JOIM: 2022
Volume 20, No. 1, First Quarter 2022
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Article
Relevance
The authors describe a new statistical method for improving forecasting called relevance. They describe their new method from both a conceptual and mathematical perspective, and they show how relevance links regressions to event studies and machine learning algorithms.
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Article
Characteristic-Based Returns: Alpha or Smart Beta?
We propose new methodology to construct arbitrage portfolios by utilizing information contained in firm characteristics for both abnormal returns and betas (and, therefore, smart-beta risk premiums). Our methodology gives maximal weight to risk-based interpretations of characteristics’predictive power before any attribution to abnormal returns. The method allows the explanatory power of a characteristic for both alpha and beta to ebb and flow. This feature is particularly important when we expect that profit opportunities may be arbitraged away by investors. We apply the methodology to a large panel of U.S. stock returns from 1965 to 2018. Empirically, characteristics have time-varying explanatory power for both factor betas and alpha. We find that the arbitrage portfolio has (statistically and economically) significant alpha and annualized Sharpe ratios ranging from 1.31 to 1.66.
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Article
Measuring the Economic and Academic Impact of Philanthropic Funding: The Breast Cancer Research Foundation
Using survey data gathered from grantees of the nonprofit Breast Cancer Research Foundation (BCRF), we investigated the commercial and non-commercial impacts of their research funding. We found significant impact in both domains. Commercially, 19.5% of BCRF grantees filed patents, 35.9% had a project that has reached clinical development, and 12 companies have or will be spun off from existing projects, thus creating 127 new jobs. Non-commercially, 441 graduate students have been trained by 116 grantees, 767 postdoctoral fellows have been trained by 137 grantees, 66% of grantees have used funding for faculty salaries, 93% have achieved collaboration with other researchers, and 42.7% have enacted process improvements in research methodology. Econometric analysis identifies BCRF funding and associated process improvements as key factors associated with the likelihood to file patents. However, we also found that the involvement of more than one institution in a collaborative project had a negative impact on subsequent development. This may point to frictions introduced by multi-university interactions.
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Article
How Well Do Factor ETFS Capture the FAMA–French Factors?
Institutional investors are investigating systematic, rule-based investment directions other than purely passive investing, such as factor-based investing. This study examines how well the factor-ETFs capture the Fama–French factors and attempts to explain their difference from the smart beta indexes applied in practice. The findings document that the market factor explains a substantial part of the expected returns, with the remaining factors, except momentum, posting smaller or no contribution. Style ETFs exhibit mixed results in capturing their referenced style, with almost all of them exhibiting non-neutral momentum. The findings are of interest to investment managers, investors, risk managers, and stock exchanges.
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Article
Exponential Glide Paths
In the absence of market-timing ability, investors are better-off keeping their asset allocation constant through time. Target-date funds help reduce variation in the asset allocation, by taking into account that human capital, which is a part of the investor’s total portfolio and is typically considered to be bond-like, diminishes with age. To compensate, target date funds reduce the allocation to equities in the financial portfolio over time. Funds almost universally do so in a linear fashion, following straight-line glide paths. We show that linear glide paths imply two systematic deviations from constant asset allocation, and suggest a simple correction, the exponential glide path. Exponential glide paths lead to a typical increase of 5–22% in welfare relative to linear glide paths.
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Practitioner's Digest
Practitioner’s Digest • Vol. 20, 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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Book Review
In Pursuit of the Perfect Portfolio
“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
NFTs as Alternative Investments?
“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 20, No. 2, Second Quarter 2022
ESG Investing
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Article
ESG, Investing, and Corporate Finance: Some Basic Questions
This paper is devoted primarily to asking questions about the implications of the growing focus on ESG (environment, social and governance) for investing and corporate financial policy rather than offering answers. Many of the questions raised here were anticipated by Milton Friedman in his classic New York Times article. Although many critics now dismiss Friedman’s article as stogy and dated, I argue that the critical questions he raised remain unresolved today and lie at the core of much of the debate regarding ESG.
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Article
Sustainable Investing From a Practitioner’s Viewpoint: What’s in Your ESG Portfolio?
Many investors have shifted their asset allocations to account for Environmental, Social, and Governance (ESG) issues. While we welcome this shift from an ethical perspective, the financial and non-financial benefits of ESG investing as well as best practices for portfolio construction are subjects of heated debate. We look at aspects of the debate through a series of practical examples. First, we illustrate the trade-off between risk control and unwanted exposures in energy and “vice" stock exclusions, which have exhibited inconsistent performance at a 10-year horizon. Next, we show how recent underperformance of a gender lens portfolio has been confounded by technology stocks. Finally, we explore how ESG score disparities lead to important differences in portfolios constructed with these scores. In aggregate, our examples point to the inherent complexity of ESG investing, which will benefit from better data, transparency, customization, and an acknowledgement that doing good does not necessarily lead to doing well. An important theme throughout this paper is that everything should be made as simple as possible, but no simpler.
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Article
Sustainable Alpha in Sovereign and Corporate Bonds
We construct fixed income portfolios for sovereign bonds and corporate bonds with sustainable insights. The climate methodology for sovereign bonds can be applied as an overlay on any benchmark and tilts toward sovereigns more prepared with the climate transition and away from those which are less prepared. The tilts reduce sovereign carbon emissions in line with the Paris Agreement. For corporate bonds, we investigate three sustainable signals that predict excess returns: environmental, social, and governance (ESG) scores of corporations scored across various rating and sector buckets, firm carbon emission intensities, and corporate commitments that signal reduced carbon emissions.
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Insight
Financing Vaccines for Global Health Security
Recent outbreaks of infectious pathogens such as Zika, Ebola, and COVID-19 have underscored the need for the dependable availability of vaccines against emerging infectious diseases (EIDs). Prior to the COVID-19 pandemic, the cost and risk of R&D programs and uniquely unpredictable demand for EID vaccines discouraged many potential vaccine developers, and government and nonprofit agencies have struggled to provide timely or sufficient incentives for their development and sustained supply. However, the economic climate has changed significantly post-pandemic. To explore this contrast, we analyze the pre-pandemic economic returns of a portfolio of EID vaccine assets, and find that, under realistic financing assumptions, the expected returns are significantly negative, implying that the private sector is unlikely to address this need without public-sector intervention. However, in a post-pandemic policy landscape, the financing deficit for this portfolio can be closed, and we analyze several potential solutions, including enhanced public–private partnerships and subscription models in which governments would pay annual fees to obtain access to a portfolio of stockpiled vaccines in the event of an outbreak.
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Insight
Toil and Trouble, Don’t Get Burned Shorting Bubbles
Bubbles are among the most puzzling and controversial phenomena of financial markets. Although rare, their cumulative impact on both investor returns and the broader economy can be great. One particular question that has motivated research is why shrewd short
sellers don’t prevent excessive price increases.
The “limits to arbitrage” idea argues that correcting inefficient market prices is neither
easy, cheap nor riskless. The “rational bubble” literature identifies situations in which being long the bubble is a better trade than being short, even if investors know for certain the bubble will pop. And there is a theory that bubbles only inflate after the shorts have
suffered significant losses.
We examine the “short subprime” trade from 2005 to 2008 to evaluate these and other explanations. We argue that the short subprime trades had more risk than is commonly appreciated. We discuss how the opaque and illiquid nature of subprime mortgages deterred some investors from purchasing CDS contracts and note that other investors assessed the risk of counterparty failure, government intervention and unknown time horizon to be sufficient enough not to purchase CDS contracts.
In addition, we describe how factors such as performance convexity and credit convexity made the subprime short more profitable than most ex-ante calculations suggested. We also outline why the subprime short trade was ineffective at reining in the subprime bubble and how buying subprime after the crisis was an equally, if not more, attractive trade that potentially did more to mitigate the harm of the bubble. Looking back at the last major bubble with a decade of hindsight yields insights that might be helpful to market participants and policy makers thinking about future bubbles. -
Practitioner's Digest
Practitioner’s Digest • Vol. 20, 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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Insight
In Memoriam—Louis A. Simpson
Louis A. Simpson
December 23, 1936–January 8, 2022 -
Book Review
The Future of Money: How the Digital Revolution is Transforming Currencies and Finance
“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.
Volume 20, No. 3, Third Quarter 2022
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Practitioner's Digest
Practitioner’s Digest • Vol. 20, 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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Insight
Interview with Dean Lebaron and Charley Ellis
As part of our twentieth anniversary of the JOIM, I have asked a few luminaries to share their sage thoughts in our “Insights” section. The following contribution is from Dean LeBaron who also enlisted comments from Charley Ellis in an interview which preceded our publication. My thanks to Dean and Charlie for their thoughtful input to the historical perspective of investment management.
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Article
Tax-Rate Arbitrage: Realization of Long-Term Gains to Enable Short-Term Loss Harvesting
We look at an enhanced loss-harvesting strategy, tax-rate arbitrage, which exploits the differential between short- and long-term tax rates. In ourstudy, we examine tax-managed strategies over numerous historical periods. For the ideal tax-rate arbitrage investor, one who is subject to the highest federal-only 2020 tax rates, who has a long horizon and a planned liquidation date, and who launches the strategy from all cash, tax-rate arbitrage generated an average of 0.78% in excess after-tax active return at a 10-year horizon relative to a standard loss-harvesting strategy. Other investors with different profiles may benefit from tax-rate arbitrage but typically to a lesser extent.
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Article
Portfolio Performance Attribution via Shapley Value
We consider an investment process that includes a number of features, each of which can be active or inactive. Our goal is to attribute or decompose an achieved performance to each of these features, plus a baseline value. There are many ways to do this, which lead to potentially different attributions in any specific case. We argue that a specific attribution method due to Shapley is the preferred method, and discuss methods that can be used to compute this attribution exactly, or when that is not practical, approximately
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Article
Just Say No to Leveraged ETFs
The daily return on a positive Leveraged Exchange-Traded Fund (LETF) is a multiple of its benchmark. We compare the risk–reward trade-off of investing in an LETF relative to the benchmark. The main contribution is straightforward: Sharpe Ratio (SR) adequately and sufficiently captures the trade-off. An LETF return distribution differs from the benchmark by location and scale. As a result, LETF and benchmark have the same higher-order cumulants. A wide variety of coherent performance measures monotonically depend on the SR. For all horizons, the LETF SR is lower than the benchmark. We find strong and robust empirical support for these predictions.
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Article
What’s in the Moneyness? Moneyness Spread and Future Stock Returns
There exists a significant and positive cross-sectional relation between moneyness spread and future stock returns. Stocks with high moneyness spread outperform stocks with low moneyness spread, measured by raw and risk-adjusted returns. This predictability can last for at least 15 days, and the predictability of open interest-weighted moneyness spread is more persistent than that of dollar-volume weighted moneyness spread. The long–short portfolio, which buys stocks in the top decile and shorts stocks in the bottom decile, outperforms the market. After accounting for transaction costs, this outperformance continues to hold except the daily-rebalanced portfolio based on dollar volume-weighted moneyness spread.
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Case Study
Passive Versus Active ESG Investing: How a Small Hedge Fund Converts an Oil Giant
“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
Investing Amid Low Expected Returns
“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.
Volume 20, No. 4, Fourth Quarter 2022
ESG Investing II
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Practitioner's Digest
Practitioner’s Digest • Vol. 20, 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.
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Article
Carbon Emissions and Asset Management
Two common methods that portfolio managers use to reduce the carbon footprint of their portfolios are either to exclude carbon emitters from their portfolios or to engage/cajole underlying companies to reduce their carbon footprint by taking actions to reduce emissions. We estimate the costs of excluding carbon emitters from a portfolio. We highlight the costs and benefits of a third alternative that seeks to preserve the separation principle such that managers select their optimal portfolio based on return and risk optimizations, and separately incur transaction costs to satisfy investors’ demands toward “net zero” by purchasing carbon credits to offset the carbon footprint of their optimal portfolios. By doing so, although the composition of the portfolio may contain carbon emitters, the portfolio itself is carbon neutral. To acquire these carbon credits efficiently either directly or in secondary markets requires asset management skills. We believe that investors in mutual funds or ETFs would determine their own preferences toward carbon “net zero” by buying a combination of a fund that offsets fully emissions of the companies in the underlying portfolio and another(a clone of the other)that did not.
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Article
ESG Investment Performance Evaluation: An Integrated Approach
ESG investment strategies have experienced a massive inflow of capital over the past decade despite investors having few methods to evaluate their performance and communicate their ESG values, objectives, and preferences to investment managers. This paper develops a three-dimensional performance evaluation metric that incorporates return, risk, and ESG outcomes. It is predicated on an investor’s willingness to trade off financial gain for non-financial gain and can accommodate any traditional riskadjusted performance measure. Withoutsuch frameworks, investors can neither determine whether outcomes match their expectations nor compare performance across managers and allocate capital accordingly.
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Article
Factor Investing in Paris: Managing Climate Change Risk in Portfolio Construction
The 2015 Paris Agreement is a landmark in limiting emissions and targeting global warming well below 2◦C, preferably 1.5◦C compared to pre-industrial levels. In this light, we investigate how to efficiently construct equity portfolios that help mitigating climate change risk but at the same time enable harvesting well-established return drivers such as value, momentum or quality. A pure reduction in greenhouse gas intensity or a divestment from fossil fuel sectors is not necessarily leading to a better temperature alignment of a portfolio. Given the limited set of temperature-aligned assets, keeping the average temperature increase below 2 degrees comes with considerable active risks. To this end, we propose a net zero portfolio construction framework that brings temperature alignment together with a reduction in carbon intensity while harvesting equity factor premia.
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Article
Climate-Aware Risk Budgeting
Climate change is a risk investors are thinking about, but how can it be practically incorporated into an asset allocation framework? This paper presents two different approaches. One is a traditional approach where the covariance matrix and excess return vector is adjusted to account for climate change. More detail is given for a second approach, a risk-budgeting approach. In this approach, investors adjust their risk budgets based on climate change information.
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Article
ESG Screening in the Fixed-Income Universe
This paper evaluates the impact of a screening process based on Environmental, Social, and Governance (ESG) scores for an otherwise passive portfolio of investment-grade corporate bonds. The main result is that a global exclusion strategy leads to a substantial improvement of the targeted ESG score without reducing the risk-adjusted performance but with significant biases in regional, sectoral, and risk factor exposures. We demonstrate that a best-in-class strategy implemented at the regional and sectoral levels allows investors to eliminate undesirable regional and sectoral exposures while delivering similar ESG scores and risk-adjusted performances.
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Insight
Bias and Noise in Humans & AI: When to Trust Humans & Machines in Decision-Making .
When should we trust machine-based and human decisions in finance? In this article I answer this question by drawing on two sets of insights about decision error. I first draw on research of leading theorists on human decision-making and prediction, summarized through a set of articles and conversations with them about the two sources of decision error, namely, bias and noise. I also draw on two decades of experience operating a machine-learning based trading platform, where algorithmic bias and noise also manifest themselves, but very differently than in human decision-making. This two-pronged analysis of the properties of humans and algorithmic decision-making provides a backdrop against which the challenges and opportunities for creating trustable decision-making systems in finance come into sharp focus.
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Case Study
ESG Greenwashing and Recent Sec Actions
“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
Where the Money Is: Value Investing in the Digital Age
“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.