JOIM: 2015
Volume 13, No. 1, First Quarter 2015
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Insight
Reserve Primary: Fools Rush in Where Wise Men Fear to Tread!
This is a clinical analysis of the demise of the Reserve Primary Fund, the first ever money market fund. Reserve Primary was caught in a perfect storm of its own making when the financial markets went into a full-blown crisis mode with the bankruptcy of Lehman Brothers on September 15, 2008. However, if the fund’s management had not abandoned the core principles that had guided the fund for more than 30 years, then the Lehman bankruptcy would likely not have led to the closing and liquidation of the Reserve Primary Fund.
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Article
OIS Discounting, Interest Rate Derivatives, and the Modeling of Stochastic Interest Rate Spreads
Before 2007, derivatives practitioners used a zero curve that was bootstrapped from LIBOR swap rates to provide “risk-free” rates when pricing derivatives. In the last few years, when pricing fully collateralized transactions, practitioners have switched to using a zero curve bootstrapped from overnight indexed swap (OIS) rates for discounting. This paper explains the calculations underlying the use of OIS rates and investigates the impact of the switch on the pricing of plain vanilla caps and swap options. It also explores how more complex derivatives providing payoffs dependent on LIBOR, or any other reference rate, can be valued. It presents new results showing that they can be handled by constructing a single tree for the evolution of the OIS rate.
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Article
Investing With Style
Investors are bombarded by a variety of investment strategies from a growing and increasingly complex financial industry, each claiming to improve returns and reduce risk. Amid the clamor, academic research has sifted through the vast landscape and found four intuitive investment strategies that, when applied effectively, have delivered positive long-term returns with low correlation to each other and traditional markets. The four “styles”— value, momentum, carry, and defensive—have uniquely held up across a multitude of asset classes, markets, and time periods using very liquid securities and form the core foundation for explaining the cross-section of returns in most asset classes. We discuss the intuition and evidence for these four pervasive styles and detail how to implement a strategy that can access these style premia to improve the risk and returns of traditional portfolios.
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Article
Momentum, Acceleration, and Reversal
This paper studies the impact of accelerated stock price increases on future performance. Accelerated stock price increases are a strong contributor to both poor future performance and a higher probability of reversals. It implies that accelerated growth is not sustainable and can lead to drops. The acceleration mechanism is also able to reconcile the well-documented 2–12 month momentum phenomenon and 1-month reversal.
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Book Review
Asset Management: A Systematic Approach to Factor Investing
“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.
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Insight
Investment, Financial System, Real Output and Macro-Risk Management
Loan underwriting standards and quantitative easing are examples of macro-risk management tools that affect the financial sector, which in turn affects real sector outputs. And therefore asset returns, real sector outputs, financial sector, and macro-risk management are interrelated. This paper shows that investors need to understand these relationships to enhance investment performance.
Recently, a macro-financial model (Ho et al., 2012, 2013; Ho and Lee, 2015a, 2015b) suggests that financial regulations must be dynamic to ensure optimality of real sector outputs while maintaining safety and soundness of the financial system. Since the real output exhibits a decreasing marginal increase in real growth with an increase in real output risk, an optimal macro-financial leverage exists, given risk and return preference of an economy. Macro-risk management is important to a dynamic economy.
This paper suggests a framework for policy makers to implement macro-risk management and for investors to incorporate changing financial regulations in their investment process. -
Case Study
Cobb-Douglas
“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.
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Article
Impact of Credit Markets on Dynamic Stochastic Real Aggregate Production
This paper provides a dynamic stochastic macro-financial model that describes the impact of the credit market on real production risk and provides some empirical evidence of the reasonableness of the model. Our model shows that the uncertain real sector output affects the performance of the credit market, which in turn, impacts the real production of an economy, resulting in a positive feedback effect. Our model shows that an increase in financial sector leverage and household sector leverage would induce a stronger feedback effect and increasing marginal production of financial leverage. Our model identifies the key risk drivers in measuring the performance of an economy that can be used to attribute quarterly gross domestic product (GDP) growth rate over the sample period 2000 Q1 to 2013 Q3. The empirical results can be used to interpret the underlying causes of economic boom–bust cycles and provide insights into a sustainable GDP growth pattern. This macro-finance model has many applications. For example, the risk drivers of the GDP growth rates can be used to study equity broad-based market returns (Ho and Lee, 2014).The model can also be used to specify a structural macro-finance model that can be used to evaluate efficacy of some financial regulations (Ho and Lee, 2015b).
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Practitioner's Digest
Practitioner’s Digest • Vol. 13, 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.
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Practitioner's Digest
Practitioner’s Digest • Vol. 13, 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 13, No. 2, Second Quarter 2015
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Article
Equity Indices’ Returns: Contingent Claims on GDP Stochastic Movements
This paper proposes an equity index contingent claim model. The model assumes that the equity broad-based market indices’stochastic movements are contingent to macroeconomic risk factors that are derived from Ho et al.’s (HPS, 2012, 2013) and Ho and Lee’s (HL, 2015b, 2015c) theoretical models. The results show that these factors can explain the equity indices’ returns reasonably well.
Our model accounts for the complex lagged effect of GDP growth rate modeled by HPS and estimated by HL, and determines the sensitivities of a market index to the stochastic GDP multiple factors. We show that the S&P Index seems to have anticipated the Great Recession and the higher growth rate of the current recovery. The results also show that the market premiums of Dow Jones and NYSE indices move mostly in tandem with those of S&P. However, such as not the case with NASDAQ and Russell. The model can be used for asset allocation and hedging in investment strategies, and we have provided multiple hedging strategies in this paper to illustrate some applications of our model. -
Article
A Structural Macro-Financial Model an Macro-Risk Management
This paper provides a structural macro-financial model that can be used for the cost and benefit analysis of alternative financial regulatory regimes. The model solves for the optimal financial sector size to the real aggregate asset (household leverage) and to the aggregate capital (financial leverage) that maximize the expected real output. This paper suggests that macro-risk management is necessary and managing the aggregate capital in the financial sector is important.
We illustrate the impact of some regulatory policies on the real outputs with some numerical examples. Our model shows that holding 2.39% in excess of the optimal capital ratio would lower theGDPgrowth rate by 0.61%. Since the model shows that higher financial leverage would result in higher expected growth rate and volatility of real outputs, we suggest that macro-risk management also needs to determine a risk and return tradeoff of real output.
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Article
Growth Optimal Portfolio Insurance for Long-Term Investors
We solve the growth-rate optimal multiplier of a portfolio insurance strategy in the general case with a locally risky reserve asset and stochastic state variables. The level of the optimal time-varying multiplier turns out to be lower than the standard constant multiplier of Constant Proportion Portfolio Insurance (CPPI) for common parameter values. As a consequence the outperformance of the growth-optimal portfolio insurance (GOPI) strategy does not come with higher risk. In the presence of mean reverting stock returns the average allocation to stocks increases with horizon and the optimal multiplier introduces a countercyclical “tactical” component to the strategy. Furthermore, we unveil a positive relationship between the value of the strategy and the correlation between the underlying assets.
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Article
Alternative Currency Hedging Strategies With Known Covariances
Informed investors understand that they should hedge at least some of their portfolios’currency exposure, but the best strategy for doing so remains an open question. We investigate a variety of currency hedging strategies, including linear strategies, non-linear strategies, and combinations thereof, for the purpose of helping investors determine which strategies best meet their objectives.
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Insight
What Piketty Doesn’t Understand
“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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Article
Strategic Asset Allocation with Low-Risk Stocks: A Bootstrap Analysis
Traditional asset allocations such as the 60/40 portfolio of stocks/bonds are not as well diversified as many investors believe since almost all the portfolio’s returns are driven by the stock component. This paper examines a novel approach to strategic allocation by combining stocks with low betas and high dividend yield. Our “beta-yield” portfolio exploits the beta anomaly (low beta stocks have higher risk-adjusted returns than high-beta stocks) and the hedging property of high dividend yield stocks in declining markets.We use bootstrap simulations to analyze the long-term performance of the beta-yield portfolio and find that it outperforms 60/40, 70/30, and 80/20 stock/bond portfolios in terms of shortfall risk, Omega ratio, and Prospect Theory utility. The results hold even with relatively high loss-aversion, and when the beta-yield strategy is assumed to have counterfactually low average returns.
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Practitioner's Digest
Practitioner’s Digest • Vol. 13, 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.
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Book Review
Think Like a Freak
“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.
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Case Study
Failure of the Real Wage to Grow
“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.
Volume 13, No. 3, Third Quarter 2015
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Book Review
Investors and Markets
“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.
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Article
The Value of Active Investing
We examine whether the value of active investment management can exceed its cost, and find that it can, by a substantial margin. We consider the 0.67% average cost estimate in French (2008), comparing it with the expected value of a known active investment strategy. For a “passive” benchmark, we develop a 225 year index of monthly U.S. equity market returns, from July 1789 through June 2014. This timeframe encompasses the entire history of every U.S. exchange and includes all known periods of secondary market stock trading in the United States. We then estimate the long-run monthly returns of an active investment strategy based on an actual 11-year investment strategy. We present a new performance model extending the Treynor and Mazuy (1966) model and implement it to estimate monthly returns to the active strategy over the same 225 year period.We believe that this experiment offers a good example of how the value of well-constructed active investment strategies can be worth substantially more than their cost.
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Article
Beware of Children Trading
Guardians behind underaged accounts are successful at picking stocks. These informed traders tend to channel their best trades through the accounts of children, especially when they trade just before major earnings announcements, large price changes, and takeover announcements. Building on these results, we argue that the proportion of total trading activity through underaged accounts (labeled BABYPIN) is an effective proxy for firm-specific information asymmetry. Consistent with this claim, we show that investors demand a higher return for holding stocks with a higher probability of informed trading as proxied by BABYPIN.
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Article
Augmented Risk Models to Mitigate Factor Alignment Problems
Construction of optimized portfolios entails a complex interaction between three key entities, namely, the risk factors, the alpha factors and the constraints. The problems that arise due to mutual misalignment between these three entities are collectively referred to as Factor Alignment Problems (FAP). Examples of FAP include risk u underestimation of optimized portfolios, undesirable exposures to factors with hidden and unaccounted systematic risk, consistent failure in achieving ex-ante performance targets, and inability to harvest high quality alphas into above-average IR. In this paper, we give a detailed analysis of FAP and discuss solution approaches based on augmenting the user risk model with a single additional factor y. For the case of unconstrained mean–variance optimization (MVO) problems, we develop a generic analytical framework to analyze the ex-post utility function of the corresponding optimal portfolios, derive a closed-form expression of the optimal factor volatility value and compare the solutions for various choices of y culminating with a closed-form expression for the optimal choice of y. Augmented risk models not only correct for risk underestimation bias of optimal portfolios but also push the ex-post efficient frontier upward thereby empowering a portfolio manager (PM) to access portfolios that lie above the traditional risk–return frontier. We corroborate our theoretical results by extensive computational experiments, and discuss market conditions under which augmented risk models are likely to be most beneficial.
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Article
Decentralization in Pension Fund Management
The past few decades have seen a major shift from centralized to decentralized investment management by pension fund sponsors, despite the increased coordination problems that this brings. Using a unique, proprietary dataset of pension sponsors and managers, we identify two secular decentralization trends: sponsors switched (i) from generalist (balanced ) to specialist managers across asset classes and (ii) from single to multiple competing managers within each asset class.We study the effect of decentralization on the risk and performance of pension funds, and find evidence supporting some predictions of recent theory on this subject. Specifically, the switch from balanced to specialist managers is motivated by the superior performance of specialists, and the switch from single to multiple managers is driven by sponsors properly anticipating diseconomies of scale within an asset class (as funds grow larger) and adding managers with different strategies before performance deteriorates. Indeed, we find that sponsors benefit from alpha diversification when employing multiple fund managers. Interestingly, competition between multiple specialist managers also improves performance, after controlling for size of assets and fund management company-level skill effects. We also study changes in risk-taking when moving to decentralized management. Here, we find that sponsors appear to anticipate the difficulty in coordinating multiple managers by reducing their overall risk budget following decentralization, which helps to compensate for the suboptimal diversification that results. In summary, our results shed light on the complex array of factors that affect the decision of pension funds to delegate investment choice.
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Article
Retirement Readiness and Behavioral Finance
More than 10,000 Baby Boomers will be reaching retirement age every year from now through 2030. Inadequate savings, high cost and poorly designed retirement plans as well as investor behavioral mistakes combine to level most of them woefully unprepared for retirement. The paper suggests a number of possible solutions to improve our country’s retirement readiness.
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Insight
Consumption, Investment and Insurance in the Game of Life
Markowitz (1991) proposed the development of a “Game of Life” simulator in which portfolio selection was just one type of move in the financial actions of a subject household. Sherri Grabot’s invitation to Markowitz in the late 1990s to form and join the design committee of GuidedChoice (originally a 401k advisory service) permitted Markowitz and team to take the first steps in applying the theory in practice, with favorable results for participants.
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Practitioner's Digest
Practitioner’s Digest • Vol. 13, 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 13, No. 4, Fourth Quarter 2015
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Article
Funding Translational Medicine via Public Markets: The Business Development Company
A business development company (BDC) is a type of closed-end investment fund with certain relaxed requirements that allow it to raise money in the public equity and debt markets, and can be used to fund multiple early-stage biomedical ventures, using financial diversification to de-risk translational medicine. By electing to be a “Regulated Investment Company” for tax purposes, a BDC can avoid double taxation on income and net capital gains distributed to its shareholders. BDCs are ideally suited for long-term investors in biomedical innovation, including: (i) investors with biomedical expertise who understand the risks of the FDA approval process, (ii) “banking entities,” now prohibited from investing in hedge funds and private equity funds by the Volcker Rule, but who are permitted to invest in BDCs, subject to certain restrictions, and (iii) retail investors, who traditionally have had to invest in large pharmaceutical companies to gain exposure to similar assets. We describe the history of BDCs, summarize the requirements for creating and managing them, and conclude with a discussion of the advantages and disadvantages of the BDC structure for funding biomedical innovation.
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Case Study
Male Life Expectancy Graph
“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.
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Book Review
Portfolio Management Under Stress: A Bayesian-Net Approach to Coherent Asset Allocation
“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.
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Article
Is U.S. Insider Trading Still Relevant? A Quantitative Portfolio Approach
For 40 years academic literature has reported statistically significant excess returns to selected insiders trading in their firms’ shares, and similar evidence for outsiders who selectively mimic insider trading decisions spans three decades. However, constructing tradable signals leveraging insider trading data is challenging due to the irregular frequency of trades. We report that carefully constructed insider trading signals continue to produce statistically significant excess returns in US equity markets. We combine an insider factor with a non-insider stock selection model that is itself statistically significant and report economically meaningful incremental returns. The combined model is robust to different portfolio optimization techniques.
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Article
Investing in the Asset Growth Anomaly Across the Globe
We document the existence of an anomalous asset growth effect globally and find that it comprises some combination of a market mispricing and some pervasive global systematic risk. To support our findings, we explore a battery of tests to include how country-level governance and market characteristics explain the cross-country differences in the effect. We also find evidence that any profits to a trading strategy based on the asset growth effect globally are reduced, though not eliminated, by arbitrage costs.
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Article
Efficiently Combining Multiple Sources of Alpha
In this article, we examine the question of efficiently combining multiple sources of alpha. We begin with a comparison of the various methods used by practitioners for constructing portfolios that capture a single alpha signal. These methods are broadly categorized as either: (a) simple factor portfolios, (b) pure factor portfolios, or (c) minimum-volatility factor portfolios. We then derive an equation that shows the optimal alpha weights given the expected returns and covariance matrix of the alpha signals.We provide a discussion on how the required inputs can be estimated in practice, and conclude with an empirical example to illustrate these effects.
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Article
Fundamental Indexation and the Fama-French Three Factor Model: Risk Assimilation or Stock Mispricing?
We confirm the outperformance of fundamental indexation (FI) portfolio returns as due to an exploitation of stock mispricing, while, simultaneously, largely explained in terms of the Fama–French three-factor (FF-3F) model. This leads us to conclude that rather than FI representing a repackaging of the book to market and small firm size effects as encountered in the FF-3F model, the impact of these factors in the FF-3F model is explained by their ability to differentiate on aggregate between over- and under-priced stocks.
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Insight
Limits on the Level of Demand a Country Can Afford
With home goods (e.g urban services) output equals demand; when demand increases we put older machines back to work. But the real wage depends on the productivity of the marginal home goods plant. Because money prices go up when the real wage goes down, an increase in demand is inflationary.
On the other hand, with tradable goods (e.g., commodities), an increase in demand results in virtually no increase in local output, hence in an almost equal increase in the trade deficit.
In both cases, a failure to invest in plant capacity results in an increase in demand the country can’t afford.