Volume 15, No. 4, Fourth Quarter 2017

How to Calibrate the Risk of Buyout Investments? Through Buyout-Backed Initial Public Offerings

by: Jean-François L’Her, Ram Karthik and Stéphanie Desrosiers

This paper proposes to use the public market returns of buyout-backed initial public offerings (BO-backed IPOs) as a proxy for buyout funds’ appraisal-based returns. Because they provide an economically significant route to exit, and their leverage and fund ownership are still significant three years after the IPO, they represent unique public candidates to directly assess the risks of buyout investments, and to circumvent the stale pricing issue inherent in appraisal-based returns. Our sample covers the 1980–2013 period, and comprises 1,063 BO-backed IPOs. Our risk factor analysis shows that the market betas are close to 1.2, and the loadings on size, value and liquidity are significantly positive. Further, the loadings on the Fama and French profitability and investment are both significantly negative. These results can guide the calibration of the expected return and risk of buyout investments in strategic asset allocation: beyond exposure to Large Cap Equities, approximately 40% of the risk and return of BO-backed IPOs is explained by additional exposure to the market, and exposures to risk factors.

A Portfolio Strategy with Hedge Funds and Liquid Alternatives

by: E. William Stone and Paul J. White

The advent of liquid alternatives in mutual fund format in recent years has brought with it challenges and opportunities with regards to portfolio strategy. Interpretation of these vehicles as return enhancers or risk diversifiers can lead to very different approaches in portfolio construction. Equally indeterminate is the extent to which liquid alternatives substitute for hedge funds, that is, do liquid alternatives and hedge funds have similar risk exposures. A fundamental concern is that an investor does not overpay for exposures more cheaply accessed in liquid format as opposed to the typically more expensive limited partnership format. We present a general approach for dealing with this challenge that divides the components among beta, alternative beta (a mix of alpha and beta for liquid alternatives), and complementary beta (neither alpha nor beta for hedge funds). Our approach holds steady the amount of beta in the alternative beta portfolio (liquid alternatives portfolio), and it minimizes the amount of beta and alternative beta in the complementary beta portfolio (hedge fund portfolio). Our approach is indifferent with respect to the exact shape of the returns distribution.

Investment Horizon Risk and Volatility Metrics

by: Robert Korkie

We re-examine the literatures’ disparate conclusions that stock returns are more (less) volatile over longer investment horizons. We claim that the commonly employed variance ratio is incapable of generally determining whether investment risk increases with investment horizon. We demonstrate that the use of effective returns and standard deviation ratios have significantly different results compared to continuous return variance ratios. Using basic return generating processes and standard deviations, plus a recent well-specified study, we find stocks are less volatile over short to long horizons but are more volatile over very long horizons. The conclusions are consistent with some research for very long horizons but inconsistent in short to long horizons.

The Impact of Costs on Recent Target Date Fund Performance

by: C. Edward Chang, Thomas M. Krueger and Mark A. Wrolstad

Target date funds (TDFs) are rapidly becoming a common means to prepare for retirement. Given the swelling demand for these funds, this research is a timely look at TDFs’ most recent decade. As of March 2016, 518 TDFs have been in existence for over ten years, providing a good sample period by which to assess their performance. Analysis of the entire universe of TDFs with ten years of data reveals that a significant factor in differentiating between better and worse TDF investment performance is their expenses and loads. Among the TDFs with the lowest 25% of expenses, we find significantly better returns without an appreciable impact on standard deviation of returns or beta. Selecting TDFs without loads increases both returns and risk measures. Risk-adjusted returns using standard deviation, negative return variance, or beta all demonstrate the value of avoiding high expenses and load/commission fees.

Pricing for Survival in the Biopharma Industry: A Case Study of Acthar Gel and Questcor Pharmaceuticals

by: Terence C. Burnham, Samuel Huang and Andrew W. Lo

Recent cases of aggressive pricing behavior in the biopharmaceutical industry have raised serious concerns among payers and policymakers about industry ethics. However, these cases should not be confused with price increases motivated by challenging business conditions that ultimately lead to greater investment in R&D and improved patient access to therapeutics. We study the example of Questcor Pharmaceuticals, which was forced to choose between increasing the price of an effective drug in 2007 and ceasing production and shutting down. We consider Questcor’s journey from inception to its acquisition in 2014, analyze the factors leading up to the price hike of its main revenue generator, Acthar Gel, and discuss its resulting impact on patients after 2007. A counterfactual financial simulation of the company’s prospects in the case where prices were not increased shows that Questcor would have become insolvent between 2008 and 2010.

Behavioral Risk Management: Managing the Psychology that Drives Decisions and Influences Operational Risk

by: Hersh Shefrin • reviewed by: Cel Kulasekaran

“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.

Machine Learning in Finance: The Case of Deep Learning for Option Pricing

by: Robert Culkin and Sanjiv R. Das

“Surveys& Crossovers” This section provides surveys of the literature in investment management or short papers exemplifying advances in finance that arise from the confluence with other fields. This section acknowledges current trends in technology, and the cross-disciplinary nature of the investment management business, while directing the reader to interesting and important recent work.

Practitioner’s Digest • Vol. 15, No. 4

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.