Innovations in Finance

A Major Plan First Commits to Indexing

New York Telephone Company Nobel Prize Recognizes invests $40 million in an S&P 500 Modern Finance Index fund. Economists who shaped the way we The first major plan to index. The Size Effect invest are recognized, emphasizing the role of science in finance. Helps launch the era of indexed Rolf Banz The Birth of Index Funds investing. William Sharpe for the Capital Asset John McQuown, Analyzed NYSE stocks, Pricing Model. Wells Fargo Bank, 1971; “Fund spokesmen are quick to point 1926-1975. Rex Sinquefield, out you can’t buy the market Harry Markowitz for portfolio theory. American National Bank, 1973 averages. It’s time the public could.” Finds that, in the long term, small companies have higher expected Merton Miller for work on the effect of Banks develop the first passive S&P Burton G. Malkiel, A Random Walk returns than large companies and firms’ capital structure and dividend 500 Index funds. Down Wall Street, 1973 ed. behave differently. policy on their prices.

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Options Pricing Model Database of Securities Prices Variable Maturity Strategy Fischer Black, Robert Merton, and since 1926 Implemented Myron Scholes Nobel Prize in Economics, 1997 Roger Ibbotson and Eugene F. Fama Rex Sinquefield, The development of the Options Stocks, Bonds, Bills, and Inflation With no prediction of interest rates, Pricing Model allows new ways to Eugene Fama develops a method of segment, quantify, and manage risk. An extensive returns database for shifting maturities that identifies multiple asset classes is first optimal positions on the fixed income The model spurs the development of developed and will become one of yield curve. a market for alternative investments. the most widely used investment databases. “The Information in the Term Structure,” Journal of Financial The first extensive, empirical basis Economics 13, no. 4 (December for making asset allocation decisions 1984): 509-28. changes the way investors build portfolios.

1 Innovations in Finance

International Size Effect

Steven L. Heston, K. Geert Rouwenhorst, Improved Bond Market Transparency and Roberto E. Wessels Nobel Prize Recognizes National Association of Securities Asset Pricing Research Find evidence of higher average returns to Dealers (NASD) introduces Trade small companies in twelve international Reporting and Compliance Engine Three US academics jointly receive markets. (TRACE), which requires the reporting the award for their individual of US corporate bond trades. This contributions to the empirical analysis “The Structure of International Stock Returns data greatly improved transparency of asset prices. and the Integration of Capital Markets,” in the corporate bond market and Journal of Empirical Finance 2, no. 3 allows researchers to study trading Eugene F. Fama, Lars Peter Hansen, (September 1995): 173-97. costs in the US corporate bond market. and Robert J. Shiller,

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Multifactor Asset Pricing Model Inflation-Protected Bonds Profitability and Value Effect The Treasury conducts the first auction of Eugene F. Fama, Kenneth R. French, and Robert Novy-Marx Eugene Fama and Treasury Inflation-Protected Securities Kenneth French (TIPS), thus allowing US investors to invest for long periods with minimal default risk and Motivated by valuation theory, academic research identifies profitability as a new Improves on the single-factor asset inflation risk. dimension of expected returns. pricing model (CAPM).

Identifies market, size, and “value” factors in returns.

Develops the three-factor asset pricing model, an invaluable asset allocation and portfolio analysis tool.

“Common Risk Factors in the Returns on Stocks and Bonds,” Journal of Financial Economics 33, no. 1 (February 1993): 3-56.

2 Innovations in Finance

Conventional Wisdom circa 1950 Single-Factor Asset Pricing Efficient Markets Hypothesis “Once you attain competency, Risk/Return Model diversification is undesirable. One or The Role of Stocks Eugene F. Fama two, or at most three or four, William Sharpe securities should be bought. James Tobin Nobel Prize in Economics, 1990 Extensive research on stock price Competent investors will never be Nobel Prize in Economics, 1981 patterns. satisfied beating the averages by a Capital Asset Pricing Model: few small percentage points.” Separation Theorem: Theoretical model defines risk as Extensive research on stock price 1. Form portfolio of risky assets. market beta, or the covariance of a patterns. Gerald M. Loeb, The Battle for Investment 2. Temper risk by lending and security with the overall market. Survival, 1935 borrowing. Develops Efficient Markets A stock’s expected return is Hypothesis, which asserts that prices Analyze securities one by one. Focus Shifts focus from security selection to proportional to the stock’s market reflect values and information on picking winners. Concentrate portfolio structure. beta. accurately and quickly. It is difficult if holdings to maximize returns. not impossible to capture returns in “Liquidity Preference as Behavior Theoretical model for evaluating the excess of market returns without Broad diversification is considered Toward Risk,” Review of Economic risk and expected return of securities taking greater than market levels of undesirable. Studies, February 1958. and portfolios. risk.

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Diversification and Portfolio Risk Investments and Capital Behavior of Securities Prices First Major Study of Manager Harry Markowitz Structure Paul Samuelson, MIT Performance Nobel Prize in Economics, 1990 Merton Miller and Franco Modigliani Nobel Prize in Economics, 1970 Michael Jensen, 1965 Nobel Prizes in Economics, A.G. Becker Corporation, 1968 Diversification reduces risk. 1990 and 1985 Market prices are the best estimates of value. First studies of mutual funds (Jensen) Assets evaluated not by individual Theorem relating corporate finance and of institutional plans (A.G. Becker characteristics but by their effect on a to returns. Price changes follow random Corp.) indicate active managers portfolio. An optimal portfolio can be patterns. Future share prices are underperform indices. constructed to maximize return for a given A firm’s value is unrelated to its unpredictable. standard deviation. dividend policy. Becker Corp. gives rise to consulting “Proof That Properly Anticipated industry with creation of “Green Dividend policy is an unreliable Prices Fluctuate Randomly,” Book” performance tables comparing guide for stock selection. Industrial Management Review, results to benchmarks. Spring 1965.

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