Active Portfolio Management Research Articles

Information Coefficient: From a New Perspective

IC (Information Coefficient) is a widely and deeply accepted measure in active portfolio management.This paper investigates its probability properties that requires basic and in-depth research. First, this paper brings a new perspective on IC: a linear operator of a random unit vector generated by projecting returns onto a unit sphere. The new definition distinguishes IC from correlation coefficients or common statistics like t-statistics. Second, we theoretically solve the maximization of IC in expectation, and specify its almost closed-form solution with directional statistics. Third, simulation analysis reveals the influence of market condition like the stock number on IC, and emphasizes the difference between the optimal solutions and the population mean of returns. Last, empirical studies on Chinese stock market present a set of facts emerging from the unit transformed vectors of cross-sectional returns, and obtain the time series of IC in the real market with rolling windows. Our research profoundly reveals the nature of IC and sharply deepens the understanding of active portfolio management. Both the methodology and empirical study on IC suggest great potential in its further research.

ACTIVE MANAGEMENT: WHAT DIFFERENT STORY MEASURES TELL US IN BRAZIL?

This paper extends the debate about the evaluating the active portfolio management in order to guide academics and practitioners undertaking researches about the contribution of active management on the performance in equity mutual funds in the Brazilian market. We present a comparison between two measures of active management: Churn Rate and Active Share. Using five year-data set covering the Brazilian equity mutual funds, between 2007 and 2011, we estimate econometric models to find the relation between active management and performance. The results evidence that Churn Rate presents a negative relationship to performance, while the Active Share has a positive effect for the same period. Based on our results we can state that a combined-measure analysis can lead us to a better understanding about the type of active management that the manager is involved, avoiding misleading interpretation about the role of each strategy on the portfolio performance.

Do all clean energy stocks respond homogeneously to oil price?

This paper investigates whether the relationship between oil price and clean energy stock is homogeneous across sub-sectors of the clean energy stock market and its implications for portfolio diversification and clean energy finance policy. We contribute to the literature by being the first empirical paper to document the oil price-clean energy stock relationship at a disaggregate level, thereby providing a more detailed picture of the clean energy stock market. Our findings show that the relationship between oil price and clean energy stock varies largely across clean energy stock sub-sectors. Specifically, biofuel and energy management stocks are the most connected to oil price, while wind, geothermal, fuel cell stocks are among the least connected to oil price. This implies that the hedging cost and effectiveness of a clean energy investment portfolio is dependent on the type of clean energy stock included, therefore, active portfolio management at a disaggregate level is of particular importance. Additionally, policy should take into account the specific characteristics of individual clean energy sub-sectors in order to effectively promote clean energy investment.

Are pension funds actively decarbonizing their portfolios?

We study whether investors are actively decarbonizing their portfolios. With the adoption of the Paris Agreement in December 2015, a better understanding of portfolio related carbon dioxide (CO2) exposures has become increasingly important for investors, regulators and society at large. Carbon-intensive stocks still carry a substantial weight in common market benchmarks. We analyze if investors are actively divesting by deviating from market benchmark allocations to reduce carbon exposures. We utilize a stock-level holdings dataset of Dutch pension funds over the period 2009–2017 and combine this with firm-level CO2 emissions information to measure the portfolio carbon footprint and active portfolio management. We find that pension funds that deviate from market benchmark weights have substantially lower carbon footprints. This effect is mostly driven by reduced exposures to carbon-intensive industries and is larger for pension funds that measure and report their carbon footprints. We find no evidence that deviations from the market benchmark impair risk-adjusted portfolio performance.

Quantifying the Maximum Worth of Portfolio Management in a Multi-Period Setting

In this paper we present an approach to quantify the maximum worth of active portfolio management in a multi-period setting. This methodology estimates a hindsight upper bound on active management fees. The methodology is demonstrated in an empirical study for the Energy industry. In this study the BHCM derivative instrument considerably outperforms all other investment opportunities considered, net of management fees. The dominance of the BHCM derivative, net of management fees, is potentially sufficient to offset other investment and trading expenses. This suggests that the BHCM derivative could in fact be the optimal choice for the investor, rather than standard active or passive funds.

Active Portfolio Management with Conditioning Information

In this article, the authors propose an efficient and practical portfolio management methodology in which portfolio weights are determined by several market observations. Their method is based on the managed portfolio construction technique, which makes it tractable for fund managers. The key points of this work are as follows: (i) to impose constraints on active weights against the prespecified benchmark weights, and (ii) to show empirically that the constraints stabilize and improve portfolio performance by conducting backtests.

Can Small-Cap Active Funds Substantially Outperform the Market Over Time?

The Efficient Market Hypothesis (EMF) persist that active management is useless and that investors should rather adopt a passive investment strategy that is less expensive and less risky. However, several previous pieces of literature in the small-cap industry contrast this point of view. This paper investigates the risk and performance of small-cap equity funds in the USA markets over a ten-year period of 2009-2018. The study period is segmented into sub-investment horizons and the funds sampled are split by group of investment style. Our findings are twofold. Firstly, in contrary to the Efficiency Market Hypothesis (EMF) the size effect in small-stock markets could indeed be a proxy of outperformance for active managers. Given that, top performers are observed among active growth funds. Secondly, surprisingly the great majority of funds selected have managed to gradually generate a positive alpha meaning that active management is not always pointless. Therefore, 56.67% of the whole sample has delivered consecutive excess returns over the three investment horizons and each fund within each investment style has outperformed the market at least once. The two last observations support partially the Efficiency Market Hypothesis (EMF) in the way that not all active funds were able to generate a persistent abnormal return over the long term and that some active portfolio managers could be just lucky in picking up stocks.

How efficient is the Johannesburg Stock Exchange really?

Background: There are various studies that confirm the efficiency of the Johannesburg Stock Exchange (JSE), implying that there are no opportunities for active portfolio managers to earn excess returns over the long run.Aim: The aim of the research is to prove that the sub-indices on the JSE go through cycles of efficiency and inefficiency even though the JSE as a whole might be considered informationally efficient.Setting: Although the JSE as a whole can be considered to be weak-form efficient, portfolio managers are not bound to investing in large liquid stocks alone. Many aggressive funds allow managers to also allocate a portion of their portfolio to smaller stocks. This has implications when considering the efficiency of the stocks being selected.Methods: Given the impact efficiency has on portfolio selection, we test for the adaptive market hypothesis using a representative sample of stock indices by means of the automatic variance ratio test, the Chow–Denning joint variance ratio and the joint sign test on the JSE.Results: Our results confirm that some of the smaller, and in some instances younger, indices are not always as efficient as the all share index, thus allowing portfolio managers with an active management approach some opportunities to profit from informational inefficiencies in the market.Conclusion: The practice of active management by portfolio managers in the South African market seems to defy logic if one considers the fact that the JSE as a whole is at the very least weak-form efficient. By proving that some of the sub-indices that make up the all share index are inefficient most of the time, this article shows that the phenomenon of active portfolio managers is less of a surprise.

The Decline of Informed Trading in the Equity and Options Markets

Reliable excess returns from active portfolio management derive from informed trading. This article investigates the information content of informed trading in the equity market and the options market. The authors find that informed equity trading and options trading are positively correlated in the time series but virtually uncorrelated cross sectionally. Portfolio-level and stock-level analyses provide robust evidence that the cross-sectional return predictive power of informed trading in each market is distinct. Time-series analyses indicate that aggregate informed options trading is useful for predicting market returns but that the amount of informed trading has declined significantly in more recent years. The time-series patterns of both informed trading measures coincide closely with the decline in equity hedge fund excess returns.

The contribution of market movements, asset allocation and active management to Islamic equity funds’ performance

Where the performance of Islamic equity funds (IEFs) comes from? Is it from market movements, asset allocation policy or from active portfolio management? Our study is the first to tackle this question in the Islamic funds context. We use a database covering 281 IEFs for the period 2007-2016, and we test the role of each factor in explaining their returns. We find that market movements dominate the others components explaining nearly 50% of the monthly return variability and that, taking together, asset allocation policy and active management explain approximately the second half of IEFs returns. We argue that the IEFs underperformance observed by the existing literature could come from an inefficient and too important active portfolio management.

Portfolio selection with the effect of systematic risk diversification: formulation and accelerated gradient algorithm

In this paper, we propose an optimal trade-off model for portfolio selection with the effect of systematic risk diversification, measured by the maximum marginal systematic risk of all the risk contributors. First, the classical portfolio selection model with constraints on allocation of systematic risk is shown to be equivalent to our trade-off model under certain conditions. Then, we transform the trade-off model into a special non-convex and non-smooth composite problem equivalently. Thus a modified accelerated gradient (AG) algorithm can be introduced to solve the composite problem. The efficiency of the algorithm for solving the composite problem is demonstrated by theoretical results on both the convergence rate and the iteration complexity bound. Finally, empirical analysis demonstrates that the proposed model is a preferred tool for active portfolio risk management when compared with the existing models. We also carry out a series of numerical experiments to compare the performance of the modified AG algorithm with the other three first-order algorithms.

BV–VPIN: Measuring the impact of order flow toxicity and liquidity on international equity markets

Order flow is the measure of a trader's exposure to the risk that counterparties possess private information or other informational advantages. High levels of order flow can culminate in market makers providing liquidity at a loss or in the suboptimal execution of trades. From a regulatory perspective, high levels of can be harmful to overall market liquidity and precede precipitous drops in asset prices. The bulk volume-volume-synchronized probability of informed trading (BV-VPIN) model is one way of measuring the toxicity component of order flow, and it has been successfully applied in high-frequency trading environments. We apply the BV-VPIN to daily data from a range of international indexes in order to extend previous analyses of its properties. We find that a rise in BV-VPIN effectively foreshadows high levels of volatility in the equity indexes of several countries. If a BV-VPIN futures contract were to exist, we show that it would exhibit safe haven characteristics during market downturns. In particular, a simple active portfolio management strategy that times investments in equities (risk-free assets) when BV-VPIN levels are low (high) outperforms a buy-and-hold strategy. Thus, we find support for the application of BV-VPIN in international equity markets as a risk monitoring and management tool for portfolio managers and regulators.

Why Do Mutual Funds Hold Cash?

We examine the role of cash in a parsimonious model of active portfolio management with performance-driven capital flows and transaction costs. We argue that redemptions following bad performance pose no dilution risk to remaining investors and what appears to be liquidity management by mutual funds is managers collecting rent. Bad performance is a negative signal about a manager and reduces the optimal fund size. Liquidations of illiquid assets to satisfy performance-driven redemptions are efficient and do not justify regulatory interventions. Accommodating redemptions with cash only, as managers with performance-sensitive compensation do, amplifies outflows and destabilizes the fund.

Accounting for Bond Market Illiquidity: Causal Tests of One Provision's Constraining Effects on Banks' Fixed Income Market Making

Banks increased held-to-maturity (HTM) classifications over 500% between 2010 and 2016 to protect capital ratios from Basel III's expanded marking to market of fixed income portfolios. Accounting rules prohibit the sale of HTM securities, imbedding a tradeoff between regulatory capital stability and active portfolio management into every classification decision. I document a crowding out of dealer inventories as banks withdraw capital from market making subsidiaries to fund growing HTM portfolios. Ultimately, market liquidity worsens for securities most frequently classified as HTM. Alternative regulations are ruled out through analyses of treated and control banks, dealers, asset classes and mortgage-backed securities.

Dynamics of Indian Foreign Exchange Market Efficiency : An Adaptive Market Hypothesis Approach

Adaptive market hypothesis (AMH), a recent evolution in the field of finance, advocates that market efficiency is a time-variant element. In the present study, we empirically verified the time-varying degrees of market efficiency as per the propositions of AMH in the Indian foreign exchange market, which is assumed to provide an evolutionary alternative to the efficient market hypothesis (EMH). For the purpose, we used daily bilateral exchange rate between Indian rupee/United States dollar from January 1999 to December 2015. Statistical tests with linear and nonlinear approaches and better power properties unlike previous studies were used to trace the market efficiency. All tests employed unanimously supported time-varying nature of efficiency in foreign exchange returns, which adhere to the premise of AMH. The findings of the study confirmed market efficiency as an element which evolves with different market conditions, and thereby suggested for adoption of active portfolio management strategies for currency traders.

Using genetic algorithm to support clustering-based portfolio optimization by investor information

A clustering-based portfolio optimization scheme that employs a genetic algorithm (GA) based on investor information for active portfolio management is presented. Whereas numerous studies have investigated trading behaviors, investor performance, and portfolio investment strategies, few works have developed investment strategies based on investor information. This study is conducted in two phases. First, a basket of portfolio (i.e., a collection of stocks held in individual portfolios) is developed through a cluster analysis of investor information. A GA is then employed to optimize the weights of the selected stocks. And the optimized portfolio is rebalanced to get excess return. It is concluded that the proposed multistage portfolio optimization scheme for active portfolio management generates superior results than previously proposed methods for the Korean stock market.

The EVA Style Approach to Tactical Asset Allocation

We refine tactical asset allocation (TAA) by arguing that the equity style component of a TAA strategy should distinguish between—and rotate among—predefined value creators and value destroyers in the marketplace. We assess equity style in the context of an economic profit approach to securities analysis and active portfolio management. We illustrate TAA in the context of an economic value added style analysis, and we demonstrate both the macroeconomic aspects and cyclicality of economic profit and its equity rotational implications for TAA. We conclude with a look at some well-known value creators and value destroyers, as well as known market anomalies that can also drive an economic profit approach to TAA and active portfolio management.

Portfolio diversification in the sovereign credit swap markets

We develop models for portfolio diversification in the sovereign credit default swaps (CDS) markets and show that, despite literature findings that sovereign CDS spreads are affected by global factors, there is sufficient idiosyncratic risk to be diversified. However, we identify regime switching in the times series of CDS spreads and spread returns, and the optimal diversified strategies can be regime dependent. The developed models trade off the CVaR risk measure against expected return, consistently with the statistical properties of spreads. We consider three investment strategies suited for different CDS market participants: for investors with long positions, speculators that hold uncovered long and short positions, and hedgers with covered long and short exposures. We use the models to illustrate that diversification pays in the CDS market. The models are also tested for active portfolio management in Eurozone core and periphery, and Central, Eastern and South-Eastern Europe countries, and the optimized portfolio results outperform the broad S&P/ISDA Eurozone Developed Nation Sovereign CDS index. The paper concludes by identifying open questions in developing integrated enterprise-wide risk management models using CDS.

The Tale of Two Irrationalities: Why Money Managers Keep Promising What They Cannot Deliver and Why Clients Keep Giving Them Their Money

It appears intuitively plausible that actively managed funds by investment professionals should do better than a naive strategy of buying a market index, which any uninformed person can do at much lower cost than paying a professional manager. However, the evidence points to the contrary: professional managers are not able to beat the index consistently and investors do not cease to patronize the services of those money managers. This paper reviews the overwhelming evidence that average investors engaged in passive indexing can do much better using the naive approach on their own than soliciting the help of professional active portfolio managers. After questioning the ethics of charging fees for active management only to yield below average results, we examine some of the traditional explanations of this enigma. We then offer some behavioral explanations as to why this problem has persisted in the market for so long and discuss some possible behavioral-based policy prescriptions that may help to rectify this apparent market dysfunction.

Multifractal analysis of Moroccan family business stock returns

In this paper, long-range temporal correlations at different scales in Moroccan family business stock returns are investigated. For comparison purpose, presence of multifractality is also investigated in Casablanca Stock Exchange (CSE) major indices: MASI which is the all shares index and MADEX which is the index of most liquid shares. It is found that return series of both family business companies and major stock market indices show strong evidence of multifractality. In particular, empirical results reveal that short (long) fluctuations in family business stock returns are less (more) persistent (anti-persistent) than short fluctuations in market indices. In addition, both serial correlation and distribution characteristics significantly influence the strength of the multifractal spectrums of CSE and family business stocks returns. Furthermore, results from multifractal spectrum analysis suggest that family business stocks are less risky. Thus, such differences in price dynamics could be exploited by investors and forecasters in active portfolio management.