JOIM: 2021
Volume 19, No. 1, First Quarter 2021
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Insight
Active Investing and the Efficiency of Security Markets
This study investigates the impact of active investment management on the efficiency of public security markets. The scholarly literature indicates that active management contributes to market efficiency, thereby providing positive externalities for all investors, including investors in passively-managed funds. Contrary to popular interpretations of Sharpe’s (1991) “active arithmetic,” the benefits of active management are amplified in small and mid-capitalization U.S. stocks, enhancing the ability of these companies to raise capital for investments in the real economy. Across all public corporations, the improved efficiency afforded by active management helps to discipline capital expenditures by corporations through a more efficient stock price.
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Article
Investment Style Volatility and Mutual Fund Performance
We develop a holdings-based statistic to measure the volatility of a fund’s investment style characteristic profile over time. On average, funds with lower levels of style volatility significantly outperform more style-volatile funds on a risk-adjusted basis. We show that style volatility has a distinct impact on future fund performance compared to fund expenses or past risk-adjusted returns, with the level of indirect style volatility being the primary determinant of the overall effect. We conclude that deciding to maintain a less volatile investment style is an important aspect of the portfolio management process.
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Article
Lending to Lose: Who Buys Negatively Yielding Bonds and What it Means for Investors
I discuss the demand and supply of negatively yielding bonds, which is a recent and relatively unprecedented phenomenon in financial markets. To understand why one would lend to lose, I classify buyers into three categories, i.e. “forced buyers”, “speculators” and “non-financial government entities”. I conclude that the demand for bonds that are guaranteed to lose money can locally be justified by a variety of rational reasons. However, while locally rational, this conclusion raises important questions about global financial stability. Do negative yields mean that the bond market is distorted due to demand and supply mismatch, and if so what are the consequences if there are unforeseen macroeconomic shocks?
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Article
Idiosyncratic Risk and When to Tilt Toward Value
While the outperformance of value relative to growth portfolios has been well established, there is still debate over whether this outperformance is the result of a systematic risk factor or a behavioral tendency. The distinction is crucial to determining the expected returns of value- and growth-tilted portfolios. We find that when idiosyncratic volatility—the key arbitrage portfolio holding cost—increases, the outperformance of value correspondingly increases. Conversely, when idiosyncratic volatility is low, the outperformance is reduced. This is consistent with a behavioral explanation and has important ramifications for the timing of value tilts employed by a portfolio manager.
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Article
Comovement, Liquidity and Asymmetries
Substantially increased institutional investing and index trading in the US stock market have a meaningful impact on the mechanical relationship between return comovement and liquidity, which can be quantified by a power-law function and explained by a liquidity supply model. Three well-documented asymmetries (asymmetric volume, asymmetry in non-market volatility, and positive skewness for individual stocks) are disappearing with increased basket trading, however, asymmetric correlation survives.
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Book Review
Beyond Diversification: What Every Investor Needs to Know About 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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Case Study
Pairs Trading in the Era of Meme Stocks
“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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Practitioner's Digest
Practitioner’s Digest • Vol. 19, 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 19, No. 2, Second Quarter 2021
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Article
Asset Pricing, Asset Allocation and Risk-Adjusted Performance with Multiple Goals and Agency: The Goals and Risk-Based Asset Pricing Model
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.
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Article
Active Investing as a Negative Sum Game: A Critical Review
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.
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Article
What Happens with More Funds than Stocks? Analysis of Crowding in Style Factors and Individual Equities
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. -
Article
The Magic Formula: Value, Profitability, and the Cross-Section of Global Stock Returns
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.
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Book Review
The Financial Ecosystem — The Role of Finance in Achieving Sustainability
“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. 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.
Volume 19, No. 3, Third Quarter 2021
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Article
A New Index of the Business Cycle
The authors introduce a new index of the business cycle that uses the Mahalanobis distance to measure the statistical similarity of current economic conditions with past episodes of recession and robust growth. Their approach has a key advantage compared to approaches that simply aggregate data, such as the Conference Board indexes, or approaches that rely on regression models. It considers the distribution of recession data separately from the distribution of growth data. This feature, along with the construction of the index as a relative probability, has the consequence of shifting the weights that are placed on the index inputs based on their prevailing values. In addition, their framework makes it possible to measure how the relative importance of the economic variables from which the index is constructed varies through time, which yields valuable insights about the dynamics of the business cycle.
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Article
Long-Run Implied Market Fundamentals: An Exploration
The paper studies the volatility and correlation pattern of the fundamental valuation parameters (growth rate and its determinants, discount rate) calculated from widely used valuation ratios using the Gordon formula, and compares the findings to well-known insights from the asset pricing literature. Our results reveal a substantially different picture of the volatility and cyclicality of the implied valuation parameters compared to estimates from econometric models using historical returns. We argue, in the spirit of Campbell (2008), that implied Gordon parameters can be interpreted as empirical proxies for conditional steady-state market fundamentals, which is supported by our findings. The insights of this paper are therefore particularly challenging for investors with a long-term investment horizon who base their decisions on fundamental valuation factors.
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Article
On the Use of the Daily Fama–French Risk-Free Rate
The Fama and French (1992) risk-free rate is used throughout the extant finance literature. The daily risk-free series has issues that raise concerns about its use as a benchmark. We detail the issues and discuss viable low-cost alternatives. We suggest the use of an adjusted one-year constant maturity rate for empirical analysis dating back to July 1, 1963. Our empirical results suggest that the choice matters in short-run analyses or single-day event studies, but not in studies that employ long-run averages, as is typical in asset-pricing research. We also document an interesting methodological division in empirical academic financial analysis.
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Article
Advances in Estimating Covariance Matrices
Correlation matrices are widely used in finance both for risk forecasting and for portfolio optimization. It is well known that the sample correlation matrix is unreliable for portfolio optimization. However, we show that for purposes of predicting portfolio risk, the sample correlation matrix is close to optimal. In this paper, we present a technique for estimating correlations that is well suited both for risk forecasting and for portfolio optimization. We apply our technique to estimate factor correlation matrices spanning different asset classes. We find that our technique produces improved correlation estimates compared to an alternative widely used approach.
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Article
A Market Signal-Based Alternative to Buy-and-Hold Investing
We propose a simple, hindsight-free, rule-based method of entry and exit into the stock market, with the goal of improving returns by averting large losses. Using data from 1928 through March 2020, we demonstrate that the proposed strategy delivers statistically significant outperformance over the S&P 500 total return index. Several robustness checks, including a Monte Carlo analysis, confirm the strategy’s outperformance in various sub-sample periods and investment horizons. These results hold after accounting for reasonable transaction costs for in and out trades. The strategy’s outperformance is explained by the non-normality and asymmetric persistence of market returns.
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Book Review
The Premonition
“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. 19, 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 19, No. 4, Fourth Quarter 2021
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Article
Horizon-Adjusted Portfolio Performance Measure
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.
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Article
Private Equity Valuation Before and After ASC 820
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.
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Article
The U.S. Treasury Term Structure and the Distribution of Real GDP Growth
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.
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Article
How Do Factor Premia Vary Over Time? A Century of Evidence
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.
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Book Review
Trading at the Speed of Light: How Ultrafast Algorithms are Transforming Financial 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
Good States, Bad States: What Do Options Tell Us About Schizophrenic Behavior of Mr. Market and What Can We Do About It?
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.
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Insight
Are We at the Inflection Point of Climate Investing?
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.
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Practitioner's Digest
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.