-winning paper took Harry Markowitz's "Portfolio Selection" one step further. Rather than trying to build an optimal portfolio from thousands of individual securities, Sharpe showed that investors should simply hold the market portfolio as the risky part of their allocation. If markets are efficient and investors are allowed to act in a completely unconstrained manner, then the market portfolio, which weighs each security according to its market capitalization, is inherently the most efficient possible portfolio. IFA's portfolios are based on the 3-Factor (or 5-Factor) Model proposed by Fama and French, which is an extension of the Capital Asset Pricing Model (CAPM) proposed by William Sharpe. By deviating from the market portfolio by tilting towards small cap and value with the equity portion of the portfolio, expected returns can be increased. While CAPM beautifully reinforces the idea that risk and return are inseparable, it does not do a very good job of explaining the returns of diversified portfolios. IFA's Step 8: Riskese reminds investors that risk is a reliable source of long-term returns and that there is no such thing as excess returns without risk.


3. Eugene Fama, "The Behavior of Stock Market Prices," Journal of Business (1965)

This seminal paper formalized the Efficient Market Hypothesis (EMH), which asserts that security prices reflect all readily-available information. As a result, an investor cannot consistently achieve returns in excess of market average returns on a risk-adjusted basis. While EMH is something that technically cannot be proven, we have yet to see any evidence that successfully refutes it. IFA's position is that while markets may not necessarily be perfectly efficient, they are efficient enough that the costs associated with trying to beat them outweigh the intended benefit of doing so. Most investors are better off when they behave as if markets are efficient and stick to lower-cost passively managed funds. IFA's Step 1: Active Investors warns investors to avoid all types of active investing, be it stock-picking, time-picking, manager-picking, etc.

Simulated Random Walk of Stock Prices


4. Daniel Kahneman and Amos Tversky, "Prospect Theory: An Analysis of Decision under Risk," The Economic Journal (1979)

This seminal paper in the field of behavioral economics and finance put forth the notion that human beings are not the super-rational utility maximizers that they are assumed to be in EMH and CAPM. When faced with probabilities of different outcomes, people do not necessarily make the choices that we would expect from a purely mathematical analysis. Rather, they take extraordinary measures to avoid or limit losses, which curtails their chances of achieving gains (regret avoidance). At IFA, we consider it one of our primary tasks to manage investor behavior. To quote Benjamin Graham, "The investor's chief problem - and even his worst enemy - is likely to be himself." While some practitioners may claim that behavioral finance disproves EMH and that all the sub-optimal behavior creates exploitable opportunities for gain, we note that the founding fathers of behavioral finance—Daniel Kahneman in particular—strongly advocate index funds for most investors. One academic who has done excellent work in reconciling EMH with behavioral finance is Andrew Lo of Massachusetts Institute of Technology (MIT) who has synthesized the two in his adaptive market hypothesis. IFA's Step 12: Invest and Relax conveys the idea that once investors have found and implemented a risk-appropriate portfolio, their best course of action is to avoid becoming emotionally involved when the market makes a large move because they are more likely to do more harm than good.

Emotions of Active Investors


5. Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebower, "Determinants of Portfolio Performance," The Financial Analysts Journal (1986)

These authors asked a simple question: What are the factors that explain the returns of managed portfolios such as pensions and endowments? The possibilities are security selection (stock-picking and bond-picking), market-timing, and asset allocation. In reviewing the returns data for 91 large pension plans over a ten-year period, they found that the first two paled in comparison to asset allocation, which was found to explain about 94% of the variation of returns. IFA takes the position that the single most important decision an investor can make is her asset allocation. Security selection and market timing are unlikely to add any value and usually incur unnecessary costs. IFA's Step 11: Risk Exposure is devoted to the topic of asset allocation for the purpose of capturing the risk premiums of market, size, value, term, and default that are offered by the market.

Factors that explain the Variation in Return of Large Institutional Plans


6. Eugene Fama and Kenneth French, "The Cross-Section of Expected Stock Returns," Journal of Finance (1992), (see summary on paper #8.)


7. Eugene Fama and Kenneth French, "Common Risk Factors in the Returns on Stocks and Bonds," Journal of Financial Economics (1993) , (see summary on paper #8.)


8. Eugene Fama and Kenneth French, "Size and Book-to-Market Factors in Earnings and Returns," Journal of Finance (1994)

This series of papers from Fama and French establish the 3-Factor Model for equity portfolios and the 5-Factor Model for balanced portfolios. On the equity side, IFA constructs its portfolios based on the 3-Factor Model. The Fama/French 3-Factor Model says the expected return of a broadly diversified stock portfolio in excess of a risk-free rate is a function of that portfolio's sensitivity or exposure to three common risk factors: (1) a market factor, as measured by the excess return of a broad equity market portfolio relative to a risk-free rate; (2) a size factor, as measured by the difference between the returns of a portfolio of small stocks and the returns of a portfolio of large stocks; and (3) a value factor, as measured by the difference between the returns of a portfolio of high book-to-market (or value) stocks and the returns of a portfolio of low book-to-market (or growth) stocks. The underlying premise of this model is that small cap and value stocks are riskier than large cap and growth stocks and thus carry higher expected returns. For fixed income or balanced portfolios, two more risk factors come into play: (1) Term (or interest rate) risk, as measured by the average duration of the bonds held; (2) Default risk, as measured by the average quality of the bonds held. These factors, collectively, have been able to explain as much as 96% of the explained variation in the returns of diversified, balanced portfolios. IFA's Step 8: Riskese details the applications of these multi-factor models. It is important to note that IFA relies on long-term historical data when drawing conclusions about asset class returns. IFA's Step 9: History delves further into this very important concept.

The Fama and French Five Factor Model


9. John Graham and Campbell Harvey, "Market Timing Ability and Volatility Implied in Investment Newsletter Asset Allocation Recommendations," National Bureau of Economic Research Paper #4890 (1995)

The authors analyzed over 15,000 asset allocation recommendations from 237 investment newsletters from 1980 to 1992. On a risk-adjusted basis, they found that over 75% of the newsletters produced negative abnormal returns. To quote them, "Some recommendations are remarkably poor. For example, the (once) high profile Granville Market Letter-Traders produced an average annual loss of 5.4% over the past 13 years. This compares to 15.9% average annual gain on the S&P 500 index." IFA's Step 4: Time Pickers documents the futility of market-timing.

237 Market Timing Newsletters


10. Eugene Fama and Kenneth French, "Value versus Growth: The International Evidence, " Journal of Finance (1998)

This paper tested the validity of the Fama-French 3-Factor Model on out-of-sample data, international equity returns. It survived falsification. IFA advises having a small and value tilt in both international and emerging markets equities. Besides having a higher expected return, there is an additional benefit of a lower correlation with the U.S. market, which provides a diversification benefit.

Large Small Value and Grwoth Indexes Around the World


11. Laurent Barras, Olivier Scaillet, Russ Wermers, "False Discoveries in Mutual Fund Performance: Measuring Luck in Estimating Alphas," Journal of Finance (2010)

When a mutual fund manager has a statistically significant different performance than the fund's benchmark (i.e., positive or negative alpha with a t-stat of 2 or more), there are two possible explanations: skill or luck. The authors define a "false discovery" as a mutual fund that exhibits significant alpha by luck alone. Using a sample of 2,076 actively managed US equity funds between 1975 and 2006, the authors found that total observed alpha is consistent with the following breakdown of the population: 75.4% of the funds have a true alpha of zero after costs and 24.0% have a true alpha that is negative, which leaves only 0.6% with a true positive alpha, a number that the authors consider to be "statistically indistinguishable from zero". IFA's Step 3: Stock Pickers admonishes investors not to pick stocks for themselves or expect a Wall Street professional to add value by picking stocks on their behalf.


12. Amit Goyal and Sunil Wahal, "The Selection and Termination of Investment Managers By Plan Sponsors," Journal of Finance (2008)

The authors examine the performance of investment managers in pre- and post-termination and hiring decisions. Newly hired managers tend to have excess returns that are statistically significant before hiring and then become statistically indistinguishable from zero after hiring. In an ironic twist, fired managers tend to have higher returns than the hired managers that replaced them. This study was based on an analysis of almost 8,800 hiring decisions by more than 3,400 plan sponsors from 1994 to 2003. The sample also included 869 firing decisions made by 482 plan sponsors. IFA's Step 5: Manager Pickers documents the repeated failures of people who think they can find market-beating active managers.


13. Scott D. Stewart, CFA, John J. Neumann, Christopher R. Knittel, and Jeffrey Heisler, CFA, "Absence of Value: An Analysis of Investment Allocation Decisions by Institutional Plan Sponsors," Financial Analysts Journal (2009)

This study is similar to the Goyal and Wahal study described above, but rather than looking at hiring and firing decisions that stayed within the same asset class, the authors examined changes in asset allocations made by plan sponsors, which automatically necessitate hiring and firing decisions. The authors found that only in two out of the eighteen years from 1985 to 2002 did plan sponsor decisions add value over the next five years. It is clear that performance-chasing is the primary underlying cause of this underperformance. Plan sponsors are more likely to throw money at the asset class that has recently had high returns, only to be disappointed. The authors estimate the economic impact of these ill-fated decisions to be $170.2 billion for the full sample period. IFA's Step 6: Style Drifters admonishes investors to avoid repeatedly moving from one investment style to another and to avoid hiring active managers who are notorious for style drift.

Value Gained or Lost When Moving Assets From One Manager to Another


14. A Collection of Peer Reviewed Articles Showing Lack of Skill Among Investment Managers