Volume 15, No. 2, Second Quarter 2017

The Impact of Different Default Triggers on CMBS Risk Evaluation

by: Andreas D. Christopoulos

This paper presents a structural generalization for pricing commercial mortgage backed securities (CMBS) and their derivatives, CMBX. I compare results for the structural generalization with a reduced-form approach using identical data sets and analyses. My comparisons are made at both the loan and bond levels and cover the period November 2007 through June 2015 using $389 billion of loans serving as the underlying collateral for CMBX Series 1 through 8. The sole difference between the two modelling approaches is found in the set of conditions and methods for simulating the default event which together comprise the ‘default trigger’ that differ for each model. I statistically validate the default estimations and then construct an automated long/short trading strategy using the risk measure Theta to compare the impact of default estimates on investment and risk management decision making. The findings indicate the reduced form provides greater precision than the structural generalization in estimating default events and in assessing trading opportunities.

Rethinking the Fundamental Law of Active Management

by: Jose Menchero

The fundamental law of active management provides a powerful framework for analyzing portfolio diversification and risk-adjusted returns. It states that the information ratio of an unconstrained optimal portfolio is given by the product of the information coefficient (a measure of skill) and the square root of breadth, where breadth is the number of “independent” bets. A basic limitation of previous formulations of the fundamental law is that it was not possible to determine portfolio breadth for realistic portfolios under a general covariance structure. In this paper, we present a new formulation of the fundamental law of active management. We derive a new measure of skill, denoted the Signal Quality, and obtain an exact closed-form expression for the square root of breadth, which we denote as the Diversification Coefficient. Our formulation is easily applied to real-world portfolios described by general covariance matrices. We conclude with a discussion of the transfer coefficient, which measures the drop in portfolio efficiency due to investment constraints.

A Pitfall in Ethical Investing: ESG Disclosures Reflect Vulnerabilities, not Virtues

by: Gerald T. Garvey, Joshua Kazdin, Ryan LaFond, Joanna Nash and Hussein Safa

It is widely believed that ESG (Environmental, Social, Governance) investing reduces regulatory and reputational risks. In a large global panel, we find that business ethics controversies and regulatory issues are more likely for firms that disclose a richer set of ESG-friendly policies. The effect is attenuated by controlling for size, industry, and country but remains economically and statistically significant. We also show that some prominent ESG indices favor companies that disclose more ESG policies and as a consequence have greater controversy exposure than an ESG-unaware benchmark.

Horizon Effects that are Larger than You Think: Dynamic Allocation

by: Thomas J. O’Brien

This paper illustrates optimal dynamic allocation in a traditional two-fund capital market model. As in previous literature, a mean-reverting market portfolio implies a “horizon effect” in typical investors’ allocations. For investors whose risk aversion is higher than the representative investor’s, the horizon effect becomes substantially larger in the capital market model than in previous models.

Leaning with the Wind: Long-Term Asset Owners and Procyclical Investing

by: Bradley A. Jones

This paper seeks to shed light on the systematic investment patterns of long-term asset owners. Based on a sample of representative portfolios (totaling $24 trillion) for global central banks, U.S. public and private pension funds, U.S. insurers and U.S. endowment funds, four main findings are established. First, asset allocation decisions appear to reflect pro- rather than countercyclical tendencies. Second, procyclicality takes two forms of roughly equal importance—contemporaneous drift (in the sense that portfolio weights are allowed to inherit relative annual returns), and more active multi-year performance chasing. Third, there is little evidence that asset owners lean against time-varying risk premia. Fourth, procyclicality appears most evident in private pension funds. In reconciling these portfolio characteristics with stylized patterns in asset class returns and financial theories, I suggest the long-term asset owners examined in this study do not avail of their long-horizon edge.

Practitioner’s Digest • Vol. 15, No. 2

The “Practitioners Digest” emphasizes the practical significance of manuscripts featured in the “Insights” and “Articles” sections of the journal. Readers who are interested in extracting the practical value of an article, or who are simply looking for a summary, may look to this section.

Book of Value: The Fine Art of Investing Wisely 2016

by: Anurag Sharma • reviewed by: Bruce Grantier

“Book Reviews” identifies important, and often popular, new books from a wide range of investment topics. Beyond providing a summary and review of the content and style of the books, “Book Reviews” seeks to contribute to a conscious, critical, and informed approach to investment literature.

The Rational Investor

by: Craig French

“Case Studies” presents a case pertinent to contemporary issues and events in investment management. Insightful and provocative questions are posed at the end of each case to challenge the reader. Each case is an invitation to the critical thinking and pragmatic problem solving that are so fundamental to the practice of investment management.

In Memory of Stephen A. Ross

by: Stephen Foerster

JOIM Conference Series, March 2017 / San Diego

The Legacy of Jack Treynor: Friends Reflect

by: Stephen Foerster

JOIM Conference Series, March 2017 / San Diego