JOIM: 2019
Volume 17, No. 1, First Quarter 2019
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Article
Does Extreme Correlation Matter in Global Equity Asset Allocation?
Global asset allocation provides risk diversification. But international market correlation increases sharply during global crises and diversification benefit disappears when it is most needed. We model these correlation breaks and derive the asset allocation implications. The model can quickly detect crises and suggests adapting allocation for changing correlation and volatility, as the crisis probability evolves. The out-of-sample results for ten major equity markets over 2008–2016 show significant improvements in the Sharpe ratio and maximum drawdown over mean–variance, fat-tail distribution, passive indices, and 1/N rule. A benefit of the model is that it is conceptually intuitive and amenable to simple implementation in asset allocation and risk management.
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Article
Explaining Buyout Industry Returns: New Evidence
Traditional equity factors such as the leveraged equity risk premium, the small-cap premium, and the value premium have had high historical returns on average, as has the buyout fund industry in aggregate. Previous research has argued that these factors explain the excess performance of private equity over public equity. However, time series regression analysis reveals that these factors explain surprisingly little variation in buyout performance. In contrast, I find that other factors such as the credit premium and dynamic sector selection are more effective at explaining variation in performance of the buyout industry over time.
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Book Review
Rational Investing: The Subtleties of Asset Management
“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
Lessons Learned From Student Managed Portfolios
We study asset management decisions of three competing student managed funds in Vienna, Austria for a ten-year period. This real-world experience allows us to precisely test the tournament effect of fund management, the disposition effect, and managerial team size. We find support for risk taking by the trailing funds in an annual tournament, and risk reductions by leading funds. The disposition effect usually observed in the case of retail investors is reversed. Finally, we find that smaller management teams outperform larger ones. Using a partly controlled setting, we relate the results to practice in the areas of institutional client evaluation of managers and the social and organizational structure of asset management companies.
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Article
Portfolio Optimization With Noisy Covariance Matrices
In this paper, we explore the effect of sampling error in the asset covariance matrix when constructing portfolios using mean–variance optimization.We show that as the covariance matrix becomes increasingly ill-conditioned (i.e., “noisy”), optimized portfolios exhibit certain undesirable characteristics such as under-prediction of risk, increased out-of sample volatility, inefficient risk allocation, and increased leverage and turnover. We explain these results by utilizing the concept of alpha portfolios (which explain expected returns) and hedge portfolios (which serve to reduce risk). We show that noise in the covariance matrix leads to systematic biases in the volatility and correlation forecasts of these portfolios, which in turn explains the adverse effects cited above.
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Survey & Crossover
Predicting Investor Success Using Graph Theory and Machine Learning
“Surveys& Crossovers” This section provides surveys of the literature in investment management or short papers exemplifying advances in finance that arise from the confluence with other fields. This section acknowledges current trends in technology, and the cross-disciplinary nature of the investment management business, while directing the reader to interesting and important recent work.
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Practitioner's Digest
Practitioner’s Digest • Vol. 17, 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 17, No. 2, Second Quarter 2019
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Article
A Portfolio Approach to Accelerate Therapeutic Innovation in Ovarian Cancer
We consider a portfolio-based approach to financing ovarian cancer therapeutics in which multiple candidates are funded within a single structure. Twenty-five potential early-stage drug development projects were identified for inclusion in a hypothetical portfolio through interviews with gynecological oncologists and leading experts, a review of ovarian cancer-related trials registered in the ClinicalTrials.gov database, and an extensive literature review. The annualized returns of this portfolio were simulated under a purely private sector structure both with and without partial funding from philanthropic grants, and a public–private partnership that included government guarantees. We find that public–private structures of this type can increase expected returns and reduce tail risk, allowing greater amounts of private sector capital to fund early-stage research and development.
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Article
Quantifying the Skewness Loss of Diversification
Diversification is widely viewed as the “only free lunch” of finance. Unbeknownst to the free lunch crowd, skewness is typically positive for individual stocks and negative for diversified portfolios and thus diversification is not free. This undesirable move from positive to negative skewness that comes with diversification is the skewness loss of diversification. We quantify the economic value of skewness loss using option pricing models, and show that skewness loss is a meaningful cost for investors with skewness preferences and short horizons.
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Article
A Model of Bond Value: Explaining Yields with Growth and Inflation
This paper looks to establish a new heuristic for investors, giving them a simple, intuitive way to relate bond yields to prevailing trends in growth and inflation. The model offers an alternative to forecasting surveys, which have been over-estimating 10-year Treasury yields for decades and continue to project yields above 4% in the long run. The model does well in in-sample and out-of-sample tests used in the literature to evaluate other measures of value. The model can be used on its own or in conjunction with other models to forecast yields and also as a benchmark to evaluate yield forecasts. The model is consistent with some of the more advanced economic models of interest rates that suggest that the low bond yields of recent years are in line with broader economic trends, rather than due to temporary factors that are likely to reverse quickly.
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Article
Automated Financial Management: Diversification and Account Size Flexibility
We study the value added of automated financial management (AFM) services along two dimensions: diversification and account size exibility. First, using a company-specific experiment with matched AFM and traditional portfolios, we find that AFM portfolios are significantly better diversified. Underdiversified investors are more likely to set up an AFM account, with a 1 standard deviation increase in underdiversification raising the probability of doing so 3 percentage points. Next, we study account size flexibility using an exogenous reduction in minimum account size. The reduction led to a net increase in total deposit inflows and disproportionately raised new account formation by less-wealthy investors.
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Article
Optimal Holdings of Active, Passive and Smart Beta Strategies
The growing dominance of the core and explore model — a large passive index combined with a collection of high tracking error satellite portfolios — in conjunction with the growth of factor investing has renewed interest in how to allocate among different equity strategies. We study this problem from an expected shortfall perspective and find that portfolios that minimize expected shortfall differ substantially from portfolios generated using conventional methods.
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Book Review
The Fifth Risk
“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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Practitioner's Digest
Practitioner’s Digest • Vol. 17, 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 17, No. 3, Third Quarter 2019
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Article
Does Trading by ETF and Mutual Fund Investors Hurt Performance? Evidence from Time- and Dollar-Weighted Returns
This paper analyzes the “return gap” between internal rate of returns that account for intermediate investor flows (“dollar-weighted returns”) and more familiar buy-and-hold returns that funds typically must report. Our sample constitutes all US-domiciled open- end mutual funds and exchange-traded funds (ETFs), and covers both fixed income and equity funds, as well as active and index styles of management. We find that return chasing behavior explains the cross-sectional pattern of the return gap. We conclude that high turnover of liquid ETFs does not lead to sub-par returns for investors in these funds.
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Article
How to Beat the Machines Before They Beat You
The use of “big” data, algorithms and machine learning is disrupting investment management. By carefully selecting domains where data is sparse and there is possibility of regime changes, a human investor can not only survive, but also thrive in a world of investment machines.
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Article
Embedded Betas and Better Bets: Factor Investing in Emerging Market Bonds
We document novel empirical insights driving the prices of sovereign external emerging market bonds. In the time series, we examine the market portfolio’s time-varying exposures to a broad set of macro factors (rates, credit, currency, and equity) and identify these embedded betas as key drivers of its excess returns. In the cross-section, we construct complementary value and momentum style factors and demonstrate their ability to explain country expected returns. Building off these insights, we introduce a simple risk-on versus risk-off framework to characterize the correlation structure spanning our macro and style factors. Lastly, we show how our style factors can be incorporated into an optimized long-only portfolio to generate outperformance relative to a value-weighted benchmark portfolio.
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Article
Return Predictability and Market-Timing: A One-Month Model
We use weighted least squares to combine 15 diverse variables to build a predictive model for the one- month-ahead market excess returns.We transform our forecasts into investable positions to form a market-timing strategy. From 2003 to 2017, our strategy had 16.6% annual returns with 0.92 Sharpe ratio and 20.3% maximum drawdown. In comparison, the S&P 500 had annual returns of 10%, 0.46 Sharpe ratio, and maximum drawdown of 55.2%.We also combine our one-month model with the six-month model of Hull and Qiao (2017). The combined model had 15% annual returns, Sharpe ratio of 1.12, and maximum drawdown of 14%
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Article
Bill Gross’Alpha: The King Versus the Oracle
We set out to investigate whether “Bond King” Bill Gross demonstrated alpha (excess average return after adjusting for market exposures) over his career, in the spirit of earlier papers asking the same question of “Oracle of Omaha,” Warren Buffett. The journey turned out to be more interesting than the destination. We do find, contrary to previous research, that Gross demonstrated alpha at conventional levels of statistical significance. But we also find that result depends less on the historical record than on whether we take the perspective of academics interested in market efficiency, investors picking a fund or someone (say a potential employer) asking whether a manager has skill or is throwing darts to pick positions. These are often thought to be overlapping or even identical questions. That is not completely unreasonable in equity markets, but in fixed income these are distinct. We also find quantitative differences, mainly that fixed-income securities have much higher correlations with each other than equities, make alpha 4.5 times as hard to measure for Gross than Buffett.We do not think our results will have much practical effect on attitudes toward Gross as an investor, but we hope they will advance understanding of what alpha means and appropriate ways to estimate it.
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Practitioner's Digest
Practitioner’s Digest • Vol. 17, 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.
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Case Study
Do You Know the Provenance of Your Alternative Data
“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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Survey & Crossover
The F-Utility of Wealth: It’s All Relative
Finance theory is based on a very simple, yet critical assumption that “individuals maximize the expected utility of wealth”. However, there are three crucial elements of this simple six-word phrase that does not really stand the test of what investors actually do and one could argue that the incorrect use of Modern Portfolio Theory (MPT) has led to the looming global retirement crisis. First, investors care about relative wealth (i.e., wealth relative to a goal) rather than absolute wealth, popularly called “Goals-Based Investing”. Second, individuals (or principals) are not always the ultimate decision-makers—rather, many investment decisions are delegated to agents, which distorts behavior. Third, and most crucially, most investors do not appear to focus on utility functions, but rather seek to maximize risk-adjusted return. Instead, finance theory should start with the assumption that “investors delegate to maximize relative risk-adjusted returns.” This paper seeks to show how incorporating these three simple and completely realistic changes impacts asset pricing, asset allocation, and the correct use of risk-adjusted performance measures. While the initial step requires a rethink of finance theory and models, the more urgent goal is to ensure retirement security as this new approach leads to financial innovation, better regulation, investments and retirement outcomes
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.