JOIM: 2014
Volume 12, No. 1, First Quarter 2014
-
Case Study
NEW FINANCING METHODS IN THE BIOPHARMA INDUSTRY: A CASE STUDY OF ROYALTY PHARMA, INC.
The biotechnology and pharmaceutical industries are facing significant challenges to their existing business models because of expiring drug patents, declining risk tolerance of venture capitalists and other investors, and increasing complexity in translational medicine. In response to these challenges, new alternative investment companies have emerged to bridge the biopharma funding gap by purchasing economic interests in drug royalty streams. Such purchases allow universities and biopharma companies to monetize their intellectual property, creating greater financial flexibility for them while giving investors an opportunity to participate in the life sciences industry at lower risk. Royalty Pharma is the largest of these drug royalty investment companies, and in this case study, we profile its business model and show how its unique financing structure greatly enhances the impact it has had on the biopharma industry and biomedical innovation.
-
Insight
Stakeholders Perspectives on Norwegian Investment Responsibility
The Strategy Council for Norway's Government Pension Fund Global, supported by the Norwegian Ministry of Finance, hosted the Responsible Investment Conference held in Oslo on 20 June 2013. The conferences goal was to facilitate dialogue with stakeholders on environmental, social, and governance (ESG) issues to inform the Strategy Councils forthcoming report on the Funds responsible investment strategy. The summit was organised into three sessions, each of which focused on one ESG issue and featured speakers from Norwegian and international organisations. Overall, participants commended the Funds achievements to date while proposing a variety of new initiatives and highlighting the challenges faced by the Fund.
-
Insight
Norway’s Summit on Responsible Investing
This is a summary of the issues discussed at the 2013 Investment Strategy Summit of the Norwegian Government Pension Fund Global. The emphasis of the summit was responsible investing with a special emphasis on ways to strengthen the Funds work on responsible investment. The summit brought together experts (both practitioners and academics) and discussed ethical issues, financial performance, and activist investors in the context of social, environmental, and governance concerns.
-
Article
The Performance of Leveraged and Inverse Leveraged Exchange Traded Funds
We document significant abnormal daily returns to leveraged and inverse leveraged exchange-traded funds (ETFs). Abnormal returns are positive for leveraged funds and negative to inverse leveraged funds, and the magnitude increases in the absolute value of the leverage multiple. We propose and test a model linking the abnormal return performance to transactions costs associated with the frequent (daily) rebalancing necessary to maintain target exposures as well as other costs including the swap financing costs and the cost to borrow in the lending market. In the full cross-section, the results suggest funding costs associated with achieving leverage impact returns negatively (positively) for leveraged (inverse leveraged) funds. Capitalizing on a key institutional feature, analysis of pairs of mirror funds reveals transactions costs associated with the maintenance of daily leverage multiples meaningfully impact fund returns. The results are also consistent with inverse leveraged funds bearing the cost-to-borrow to the benefit of the leveraged (long) funds.
-
Article
Sovereign Wealth and Risk Management: A Framework for Optimal Asset Allocation of Sovereign Wealth
This paper sets out an analytical framework for optimal asset allocation of sovereign wealth, based on the theory of contingent claims analysis applied to the sovereigns economic balance sheet. A country solves an asset-liability management problem involving its sources of income and its expenditures. We derive analytically the optimal asset allocation of sovereign wealth, taking explicit account of all sources of risks affecting the sovereigns balance sheet. The optimal composition of sovereign wealth should involve a performance-seeking portfolio and three hedging demand terms for the variability of the fiscal surplus and external and domestic debt. A real-life application of our model in the case of Chile shows that its sovereign investment is under-diversified.
-
Article
The Interest Rate Sensitivity of Tax-Exempt Bonds Under Tax-Neutral Valuation
We explore the effect of taxes on the prices of municipal bonds. Although interest is tax-exempt, the gain resulting from purchasing a muni at a deep discount below the so-called de minimis threshold is subject to severe tax treatment. The gain is taxed as ordinary income at maturity; currently for a typical investor the applicable rate is roughly 40%. Thus, purchasing a bond at 80 would trigger an 8-point tax liability.
The paper develops a rigorous approach to the pricing of munis by incorporating taxes into the industry-standard OAS-based valuation framework. The key concept is tax-neutral value, which is simply the fair value that takes into account potential tax payments. Tax-neutral valuation allows us to explore how muni prices respond to changing interest rates. The basic insight is that due to the interaction of the purchase price and the related tax payment, discount tax-exempt bonds are significantly more sensitive to interest rates than taxable bonds. For example, currently the duration of a 10-year taxable bond is roughly 8.5 years, while that of a 10-year muni can exceed 13 years.
Tax-neutral valuation provides the foundation for accurately projecting the prices of munis under various interest rate scenarios. The primary application of this approach is risk management, including hedging. It is also essential for determining the optimum time to recognize a loss in order to maximize after-tax performance. -
Book Review
Risk Return Analysis
“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.
-
Survey & Crossover
An Introduction to Peer-To-Peer Loans as Investments
This paper constitutes a discussion of the rise of Peer-to-peer loans as alternative investments. Peer-to-peer loans are being incorporated into portfolios in the interest of diversification. This paper outlines this strategy and provides a guided tour of this new alternative asset class along with the current risks and barriers.
-
Practitioner's Digest
Practitioner’s Digest • Vol. 12, No. 1
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.
Volume 12, No. 2, Second Quarter 2014
-
Insight
THE LINK BETWEEN INFLATION AND THE VALUE OF PLANT
When negotiators have fixed the money wage, if the central bank wants to change the level of money prices, it has to change the real wage. But the real wage changes whenever the identity—hence the age and productivity—of the marginal plant changes. On the other hand the scarcity rents on younger, more productive plant are measured relative to the marginal plant. Investors who understand this link won’t wait for central bank action to adjust their forecasts of the rents.
-
Survey & Crossover
Sovereign Credit Default Swap Premia
This paper reviews the young but rapidly growing literature on sovereign credit default swap premia. A discussion of current debates in the academic and popular press hopefully raises thought-provoking questions with valuable insights for academics, policymakers and practitioners alike. The main elements of the review relate to the determinants of sovereign CDS spreads, spillovers and contagion, frictions, the relationship to and impact on public bonds, as well as trading in the market for sovereign credit derivatives. In addition, I describe key statistical and stylized facts about prices, the market, and its players.
-
Insight
Mutual Fund Outperformance and Growth
Does better performance lead to more assets? We examine nearly 30,000 mutual funds to determine the effect that a fund’s outperformance relative to its peers has on the fund’s later asset size. We find that a fund that earns ten percent more than the size-weighted average of its peers in its style group in one year will on average experience an extra 5% excess asset growth in the subsequent year. The findings are robust to all types of fund styles and all fund sizes, with two exceptions: small funds of any style and very large fixed income funds.
-
Article
The Shadow Price of Liquidity in Asset Allocation – A Case Study
We apply a framework for estimating the investor-specific value of liquidity which can be used to inform asset allocation decisions. The shadow price of liquidity is a central concept in this framework. In the case study, the investor considers allocation to private equity, real estate, and infrastructure alongside a public equity and bond portfolio. Given the assumptions made on how this investor uses portfolio liquidity, we find that the shadow cost of liquidity is less than 1%. In other words, the additional return required for taking on illiquidity risk is not very demanding for the case in question, but may be higher for other investors.
-
Article
Restoring Value to Minimum Variance
A long-only investable minimum variance strategy outperformed the S&P 500 over the four decades from January 1973 to December 2012. Through the lens of a factor model, we show that this outperformance can be largely attributed to implicit style bets. Specifically, minimum variance has thrived by tilting toward stocks that have lower market capitalization and volatility, and a higher ratio of earnings to price. As funds have poured into minimum variance in the wake of the financial crisis, and plausibly as a consequence of this trend, the value tilt has disappeared and a momentum tilt has emerged. This suggests that the cost of entry to minimum variance is at a historic high. We show how the value tilt can be restored to minimum variance by targeting specific exposures, and that there was a substantial long-term benefit to the restoration at most recent points of entry to the strategy.
-
Article
Does Factor Timing Explain Hedge Fund Alpha?
This paper empirically decomposes hedge fund excess return into factor timing, security selection, and risk premium. Portfolio-level tests show that security selection explains most of the excess return generated by hedge funds during 1994–2009, and the contribution of factor timing is small. Fund-level tests find significant evidence of both positive and negative timing funds, but the excess return of positive timing funds is not significantly higher than that of the other funds. These findings imply that factor timing is not the main source of hedge fund alpha, and the results are robust to different factor models.
-
Book Review
Global Macro: Theory & Practice
“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.
-
Case Study
A Solution to the Trade Deficit?
“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.
-
Practitioner's Digest
Practitioner’s Digest • Vol. 12, 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.
Volume 12, No. 3, Third Quarter 2014
-
Article
Time Diversification
To maintain constant dollar risk, an investor concerned with his terminal wealth must sell when the stock market rises and buy when it falls. Although an asset with constant dollar risk doesn’t exist in nature, it can be approximated with actual investment positions.
-
Insight
A Rule-Based Commodity Index
A commodity index is designed as an equal-weighted set of four complementary tactics. The resulting portfolio takes advantage of well-established patterns in commodity markets, including high volatility and the relative independence of the return drivers. These conditions are ideal for achieving rebalancing gains and thusly for improving risk-adjusted performance. Index performance is compared with long commodity indexes and commodity hedge funds. The benefits of an overlay strategy is shown vis-à-vis a traditional stock/bond portfolio.
-
Article
Corporate Credit Limits for Fixed Income Portfolios
Fixed income portfolio managers and risk managers constantly grapple with the question of how to size their corporate credit trades. Their task is made more difficult by the fact that corporate credit events are rare, particularly among Investment Grade bonds, and that tail risk is not well captured by most multifactor risk models. In this article, we propose a simple, but effective, method for sizing credit trades based on their spread. In particular, we model the cross-sectional behavior of corporate spreads, estimate the expected shortfall of monthly spread returns, and use our results, along with some observations on the duration of corporate bonds, to derive a simple upper bound on the permissible exposure to any single issuer in a credit portfolio.
The method has been applied successfully to Investment Grade and High Yield fixed income portfolios in both developed and emerging markets, and has proven its worth in daily use by protecting portfolios against disproportionate idiosyncratic losses, while allowing portfolio managers sufficient flexibility to express their investment views with clarity. Its use is not confined to limits on issuers—our method is easily extended to create limits on a portfolio’s exposures to individual industries, sectors, countries, and regions. -
Article
Dilution of Sector Exposures: When Does Unintended Indexing Happen?
We analyze how the inclusion of several sectors in a portfolio leads to a countering of exposures and to a replication of the index. Using a weight-based measure, we find that on a composition level unintended indexing appears to happen with only moderate severity. However, co-movement with the broad index as measured with standard techniques is a result that is found at already small numbers of included sectors. The results found are robust over time and market phases. We show that investors to sector exchange-traded funds should carefully select the number of investments and base this on the resulting exposure rather than on portfolio-weighting observations. Otherwise, their sector bets or selections are diluted by unintended indexing.
-
Survey & Crossover
A Survey of University Endowment Management Research
There is significant interest in how university endowments manage money and perform, and an emerging strand of finance research specializes in this growing area. The purpose of this paper is to survey and review the state-of-the-art in this field. We classify papers into four areas. (1) asset allocation, where we discuss the main theoretical framework and the relevant observations both across time and types of endowment; (2) performance, where (risk-adjusted) performance is discussed and distinguished by type and size of endowment; (3) spending, where the relation to the classical views and theoretical literature is reviewed as well as what university endowments do in practice; and (4) organization, where governance structure and the investment policy statement are discussed. We find that the modern framework for theoretical and empirical analyses can provide a very useful perspective for understanding the role of endowments. Nonetheless we highlight areas where more work remains to be done.
-
Book Review
The Undercover Economist Strikes Back - How to Run or Ruin an Economy
“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.
-
Book Review
The Undercover Economist Strikes Back - How to Run or Ruin an Economy
“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.
-
Article
Large Price Changes and Subsequent Returns
We investigate whether large stock price changes are associated with short-term reversals or momentum, conditional on the issuance of analyst price target or earnings forecast revisions immediately following these price changes. Our study provides evidence that prices of stocks exhibit momentum when analysts issue revisions after large price shocks, and suggests that the initial price changes were indeed based on new information. In contrast, when price changes are not followed by immediate analyst revisions, we document short-term reversals, indicating that the initial price shocks were likely caused by liquidity or noise traders. A trading strategy that is based on the direction of the price change and the existence of analyst revisions in the same direction earns significant abnormal monthly returns (over 1%).
-
Insight
Hedge Fund Beta Replication: A Five-Year Retrospective
During the past few years, hedge fund beta replication strategies have become more common. At the same time, questions about the relevance, performance, and applicability of these strategies have been raised in response to the rapidly shifting landscape in the hedge fund industry. We present a review of the growing beta replication industry with particular emphasis on the ASG Global Alternatives Fund. We discuss the motivation for its existence and the logic of its absolute and relative performance over time and across different market environments. We also explain why these strategies are complements to, and not substitutes for, direct investments in hedge funds, and provide examples of their value-added in investors’ portfolios.
-
Case Study
Time Diversification
“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.
-
Practitioner's Digest
Practitioner’s Digest • Vol. 12, No. 3
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.
-
Practitioner's Digest
Practitioner’s Digest • Vol. 12, No. 3
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.
Volume 12, No. 4, Fourth Quarter 2014
-
Insight
Free Cash Flows, Valuation and Growth Opportunities Bias
Analysts who base valuations on expected free cash flows are vulnerable to making biased assessments of terminal value because they fail to take into account the implications of disappearing growth opportunities during the terminal period. This leaves their valuations subject to “growth opportunities bias” (GOB). There are two sets of issues addressed in this paper, one narrow and the other broad. The narrow issues pertain to the basis for GOB, a technique for addressing it, and examples to illustrate the debiasing technique. The broader issues pertain to group psychology in respect to the manifestation of GOB in the analyst community, including the CFA Institute which certifies analysts.
-
Article
For Better Performance: Constrain Portfolio Weights Differentially and Globally
Even after more than six decades since the publication of the breakthrough article by Markowitz, the Mean–Variance framework is still the most commonly employed portfolio management tool. Yet, as portfolio managers know all too well, the optimal diversification and the induced performance are very sensitive to potential parameter estimation errors. This paper suggests two new and related portfolio optimization methods to deal with this problem: the Variance-Based Constraints (VBC), and the Global Variance-Based Constraints (GVBC) methods. By the VBC method the constraint imposed on the weight of a given stock is inversely proportional to its standard deviation: the higher a stock’s sample standard deviation, the higher the potential estimation error of its parameters, and therefore the tighter the constraint imposed on its weight. GVBC employs a similar idea, but instead of imposing a sharp boundary constraint on each stock, a quadratic “cost” is assigned to deviations from the naive 1/N weight, and a single global constraint is imposed on the total cost of all deviations. We find that these two new methods outperform existing methods. These results are obtained for two different data sets, and are also robust to the number of assets under consideration and to the number of return observations.
-
Article
A Simple Diversified Portfolio Strategy
We present a simple portfolio construction approach which is a blend of market weights and equal stock and sector weights. Our approach results in a highly diversified portfolio both on a stock level and on a sector level and generates higher portfolio returns at slightly lower risk than a market weighted index. We demonstrate that the higher returns of our diversified portfolio originate both from mitigating the link with market weights and from its higher return benefit due to diversification which we are able to capture because we rebalance our portfolio on a regular basis. Our diversified portfolio is highly implementable and has very high investment capacity.
-
Article
Separating Winners From Losers Among Value and Growth Stocks in Different US Exchanges: 1969-2011
The purpose of this paper is twofold: (a) to determine whether there is value premium in our sample of US stocks for the period May 1, 1969–April 30, 2011; and (b) to examine whether an additional screening to the first step of the value investing process can be employed to separate the outperforming value and growth stocks from the underperforming ones. In this paper, we document the following: We find a consistently strong and pervasive value premium over the sample period. We show that there are distinct differences between US exchanges which means that papers that aggregate all US exchanges under one umbrella may dilute findings and bias conclusions. The stocks of AMEX firms, high business risk firms and firms that report extraordinary items experience worse returns than the rest of the US stocks in our sample. We find that P/E based sortings produce better overall results than sortings based on P/B. We are able to construct a composite score indicator (SCORE), combining various fundamental and market metrics, which enable us not only to separate the winners from the losers among value and growth stocks, but also to predict future returns of value and growth stocks. SCORE portfolios give better results for sortings based on P/E and when we employed a cross-section–time series medians approach. Results remain robust for a time period out of sample, for negative P/E or P/B ratio firms and for the firms that were excluded from SCORE-based performance, namely, AMEX stocks, stocks with high business risk and firms that reported extraordinary items the year before. Finally, we provide evidence that the return of a portfolio strategy that buys (sells) stocks that rank low (high) in the composite score indicator has significant explanatory power in an asset pricing model framework and that such a strategy earns statistically significant positive returns.
-
Article
The Dependence of Upside Capture Ratios and Downside Capture Ratios on the Length of the Measurement Interval, Beta, and Alpha
Upside and downside capture ratios are used to assess the quality of investment managers and investment strategies. We propose a simple theoretical model which predicts that the upside capture ratio is an increasing function of the measurement interval length and that the downside capture ratio is a decreasing function of the measurement interval length. The model also predicts that all measurement intervals’ capture ratios depend strongly on betas, not just alphas, and that short measurement intervals’ capture ratios are dominated by betas, hence are unreliable for assessing alphas. Consequently, capture ratios are problematic for assessing managers’ skill.
-
Book Review
Performance Evaluation and Attribution of Security Portfolios
“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.
-
Case Study
Global Investing for the Value Trader
“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.
-
Practitioner's Digest
Practitioner’s Digest • Vol. 12, 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.
-
Practitioner's Digest
Practitioner’s Digest • Vol. 12, 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.