Volume 17, No. 4, Fourth Quarter 2019
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Survey & Crossover
What Does the Bet Against Beta Strategy Mean in a Multi-Factor World?
As of February 2019, an investor had a choice to invest in 1,043 smart beta Exchange-Traded Funds (ETFs). These ETFs depend on well-established asset-pricing anomalies. This paper provides a theoretical foundation justifying their existence. Loosely speaking, the investment strategy from the anomalies is simple: bet against beta. We explain the spirit of the investment strategy in a multi-factor world. In a model with heterogeneous risk-aversion agents facing margin constraints, we answer the question: What does the bet against beta strategy mean with multiple factors? Extending Frazzini and Pedersen (2014), we show that the beta is a weighted average of the factors betas. There are two implications. First, we add to the debate between fundamental indexation and cap-weighted indexation. Second, our article answers the question: which smart beta ETFs are actually smart, theoretically?
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Article
Tilt Nickels To Diamonds: An Orthogonalization Approach
Alternative index products often achieve improved performance at the cost of increased exposure to risk. In this study, we propose a portfolio tilting strategy that alleviates the risks inherent to alternative indices by projecting fundamental factors on risk factors to purge the influence of risk factors. We argue that more efficient indices can be built on the resulting orthogonalized fundamental factors and show that a tilted equity index using
return on assets, long-term-debt, and net sales as fundamental factors outperforms the Russell 1000 index by 120 basis points from 1987 to 2014. -
Article
Ratings versus Spreads as Indicators of Price Risk
Past comparisons of “market ratings,” or yield spreads over Treasury rates, and letter grades published by credit rating agencies have focused on the two indicators’ respective records in predicting defaults or promptness in reflecting company-specific changes in credit quality. Corporate bond managers who mark to market and are evaluated on the basis of their annual total return, however, care greatly about price sensitivity to market-wide changes in credit risk premiums. Empirical evidence presented in this study indicates that market ratings provide better information on that matter than agency ratings.
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Article
Don’t Get Carried Away: Uncovering Macro Characteristics in Carry Portfolios
Investors are increasingly showing interest in risk premia strategies across asset classes. Carry is one of the most studied premia. To successfully execute a risk premia strategy, it is important to have a detailed understanding of how individual premia returns are affected by macroeconomic conditions. The literature reports that carry strategies are commonly exposed to business cycle, liquidity, and volatility risks; however, evidence of direct links has never been clearly established. We build on this research by directly measuring the macroeconomic characteristics of carry factor portfolios, namely real economic growth and inflation exposures. By pairing methodologies commonly used to derive fundamental characteristics of equity portfolios, we are able to identify macro linkages that have not been previously made evident. Our holdings-based and factor-mimicking portfolio analyses provide insights into the behavior of carry strategies across various asset classes. This approach can help investors build multi-asset carry portfolios that are better aligned with their goals.
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Article
Funding Long Shots
We define long shots as investment projects with four features: (1) low probabilities of success; (2) long gestation lags before any cash flows are realized; (3) large required up- front investments; and (4) very large payoffs (relative to initial investment) in the unlikely event of success. Funding long shots is becoming increasingly difficult—even for high- risk investment vehicles like hedge funds and venture funds—despite the fact that some of society’s biggest challenges such as cancer, Alzheimer’s disease, global warming, and fossil-fuel depletion depend critically on the ability to undertake such investments. We investigate the possibility of improving financing for long shots by pooling them into a single portfolio that can be financed via securitized debt, and examine the conditions under which such funding mechanisms are likely to be effective.
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Insight
The Success Equation
“Insights” features the thoughts and views of the top authorities from academia and the profession. This section offers unique perspectives from the leading minds in investment management.
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Book Review
Weapons of Math Destruction: How Big Data Increases Inequality and Threatens Democracy
“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.