Volume 19, No. 4, Fourth Quarter 2021

Horizon-Adjusted Portfolio Performance Measure

by: Yoram Kroll and Moshe Ben-Horin

This paper presents a portfolio performance measure that accounts for the investment horizon assuming both risk and loss aversion as suggested by Tversky and Kahneman’s CPT framework. The optimal portfolio risk premiums of such investors decrease with the length of the investment horizon and our simulations indicate that the decrease is drastic. The suggested measure is theoretically-based and provides a user-friendly metric for gauging the appropriate relationship between the horizon and the investor’s optimal portfolio composition. Applying the methodology will likely lessen myopic behavior of investors and induce an increase of their portfolio’s weight on equities for longer term investors.

Private Equity Valuation Before and After ASC 820

by: Peter Easton, Stephannie Larocque and Jennifer Sustersic Stevens

We examine the effect of ASC 820 (formerly SFAS 157) on valuations reported by US private equity funds to their investors. In 2008, the FASB implemented ASC 820 to achieve more consistent measurement and increased transparency in fair value reporting. This new standard clarified the most critical accounting policy for private equity funds, which typically include highly illiquid investments. In a setting where we observe all cash flows over a fund’s lifetime, we show that reported net asset valuations more accurately predict future net distributions following ASC 820, particularly for less experienced fund managers, and for smaller and high-performing funds.

The U.S. Treasury Term Structure and the Distribution of Real GDP Growth

by: J. Benson Durham

Narrowing at the front but not the long end of the yield curve, notably in both expected rates and term premiums, forecasts lower mean real GDP growth and widens the distribution. But despite undue emphasis among some practitioners and the popular press on outright inversion and recession, compression does not strictly foreshadow unwelcome downside risks. Plus, long-run cycles of at least 5 years or longer duration primarily account for any co-movement between yield curve factors and growth. Therefore, the slope is less relevant for not only myopic but also some longer-run investors, as well as central bankers responsible for smoothing fluctuations around trend output.

How Do Factor Premia Vary Over Time? A Century of Evidence

by: Antti Ilmanen, Ronen Israel, Rachel Lee, Tobias J. Moskowitz and Ashwin Thapar

Evaluating how factor premia vary over time and across asset classes is challenging due to limited time series data, especially outside of US equities. We examine four prominent factors across six asset classes over a century. We find little evidence for arbitrage activity influencing returns, though some novel evidence of overfitting biases. We identify meaningful time variation in risk-adjusted factor returns that appears unrelated to macroeconomic risks, supporting other theories of dynamic return premia. Attempting to capture this variation, we evaluate various factor-timing strategies, but find relatively modest predictability that likely fails to overcome implementation costs.

Trading at the Speed of Light: How Ultrafast Algorithms are Transforming Financial Markets

by: Donald Mackenzie • reviewed by: Hanbin Im

“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.

Good States, Bad States: What Do Options Tell Us About Schizophrenic Behavior of Mr. Market and What Can We Do About It?

by: Vineer Bhansali and Jeremie Holdom

Option prices theoretically encapsulate participants’ expectations about good state (bullish) and bad state (bearish) market outcomes. By using a mixture of distributions and reasonable assumptions, the authors extract time series of expected returns, volatilities, and mixture probabilities of these outcomes surrounding the current US elections. The bimodality of asset return distributions suggests important modifications for asset allocation and risk management.

Are We at the Inflection Point of Climate Investing?

by: Yu (Ben) Meng

Just as the ongoing pandemic demonstrates our vulnerability to the invisible hand of the COVID-19 virus molecule, the extreme climate events are constant reminders of our vulnerability to another molecule, carbon dioxide. As a result, all walks of society are asking for solutions, especially ones that involve the financial markets playing an important role. This emphasis is reflected in the proliferation of ESG investment funds and the massive capital inflows into such funds. This article examines both the demand for and supply of such climate investments and identifies two necessary conditions for private capital to become a meaningful part of the solution to climate change: mandatory data disclosure and alignment of interests via carbon pricing.

Practitioner’s Digest • Vol. 19, 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.