Investment Universe Research Articles

Advancing Strategic Asset Allocation in aMulti-Factor World

Strategic asset allocation is arguably one of the most important, yet least advanced, aspects of investing. The authors present a new approach to strategic asset allocation that leverages the idea that long-term investment returns derive from multiple distinct sources that they call “return-generating factors.” Their approach addresses four key shortcomings of traditional approaches: First, their multi-factor model helps better understand the important sources of return in today’s complex investment universe, generating a substantial increase in estimation precision across asset classes and providing investors with a new way to think about portfolio diversification. Second, their robust portfolio optimization methodology seeks to explicitly account for the uncertainties inherent in the estimates of expected returns, delivering well-diversified portfolios with superior risk?return characteristics. Third, the factor-based risk analytics better capture the true characteristics of asset returns, such as fat tails and increased correlations at times of crises, allowing the authors to more-accurately model the downside risks of portfolios. Finally, the factor-based simulation technique accounts for the impact of different economic conditions (e.g., low interest rates) on future portfolio returns, resulting in more-precise, forward-looking projections.

A Model-Based Approach to Constructing Corporate Bond Portfolios

The authors develop a model-based approach for constructing investment-grade and high-yield corporate bond portfolios that outperforms their respective prevalent benchmark indices and popular exchange-traded funds (ETFs), with better risk–return profiles—that is, higher returns with lower or similar risk. More importantly, they obtain outperformance after controlling for credit risk, duration risk, and downside risk. The outperformance is robust across a number of different specifications of the strategy and over time. The authors also achieve outperformance by using relatively smaller, more realistic portfolios. These model portfolios can be potentially converted into new fixed-income indices or ETFs. Their model-based approach uses Moody’s Analytics’ EDF™ (expected default frequency) credit measures and the fair-value spread (FVS) valuation framework as powerful tools to control for credit risk and to exploit relative value in the bond market. To make our approach realistic and operational, we compile our investment universe from the Merrill Lynch Corporate Master Indices by applying a number of filtering criteria to our bond selection rules. We assess our model portfolios’ performance relative to Merrill Lynch (ML) and iBoxx indices, the two most widely-used fixed income portfolio benchmarks. To obtain a closer measure of the actual returns investors can achieve, we also compare results to the popular fixed-income Exchange Traded Funds (iShares ETFs) that focus on corporate credit. Additionally, we compare performance relative to the actively managed mutual fund universe, the respective U.S. fixed core fund universe. Our analyses factor in transaction costs.

Managing Risks in a Risk-On/Risk-Off Environment

Every structure has natural frequencies. Minor shocks in these frequencies can bring down any structure, e.g. a bridge. An Investment Universe also has natural frequencies, characterized by its eigenvectors. A concentration of risks in the direction of any such eigenvector exposes a portfolio to the possibility of greater than expected losses (indeed, maximum risk for that portfolio size), even if that portfolio is below the risk limits. This is particularly dangerous in a risk-on/risk-off regime. Managing Risk is not only about limiting its amount, but also controlling how this amount is concentrated around the natural frequencies of the investment universe.

Sample tangency portfolio, representativeness and ambiguity: impact of the law of small numbers

We provide a model for understanding the impact of the sample size neglect when an investor, hoping for the tangency portfolio uses the sample estimator of the covariance matrix for this purpose. By assuming a wrong hypothesis, we are looking for a family of covariance matrices such as their difference in terms of the utility function with the sample one is a decreasing function of the latter under a wrong hypothesis regarding the market structure of returns. This approach allows us to characterize the ambiguity of investor reliance on the Sharpe model (the most, the less and the relative ambiguous investors), and to compute a covariance matrix characterizing each ambiguity profile. We show that the expected loss is better for the most ambiguous, than for the relative ambiguous which is better than the one obtained from the less ambiguous profiles. However, they are all better than the sample covariance matrix. We show how the relative profile denotes actually an equilibrium state between the two extreme cases, and may be viewed as a multi-criteria maxmin approach. We show that ambiguity comes actually from the finite sample property of the investment universe and follows a power law distribution. We also derive an analytical expression of the risk aversion coming from the sample size neglect.

Sovereign Default Concentration Risk Mitigationin Global Bond Indices

This article reviews the fundamental shift in the market perception of risk factors in fixed-income investments. The sovereign spread risk has increased substantially in recent years and contributes an even bigger portion than corporate credit spread in some investment universes, like euro treasury fixed-income indices. The major drivers of sovereign spread include economic and financial systematic factors and issuer-specific solvency factors. The concentration of sovereign risk has become a critical concern to the investors in the investment of global treasury securities. This article reports major testing results using an in-house intensity-based sovereign default risk model. The model has been used to evaluate the diversification effect of weighting mechanisms using GDP and fiscal strength as risk indicators. <b>TOPICS:</b>Fixed-income portfolio management, VAR and use of alternative risk measures of trading risk, global

Portfolio Complexity and Herd Behavior: Evidence from the German Mutual Fund Market

Summary/Zusammenfassung Portfolio Complexity and Herd Behavior: Evidence from the German Mutual Fund Market We examine the herd behavior among equity funds in Germany based on a large sample of funds from 2000 to 2009. We show that a large portion of the detected herding can be explained by identical trading among funds of the same investment company. However, we also find statistically significant stock herding among funds belonging to different fund families. In contrast to existing herding studies which analyze herd behavior within a purely national stock environment, we investigate mutual fund herding in international stocks. We contribute to the literature by analyzing the impact of portfolio complexity on herd behavior. We find the most pronounced levels of herding for funds choosing their portfolio stocks from a broad, international and therefore complex investment universe. Further, we approximate a fund's portfolio complexity by its size and find high levels of herding among the biggest funds. To...

Exploiting Option Information in the Equity Market

Public option market information contains exploitable information for equity investors for an investable universe of liquid large-cap stocks. Strategies based on several option measures predict returns and alphas on the underlying stock. Transaction costs are an important factor given the high turnover of these strategies, but significant net alphas can be obtained when using a simple approach that reduces transaction costs. These findings suggest that information diffuses gradually from the option market into the underlying stock market.

Scenario-based dynamic corporate bond portfolio management

The 2008 credit crisis has deeply affected the price of corporate liabilities in both equity and fixed income secondary markets leading to unprecedented portfolio losses by financial investors. A coordinated intervention by monetary institutions limited the systemic consequences of the crisis, without, however, avoiding a significant fall of corporate bond prices across international markets. In this article, we analyse alternative portfolio optimization approaches in the fixed income market over the 2008–2009 period, a time in which credit derivative markets became very illiquid. All policies are analysed relying on a unique set of market and credit scenarios generated by common and idiosyncratic risk factors on an extended investment universe. The crisis provides an interesting test period to analyse in particular the potential of dynamic versus static portfolio selection approaches. We also consider dynamic portfolio strategies based on multistage stochastic programming versus policy rule-based methods and analyse their relative performance against a corporate bond index widely adopted in practice as a market benchmark.

Optimal Investment in Structured Bonds

Retail structured products regularly receive much criticism from financial experts but seem to remain popular with investors. This article considers a generic structured product: the principal-protected indexlinked note (structured bond), which resembles a portfolio insurance contract. The purpose of the article is to provide possible explanations for the puzzle of why small retail investors hold structured bonds. The investment universe consists of a stock index, a risk-free bank account, and a structured bond containing an option written on another index. We apply expected utility maximization and consider different utility functions and trading strategies. Our results show that investors should include structured bonds in their optimal portfolio only if they cannot access the index underlying the option directly and only if the products then provide sufficient diversification to compensate for their costs.

Investment choice and performance potential in the mutual fund industry

This article investigates the performance potential of a set of three investment choices: multi-asset, multi-management and multi-instrument. These approaches have been used recently in the asset management industry to give investors access to an extended investment universe, and to provide higher risk-adjusted returns to clients. In this context, we evaluate each investment choice's overall contribution to portfolio performance. Using bootstrapping simulations and a set of performance measures over a 20-year sample, we show that (1) extending the typical equity- and bond-focused fund to a set of five asset classes increases the Sharpe ratio by 50 per cent on average; (2) allowing for third-party funds in a client's portfolio significantly reduces company-specific risk; and (3) including single assets leads to an increased return potential for skilled portfolio managers. Thus, our empirical results suggest that investments in actively managed mutual funds are likely to benefit significantly from these multi-investment approaches, and that the current practice of providing investors with balanced in-house funds is suboptimal.

The Long-Term Performance of a Social Investment Universe

The Long-Term Performance of a Social Investment Universe

The Sustainability of Mean-Variance and Mean-Tracking Error Efficient Portfolios

In recent years, the market share of socially responsible investment funds has rapidly increased. This has sparked interest of academics and practitioners for the impact of single stock sustainability screening on portfolio performance. Besides eliminating non sustainable assets from the investment universe, a socially responsible investor also cares about the average level of portfolio sustainability. We provide a characterization of the sustainability of mean-variance and mean-tracking error efficient portfolios and derive the impact on performance of imposing a constraint on the portfolio sustainability. Over the period 2003-2010, we find that for the universe of US stocks belonging to the MSCI World index, the theoretically linear relationship between the portfolio return and sustainability of the efficient portfolios is not significant. Furthermore, we estimate the increase in variance (for a given target return) and the loss in return (for a given target variance) due to a sustainability constraint and find that the performance loss is economically small.

Return-based style analysis of domestic targeted absolute and real return unit trust funds in South Africa

By means of return-based style analysis (RBSA), heterogeneous style sub-categories were identified within the targeted absolute and real return (TARR) category of the South African unit trust market to create a framework for sub-categorisation. The study dealt with TARR funds and their place within the investment universe. The literature review emphasised the importance of asset allocation, which supports the use of RBSA to identify asset allocation and further provided a motivation for the semi-strong form of RBSA applied to the sample data. The findings suggest that in general, return-based style analysis applied to each fund identifies the asset allocation for the fund and is valid and that the collective results of return-based style analysis applied to the funds can be used to create a framework for sub-categorisation

Asset liability management for individual households

AbstractPersonal finance is a challenging topic which can benefit from a scientific approach to individual financial planning. This paper presents an individual asset liability management (iALM) model for life cycle planning which uses the methodology of dynamic stochastic optimisation and incorporates ideas from both classical and behavioural finance. Its implementation is in the form of a decision support tool for use by financial advisers or wealth managers. The investment universe is given by a set of indices for major asset classes and their returns are simulated forward over the lifetime of a household. On the liability side the foreseen cash flows of incomes and outgoings are simulated and punctuated by life events such as illness and death. The household's utility function is constructed for each time period over a range of monetary values in terms of household financial goals and preferences. Taxes and pension savings are treated using the tax shielded saving accounts specific to a national jurisdiction in terms of constraints in the optimisation sub-models. The paper goes on to present an analysis ofiALM model recommendations for a representative UK household, together with an evaluation of the sensitivity of the financial plan generated to changes in market environments such as the 2007–9 crisis. The promise of this new technology is to bring modern decision support tools to individual investors in order to facilitate custom designed consumption, savings and investment policies.

Are Capital Markets Inefficient on a Macro Level?

Samuelson’s dictum (1998) states that capital markets are “macro inefficient”. If this conjecture is true, returns should be partially predictable across different asset classes. We test for the predictability of returns on an asset class level by exploiting the advantageous features of the parametric portfolio policy approach proposed by Brandt, Santa-Clara and Valkanov (2009). We apply the parametric portfolio policy framework in a multi asset investment universe and perform a number of robustness checks such as varying the degree of risk aversion, conducting out-of-sample analyses and including transaction costs. Our results demonstrate that the parametric portfolio policy approach generates positive excess returns after costs in an out-of-sample setting by parameterizing the asset weights as a function of the assets’ value and momentum characteristics. The optimal strategy is a combination of value and momentum investing and depends on the risk aversion of investors. Risk-averse investors benefit from focusing on value investing, while our results advise risk-seeking investors to favor momentum investing. Overall, our analysis indicates that capital markets are inefficient on a macro level.

Chasing contractual cash flows

This article argues that pension funds need to re-evaluate how they invest in fixed income assets. The industry is currently heavily focused on reducing investment risk through benchmark investing. However, benchmarks may not offer investors a sensible level of risk, especially in fixed income markets where exposures may increase as companies borrow more, and therefore become riskier. Pension funds should look at their investment universe and make sure that they include fixed income assets that contractually provide them with the type of cash flows that they require to meet their liabilities. Long lease property is one such example.

The Long-Term Performance of a Social Investment Universe

This article presents a multi-decade, holdings-based attribution analysis of a U.S. social investment index. This analysis finds that differences between the index’s returns and those of the S&amp;P 500 Index are fully explained by conventional investment factors. This is true for the full time period under study as well as for two subperiods (January 1992–November 1999 and December 1999–June 2010) that coincide with periods of nominal outperformance and underperformance by the index. The authors find that unexplained returns are not statistically different from zero in either the full time period or in either of the two subperiods. This is beneficial for investors motivated by social values because it suggests that the risk exposures created by social screens can be managed through careful portfolio construction. It is less encouraging for investors seeking a performance advantage through the use of social or environmental factors—the analysis suggests that, for this universe at least, market valuations already correctly incorporate this information. <b>TOPICS:</b>ESG investing, mutual funds/passive investing/indexing, equity portfolio management

Risk-Based Asset Allocation: A New Answer to anOld Question?

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.

Risk Parity Portfolio vs. Other Asset Allocation Heuristic Portfolios

In this article, the authors conduct a horse race between representative risk parity portfolios and other asset allocation strategies, including equal weighting, minimum variance, mean–variance optimization, and the classic 60/40 equity/ bond portfolio. They find that the traditional risk parity portfolio construction does not consistently outperform (in terms of risk-adjusted return) equal weighting or a model pension fund portfolio anchored to the 60/40 equity/bond portfolio structure. However, it does significantly outperform such optimized allocation strategies as minimum variance and mean–variance efficient portfolios. Over the last 30 years, the Sharpe ratios of the risk parity and the equal-weighting portfolios have been much more stable across decade-long subperiods than either the 60/40 portfolio or the optimized portfolios. Although risk parity performs on par with equal weighting, it does provide better diversification in terms of risk allocation and thus warrants further consideration as an asset allocation strategy. The authors show, however, that the performance of the risk parity strategy can be highly dependent on the investment universe. Thus, to execute risk parity successfully, the careful selection of asset classes is critical, which, for the time being, remains an art rather than a formulaic exercise based on theory. <b>TOPICS:</b>Portfolio management/multi-asset allocation, quantitative methods, volatility measures

Feasible momentum strategies in the US stock market

Although there is a large literature documenting the profitability of momentum strategies, their implementation is afflicted with many difficulties. Most importantly, high turnover and costs to hold short positions, especially in small-cap stocks, result in high transaction costs. We restrict our investment universe to large-capitalized stocks included in the Standard and Poor's (S&P) 100 index. Moreover, we implement simple investment strategies that invest long in single stocks and short in the stock index. Such simple and cost-saving momentum strategies generate economically high and statistically significant abnormal returns. These results are robust to various risk-adjustments including the CAPM, the Fama–French (1993) three-factor model, and a conditional version of the Fama and French (1993) three-factor model.