Volume 19, No. 2, Second Quarter 2021

Asset Pricing, Asset Allocation and Risk-Adjusted Performance with Multiple Goals and Agency: The Goals and Risk-Based Asset Pricing Model

by: Arun Muralidhar

Investment managers require a consistent asset pricing model, asset allocation recommendations, and risk-adjusted performance measures (or the “three facets of investing”) to be effective in managing portfolios. Incorporating three critical realities of investing into these models (i.e., that investors have many stochastic goals, seek to delegate to skillful agents, and maximize risk-adjusted returns) provides recommendations on the three facets that are different from the foundational papers of Modern Portfolio Theory (MPT). This paper briefly surveys the literature on MPT, Goals-based Investing (GBI), and agency before providing a normative Goals- and Risk-Based Asset Pricing Model (GRAPM) that includes these three realities of investing and articulates the three facets. GRAPM exploits a simple idea that a relatively risk-free asset for one stochastic goal is a risky asset for another, and vice versa. These two assets, plus the traditional absolute risk-free rate of MPT, allow us to triangulate to establish returns for all other assets based on the return of any goal-replicating asset and multiple correlations. This approach creates a “pair-wise equilibrium” for all assets (and potentially a general equilibrium)—different from MPT— and also lends itself easily to a new asset pricing model with heterogeneous investors (i.e., each investor has a unique goal). GRAPM incorporates a “risk aversion” parameter that is also easily observable, and appears to explain why seemingly similar investors can have markedly different asset allocations or expected returns.

Active Investing as a Negative Sum Game: A Critical Review

by: Geoffrey J. Warren

The literature on whether active management adds value is examined through the prism of the proposition by Sharpe (1991) that active investing is a negative sum game after costs. Focal points include how active fund research does not directly test Sharpe’s proposition and seems inconsistent with it acting as a constraint, and the gaps that may leave room for active managers to outperform. It is argued that greater attention needs to be paid to the importance of investor circumstances and market conditions for the active-passive choice, in particular the fee paid, investor objectives and asset category.

What Happens with More Funds than Stocks? Analysis of Crowding in Style Factors and Individual Equities

by: Ananth Madhavan, Aleksander Sobczyk and Andrew Ang

The proliferation of funds juxtaposed against the decline in individual stock listing since the mid-1990s raises questions about crowding in individual stocks or style factors. We examine these issues by characterizing the common components of funds from 2007 through 2018. A key difference from the previous literature on common factors in fund returns is that we explicitly look at fund holdings over time for all US-listed equity active mutual funds
and exchange-traded funds and contrast their differences. We also explore the implications of this proliferation in funds for the pricing of individual securities and funds.

The Magic Formula: Value, Profitability, and the Cross-Section of Global Stock Returns

by: Douglas W. Blackburn and Nusret Cakici

Buying profitable, undervalued stocks and shorting unprofitable, overvalued stocks yields significant return differentials in North American, Europe, Japan, and Asia. Using data from 1991 to 2016, double sorting stocks into portfolios by gross profits, a measure of profitability, and earnings yield, a measure of value, yields significant abnormal returns for all size groups and in all global regions after controlling for size, book-to-market, momentum, profitability, and investments factors. Abnormal returns persist after accounting for transaction costs, are larger during high sentiment periods and are present across different sectors and countries.

The Financial Ecosystem — The Role of Finance in Achieving Sustainability

by: Satyajit Bose, Guo Dong and Anne Simpson • reviewed by: Hui (Stacie) Wang

“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.

Practitioner’s Digest • Vol. 19, 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.