The Finance Professionals' Post

Recent Research: Highlights from January 2012

"Optimal Hedge Fund Allocation with Improved Estimates for Coskewness and Cokurtosis Parameters"
The Journal of Alternative Investments (Winter 2012)
Asmerilda Hitaj, Lionel Martellini, and Giovanni Zambruno

Since hedge fund returns are not normally distributed, mean–variance optimization techniques are not appropriate and should be replaced by optimization procedures incorporating higher-order moments of portfolio returns. In this context, optimal portfolio decisions involving hedge funds require not only estimates for covariance parameters but also estimates for coskewness and cokurtosis parameters. This is a formidable challenge that severely exacerbates the dimensionality problem already present with mean–variance analysis. This article presents an application of the improved estimators for higher-order co-moment parameters, in the context of hedge fund portfolio optimization. The authors find that the use of these enhanced estimates generates a significant improvement for investors in hedge funds. The authors also find that it is only when improved estimators are used and the sample size is sufficiently large that portfolio selection with higher-order moments consistently dominates mean–variance analysis from an out-of-sample perspective. Their results have important potential implications for hedge fund investors and hedge fund of funds managers who routinely use portfolio optimization procedures incorporating higher moments.

Recent Research: Highlights from December 2011

A Comment on “Better Beta Explained: Demystifying Alternative Equity Index Strategies”
The Journal of Index Investing (Winter 2011)
Noël Amenc

Cap-weighted indices have been subjected to increasing criticism. Empirical evidence suggests that cap-weighted indices deliver poor risk-adjusted performance. It has also been questioned whether market cap is a reliable proxy for the size and economic influence of a company. The fact that cap-weighted indices have been found to be neither representative nor efficient has led to the development of various alternative weighting schemes. However, how to best replace cap-weighted indices remains an open question. In an article from the Summer 2011 issue of The Journal of Index Investing, Robert Arnott discusses an empirical analysis of several alternative indexing methodologies that he broadly classifies as relying on heuristics or on portfolio optimization. Although an analysis of competing non-capweighted indices should, in principle, provide useful insights, the results reported by Arnott suffer from a flawed methodology and may confuse readers about the issues with different non-cap-weighted indices in practice.

Recent Research: Highlights from November 2011

"Breadth, Skill, and Time"
The Journal of Portfolio Management (Fall 2011)
Richard C. Grinold and Ronald N. Kahn

The information ratio determines the potential of an investment process to add value, and according to the fundamental law of active management, adding value depends on a combination of skill and breadth. Grinold and Kahn use an equilibrium dynamic model to provide insight into the concept of breadth, as well as a refined notion of skill. In equilibrium, the arrival rate of new information exactly balances the decay rate of old information. Grinold and Kahn denote the information turnover rate g. It is relatively easy to measure for any investment process. If the investment process forecasts returns on N assets, the breadth of the strategy i is g · N. Skill—the correlation of forecasts and returns—increases with the return horizon for small horizons, but then asymptotically decays to zero for very long horizons. The authors’ main result is that the ex ante information ratio is  , where κ is a measure of skill.

Recent Research: Highlights from September 2011

"Contingent-Capital Solutions for Mitigating the Investment Risks of a Private Placement Stock." The Journal of Investing (Fall 2011). C.B. Garcia.

The final negotiations between angel investors and a company following a thorough due diligence usually involve the following impasse: The angel investors on one side and the company on the other are in disagreement regarding the company's valuation because the company's expectations are more optimistic than the investors'. There is no feasible solution. In this article, the author proposes a model that a mediator may use to help the two parties come to a settlement. For the model, we show why traditional instruments of equity or notes are oftentimes infeasible and how feasible solutions—solutions that are currently not considered in negotiations—may be uncovered. With this model, a mediator may at least get one side to understand the implication of the terms to his or her future ownership of the firm, the (in)feasibility of the offering, and more importantly, where the other side is coming from. Better yet, with the model, the mediator may be able to persuade the contending parties to jointly consider alternate feasible solutions, to add their own constraints, or to move their expectations (which are functions of their beliefs about capital needs, risk profiles, intellectual property, etc.) closer to each other in order to get to a quicker settlement.

"The Performance of Johnson Distributions for Computing Value at Risk and Expected Shortfall." The Journal of Derivatives (Fall 2011). Jean-Guy Simonato.

Option pricing plainly depends on the probability distribution of the underlying asset return, at least the portion of the distribution for which the option is in the money. Risk management also depends on the return distribution, but standard risk measures like value at risk (VaR) and expected shortfall (ES) concentrate only on its tails. While the lognormal may be (arguably) adequate for modeling option values, empirically, "risk" is inherently tied up with fat-tailed return processes. This result has led to interest in methods to approximate an unknown distribution by matching its first four moments. The Cornish–Fisher and Gram–Charlier expansions are frequent choices. Simonato argues, however, that these techniques do not actually work very well because the range of densities for which the approximations are valid is quite limited. For example, the density approximation may have negative portions, even when skewness and kurtosis seem quite reasonable. He proposes adopting the Johnson family of densities instead, which also uses four parameters to match the first four moments of an empirical distribution. A simulation study shows that with Johnson distributions, tail fitting is accurate and available over the full range of parameter values.

"How Do Private Equity Investors Create Value?  A Summary of Findings from Ernst & Young's Extensive Research in North America over the Past Four Years." The Journal of Private Equity (Fall 2011). John Vester.

For the past four years, Ernst & Young has conducted in-depth annual surveys in North America on the largest private equity (PE) investment exits, to enable disciplined quantitative analyses for the purpose of identifying the major drivers of investment return. The results have been published and presented regularly in various forums, and each edition of the annual E&Y PE Value Creation Study (as it has become known) delves into new areas of investigation to keep the current findings innovative and fresh. This article presents for the first time a coherent and cumulative summary of the major findings from all of the editions of this substantive PE exit research and analyses over exit years from 2006 to 2009 for the largest PE exits in North America.

"The FTSE StableRisk Indices." The Journal of Index Investing (Fall 2011). Jeremiah H. Chafkin, Andrew W. Lo, and Robert W. Sinnott.

Implicit in most asset-allocation policies is the statistical assumption of "stationarity," which means that the means, variances, and covariances of asset returns are assumed to be constant over time. This assumption is a reasonable approximation during normal market conditions but fails dramatically during periods of market turmoil and dislocation. In such periods, market volatility is highly dynamic, correlations can jump to 100% in a matter of days, and risk premia can become negative for months at a time. FTSE and AlphaSimplex Group have developed a family of rule-driven (passive), transparent, and high-capacity indices whose volatilities are rescaled as often as daily with the goal of maintaining more stable risk levels. By stabilizing the risk of each asset class over time, the FTSE StableRisk Indices have the potential to capture the long-term risk premia of asset classes and simple strategies with less severe maximum drawdowns than those of traditional indices, which have no risk controls.

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Recent Research: Highlights from August 2011

Risk-Based Asset Allocation: A New Answer to an Old Question? The Journal of Portfolio Management (Summer 2011). Wai Lee.

In recent years, we have witnessed an alarmingly large and growing amount of literature on portfolio construction approaches focused on risks and diversification rather than on estimating expected returns. Numerous simulations applied to different universes have been documented in support of these approaches based on their apparent outperformance versus passive market capitalization–weighted or static fixed-weight portfolios. Many studies attribute the better performance of these risk-based asset allocation approaches to superior diversification. Given the absence of clearly defined investment objective functions behind these approaches as well as the metrics used by these studies to evaluate ex post performance, Lee puts these approaches into the same context of mean-variance efficiency in an attempt to understand their theoretical underpinnings. In doing so, he hopes to shed some light on what these approaches attempt to achieve and on the characteristics of the investment universe, if indeed these approaches are meant to approximate mean-variance efficiency. Rather than adding to the already large collection of simulation results, Lee uses some simple examples to compare and contrast the portfolio and risk characteristics of these approaches. He also reiterates that any portfolio which deviates from the market capitalization–weighted portfolio is an active portfolio. He concludes that there is no theory to predict, ex ante, that any of these risk-based approaches should outperform.

Recent Research: Highlights from July 2011

“The Role of Speculators During Times of Financial Distress.” The Journal of Alternative Investments (Summer 2011). Naomi E. Boyd, Jeffrey H. Harris, and Arkadiusz Nowak.

One of the best-known and largest hedge fund failures was the 2006 failure of Amaranth Advisors, LLC. The authors use detailed, trader-level data to examine the role of speculators during times of financial distress—in this case, the failure of Amaranth. They find that speculators served as a stabilizing force during the period by maintaining or increasing long positions, even while prices fell. The authors develop two testable propositions regarding liquidation versus transfer of positions and conclude that the probability of transfer was more likely for distant contract expirations and for contracts more dominantly held by the distressed trader. The article also examines the role of speculators in providing liquidity and mitigating the effects of liquidity risk by evaluating the change in the number of traders, the size and time between trades, and a Herfindahl measure of speculative trader concentration during the crisis period.

Recent Research: Highlights from June 2011

“Futures-Based Commodity ETFs.” The Journal of Index Investing (Summer 2011). Ilan Guedj, Guohua Li, and Craig McCann.

Exchange-traded funds (ETFs) have become popular investments since first introduced in 2004. These funds offer investors a simple way to gain exposure to commodities, which are thought of as an asset class suitable for diversification in investment portfolios and as a hedge against economic downturns. However, returns of futures-based commodity ETFs have deviated significantly from the changes in the prices of their underlying commodities. The pervasive underperformance of futures-based commodity ETFs compared to changes in commodity prices calls into question the usefulness of these ETFs for diversification or hedging. This article examines the sources of the deviation between futures-based commodity ETF returns and the changes in commodity prices using crude oil ETFs. The authors show that the deviation in returns is serially correlated and that a significant portion of this deviation can be predicted by the term structure of the oil futures market. They conclude that only investors sophisticated enough to understand and actively monitor commodity futures market conditions should use these ETFs.

Do CEOs Get Penalized for Reporting Losses?

The decision to replace a CEO is probably one of the most important decisions made by the board of directors. The decision has long-term implications for a firm’s investment, operating, and financing decisions. CEO turnover was around 10% per year during the 1970s and 1980s and 11% in the 1990s. However, between 1992 and 2005, annual CEO turnover jumped to 15%. In the more recent years since 1998, CEO turnover is around 16.5%, implying that the average CEO tenure is just over six years. More importantly, boards have become more sensitive to firm performance and are acting decisively in response to poor performance. Overall, the results suggest that the CEO’s job is more precarious than previously thought.

Recent Research: Highlights from May 2011

“The Clash of the Cultures.” The Journal of Portfolio Management (Spring 2011). John C. Bogle.

During the recent era, the culture of short-term speculation has come to overwhelm the culture of long-term investment. The volume of transaction activity in the secondary financial markets has dwarfed the activity in the primary market where capital formation—once considered to be the principal economic mission of Wall Street—takes place. This change has been driven by many forces, including the institutionalization of stock ownership; the self-interested behavior of the financial agents who now hold 70% of all shares of U.S. stocks; the virtual disappearance of frictional trading costs (largely commissions and taxes); and the focus on the momentary illusion of stock prices rather than the eternal reality of intrinsic corporate values. The shift in the balance of mutual fund culture—from stewardship toward salesmanship—illustrates these trends and their negative impact on investors and on participation in corporate governance. Drawing on the timeless wisdom of Benjamin Graham, John Maynard Keynes, and Henry Kaufman, Bogle provides a range of recommendations that could likely foster the return to a financial system where the culture of speculation plays only a supporting role, with the starring role again played by the culture of investment.

Liquidity Level or Liquidity Risk? Evidence from the Financial Crisis

Although generally considered safe assets, liquid stocks underperformed illiquid stocks during the financial crisis of 2008–2009. The performance of stocks during the crisis can be better explained by their historical liquidity betas (risk) than by their historical liquidity levels. Stocks with different historical liquidity levels did not experience different returns after controlling for liquidity risk. The authors’ findings highlight the importance of accounting for both liquidity level and liquidity risk in risk management applications.

Continue reading "Liquidity Level or Liquidity Risk?" »

Recent Research: Highlights from April 2011

“The Impact of Illiquidity and Higher Moments of Hedge Fund Returns on Their Risk-Adjusted Performance and Diversification Potential.” The Journal of Alternative Investment (Spring 2011). Laurent Cavenaile, Alain Coën, and Georges Hübner.

This article studies the joint impact of smoothing and fat tails on the risk–return properties of hedge fund strategies. First, the authors adjust risk and performance measures for illiquidity and the non-Gaussian distribution of hedge funds returns. They use two risk metrics: the Modified Value-at-Risk and a preference-based measure retrieved from the linear exponential utility function. Second, they revisit the hedge fund diversification effect with these adjustments for illiquidity. Their results report similar fund performance rankings and optimal hedge fund strategy allocations for both adjusted metrics. They also show that the benefits of hedge funds in portfolio diversification persist but tend to weaken after adjustments for illiquidity are made.

Recent Research: Highlights from March 2011

“Capturing Alpha in the Alpha Capture System: Do Trade Ideas Generate Alpha?” The Journal of Investing (Spring 2011). Jean W. Thomas.

In the wake of recent failures of such factors as price momentum and estimate revision to generate excess returns to traditional and quantitative strategies, this study explores the potential for using Trade Ideas as a new source of alpha in long-only and hedge strategies.

Recent Research: Highlights from February 2011

“Policy Portfolios and Rebalancing Behavior.” The Journal of Portfolio Management (Winter 2011). Martin L. Leibowitz and Anthony Bova.

An institutional fund typically has a multi-asset allocation—the policy portfolio—that is maintained over time. When allocations shift, the fund rebalances back to the policy portfolio. The discipline of the policy portfolio has many benefits: simplicity, convenient benchmarking, and a minimum of organizational frictions. Its very routine nature can lead, however, to an overemphasis on relative returns and an insensitivity to fundamental changes in fund status and market structure. In 2003, the late Peter Bernstein questioned whether rigid adherence to the policy portfolio made sense, given frequent market dislocations and high levels of volatility. In this article, Liebowitz and Bova attempt to shed further light on the Bernstein question by analyzing the risk tolerance and return assumptions of a basic two-asset (equity and cash) fund. One key finding is that policy portfolio rebalancing implicitly assumes that the risk tolerance and return premiums remain fixed over time. But few funds have the sponsorship, liquidity, or organizational conviction to keep such a constant risk tolerance in the face of severely adverse markets. One argument for the policy portfolio rebalancing is that assets become “cheaper” after a decline, but this is inconsistent with a constant return premium. Moreover, “cheaper” assets should actually call for rebalancing beyond the original policy portfolio to a more aggressive allocation. One idea for a more pro-active, market-sensitive process is to develop pre-planned contingency actions for various market scenarios.

Recent Research: Highlights from January 2011

“The StressVaR: A New Risk Concept for Extreme Risk and Fund Allocation.” The Journal of Alternative Investments (Winter 2011). Cyril Coste, Raphaël Douady, and Ilija I Zovko.

In this article the authors introduce an approach to risk estimation based on nonlinear factor–models—the “StressVaR” (SVaR). Developed to evaluate the risk of hedge funds, the SVaR appears to be applicable to a wide range of investments. The computation of the StressVaR is a three-step procedure whose main component is to use the fairly short and sparse history of the hedge fund returns to identify relevant risk factors among a very broad set of possible risk sources. This risk profile is obtained by calibrating a polymodel, which is a collection of nonlinear single-factor models, as opposed to a single multi-factor model. The authors then use the risk profile and the very long and rich history of the factors to assess the possible impact of known past crises on the funds, unveiling their hidden risks and so called “black swans.”

Recent Research: Highlights from December 2010

“An Empirical Investigation of the Performance of Commodity-Based Leveraged ETFs.” The Journal of Index Investing (Winter 2010). Robert Murphy.

The authors investigate the ability of 12 commodity-based leveraged ETFs in the ProShares family to achieve their stated investment objectives.They find that these 12 ETFs generate average daily returns that are not statistically significantly different from their stated objectives.They also find evidence that over their entire lives these ETFs generally underperform expectations when considering their exposure (long vs. short), desired leverage, and expense ratios. Despite this general underperformance relative to expectations, the authors also find that roughly 1/3 of the ETFs outperform expectations. They also report that over their entire lives the 12 leveraged ETFs in their sample struggle mightily to beat the performance of their corresponding unlevered commodities or indices. Their general inability to beat their corresponding unlevered commodities or indices over the long run is demonstrated to be a function of the price volatility of the commodities and indices. The authors conclude that these commodity-based leveraged ETFs are effective ways to gain double and double inverse exposure to the corresponding commodities and indices on a daily basis.However, they advise against using these ETFs in any sort of buy-and-hold investment program.

 

Behavioral Finance: Theories and Evidence

That behavioral finance has revolutionized the way we think about investments cannot be denied. But its intellectual appeal may lie in its cross-disciplinary nature, marrying the field of investments with biology and psychology. This literature review discusses the relevant research in each component of what is known collectively as behavioral finance.

Click here to read the full literature review, written by Alistair Byrne, CFA, and Mike Brooks. 

Recent Research: Highlights from November 2010

“Is Patience a Virtue? The Unsentimental Case for the Long View in Evaluating Returns.” The Journal of Portfolio Management (Fall 2010). David L Donoho, Robert A Crenian, and Matthew H Scanlan.

In this article, Donoho, Crenian, and Scanlan report the results of their study into the cost of institutional investor impatience. Using Monte Carlo simulation techniques, the authors construct an idealized world with a universe of investment managers of precisely quantified skill, with skill levels varying among the managers. Although many institutions base manager hiring decisions heavily on the manager’s performance in the most recent months or years, the authors’ simulations show that institutions that rely on longer performance horizons of 5–10 years are more likely to find and stick with the better managers. This happens because on shorter time scales, the relatively few highly skilled managers are often temporarily outperformed by one of the many lesser-skilled managers, specifically, unskilled managers who have recently happened to simply be lucky. Hence, if a plan that previously was long-term oriented starts to hire managers based on short-term results, it will often find that the newly chosen manager underperforms both his own previous performance and also the manager previously managing the plan’s funds. It can, however, truly take patience to keep a skilled manager in a fund portfolio. In the authors’ simulations, skilled managers have deeper, longer, and more frequent drawdowns than many investors would expect.

Recent Research: Highlights from October 2010

“An Examination of Traditional Style Indices.” The Journal of Index Investing (Fall 2010). Jason Hsu, Vitali Kalesnik, and Himanshu Surti.

For investors using a core–satellite approach to strategic asset allocation, traditional style indices, such as value and smallcap indices, represent convenient passive vehicles for achieving strategic or even tactical portfolio tilts. In this article, the authors examine traditional style indices using the Fama–French three-factor analysis. They find that most of the style indices exhibit a negative Fama–French alpha and statistically conclude that traditional style indices are suboptimal means for creating style tilts in portfolios. They posit that the source of the sub-optimality comes from the capweighted construction methodology, which these indices are rooted in and demonstrate that using a simple non-priceweighted approach for creating the style indices would result in more efficient exposures.

Recent Research: Highlights from September 2010

“Are Vanguard’s ETFs Cannibalizing the Firm’s Index Funds?” The Journal of Index Investing (Summer 2010). Anna Agapova.

Existing literature on ETFs and conventional index mutual funds suggests that the two fund types are substitutes for each other in terms of attracting investors’ money. Vanguard is an industry-leading index fund provider that offers both conventional index mutual funds and ETFs. The question is whether Vanguard experiences a substitution effect between its index funds and ETFs to the same degree as is observed in the industry in general. The examination of the substitutability of the two fund types can help explain Vanguard’s decision to offer ETFs that could cannibalize the firm’s existing products. Results of the article show that contrary to the initial expectations, Vanguard’s ETFs and corresponding index funds are not substitutes but rather complements. The flows of ETFs and index funds positively affect each other. Positive spillover effects, such as ETF tax efficiency, may help explain the synergy between Vanguard index products. The results can help fund families take advantage of similar efficiency spillover effects when structuring new products.

Recent Research: Highlights from August 2010

“Celebrating 10 Years of ETFs in Europe.” The Journal of Index Investing (Summer 2010). Deborah Fuhr, Shane Kelly.

This article is a comprehensive report on the history and outlook for the exchange-traded fund industry in Europe. It covers both ETFs and exchange-traded products (ETPs). ETFs are open-end index funds that provide daily portfolio transparency, are listed and traded on exchanges like stocks on a secondary basis, and utilize a unique creation and redemption process for primary transactions. ETPs are products that have similarities to ETFs in the way they trade and settle, but they do not use a mutual fund structure. The use by ETPs of other structures, including grantor trusts, partnerships, notes, and commodity pools, can create different tax and regulatory implications for investors when compared to ETFs.

Recent Research: Highlights from July 2010

"Index Volatility in Perspective" The Journal of Index Investing  (Summer 2010). Joanne M. Hill.

As the number of indexes and index-based investment products expands, it is critical for investors to understand relative index volatility. This article discusses the issues to consider when evaluating index risk and shares insights and data from the author’s recent historical index volatility analysis. The research evaluates the risk of index exposure from multiple perspectives—over time and on a relative basis—and encompasses U.S. equity, global equity, U.S. sector, U.S. Treasury, and select commodity market indexes. Specifically, the author explores how time dimension affects perception and assessment of risk, the cyclicality of volatility measures, patterns that may signal a future shift in risk, how index volatility measures trend compared to index return measures, and how index volatility behaves above and below the median, as well as under increasing levels of risk. Based on this research, the author shares several important insights, including the observation that risk can suddenly shift well above median levels for a given index, and those shifts often occur simultaneously across multiple indexes. As a result, significant short-term value changes may occur if portfolios are not modified to reduce risk when the inherent volatility of indexes rises. Alternatively, heightened risk may also present tactical investment opportunities for investors who have an ability to anticipate directional index moves.

Safe House: The Housing Market and the End of the Recession

A great deal of attention has recently been devoted to examining trends in the housing market and to predicting possible outcomes of the recession. If housing is at the center of the current storm, how soon will recovery in this sector offer the rest of the economy some shelter from the nasty weather? Inevitably, stabilization in the real estate market has to be achieved through reestablishing the broken link between real values and market prices.

Recent Research: Highlights from June 2010

"A Valuation Study of Stock Market Seasonality and the Size Effect." The Journal of Portfolio Management, Spring 2010. Zhiwu Chen and Jan Jindra.

Existing studies on market seasonality and the size effect are largely based on realized returns. In this article, Chen and Jindra investigate seasonal variations and size-related differences in a cross-stock valuation distribution. They use three stock valuation measures, two derived from structural models and one from the book-to-market ratio. The authors find that the average valuation level is highest in mid-summer and lowest in mid-December. Furthermore, the valuation dispersion (kurtosis) across stocks increases toward year-end and reverses direction after the turn of the year, suggesting increased movements in both the underand overvaluation directions. Among size groups, small-cap stocks exhibit the sharpest decline in valuation from June to December and the highest rise from December to January. For most months, small-cap stocks have the lowest valuation among all size groups and show the widest cross-stock valuation dispersion, meaning that they are also the hardest to value. Overall, large-cap stocks enjoy the highest valuation uniformity and are the least subject to valuation seasonality. 

Recent Research: Highlights from May 2010

"Risk Management Lessons Worth Remembering from the Credit Crisis of 2007–2009"
The Journal of Portfolio Management (Summer 2010). Bennett W. Golub and Conan C. Crum.

This article by Golub and Crum presents six important lessons worth remembering from the credit crisis of 2007–2009.The recent credit crisis revealed the inadequacy of many standard methods in quantitative risk management and called into question the general efficiency of markets. Golub and Crum’s analysis of the six lessons learned provides insights into what went wrong and offers advice on steps that institutions can take to avoid similar failures in the future.The authors present detailed analysis on risk management issues relating to liquidity, securitized products, certification,market risk, and policy risk. 

Research Overview: Cornelia Betsch's Preference for Intuition or Deliberation Scale

Recent work by Cornelia Betsch (Center for Empirical Research in Economics and Behavioral Sciences—CEREB, University of Erfurt, Nordhaeuser Strasse 63, D-99089, Erfurt, Germany) suggests some interesting findings regarding strategies used to make a choice. Several key points of this research are as follows.

Research Overview: Phantastic Objects and the Financial Market’s Sense of Reality

David Tuckett and Richard Taffler have an interesting paper recently published in the International Journal of Psychoanalysis entitled “Phantastic Objects and the Financial Market’s Sense of Reality: A Psychoanalytic Contribution to the Understanding of Stock Market Instability.” The article suggests that in the context of uncertainty and ambiguity, emotions and states of mind determine the way information about reality is processed. Three questions are posed as follows: