Lower Risk-adjusted Returns Research Articles

Embedded Leverage

Abstract Many financial instruments are designed with embedded leverage, such as options and leveraged exchange-traded funds (ETFs). Embedded leverage alleviates investors’ leverage constraints, and, therefore, we hypothesize that embedded leverage lowers required returns. Consistent with this hypothesis, we find empirically that options and leveraged ETFs provide significant amounts of embedded leverage; this embedded leverage increases return volatility in proportion to the embedded leverage; and higher embedded leverage is associated with lower risk-adjusted returns. The results are statistically and economically significant, and we provide extensive robustness tests and discuss the broader implications of embedded leverage for financial economics. (JEL G02, G11, G12, G13, G14, G20)

Chasing the Beta, Losing the Alpha

In this paper, we tackle the Beta anomaly, namely the fact that high-Beta assets tend to be associated with lower risk-adjusted returns than low-Beta assets, and connect it to mutual funds' expectations. We present a model with two types of investors, mutual funds and hedge funds, with heterogeneous market expectations and margin constraints. We show that the Beta anomaly is especially present for stocks purchased by over-optimistic mutual funds. On the empirical side, we first introduce a mutual fund-level measure of market expectations. Then, portfolio analyses and regressions confirm the model's prediction. The results are robust to alternative definitions of the mutual funds’ market beliefs variable that correct for stock picking, and carry predictive power for mutual funds' returns.

The Long-Lasting Effects of Living under Communism on Attitudes towards Financial Markets

We analyze the long-term effects of living under communism and its anticapitalist doctrine on households’ financial investment decisions and attitudes towards financial markets. Utilizing comprehensive German brokerage data and bank data, we show that, decades after Reunification, East Germans still invest significantly less in the stock market than West Germans. Consistent with communist friends-and-foes propaganda, East Germans are more likely to hold stocks of companies from communist countries (China, Russia, Vietnam) and of state-owned companies, and are unlikely to invest in American companies and the financial industry. Effects are stronger for individuals exposed to positive “emotional tagging,” e.g., those living in celebrated showcase cities. Effects reverse for individuals with negative experiences, e.g., environmental pollution, religious oppression, or lack of (Western) TV entertainment. Election years trigger further divergence of East and West Germans. We provide evidence of negative welfare consequences due to less diversified portfolios, higher-fee products, and lower risk-adjusted returns. Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

Carbon Risk Integration with Factors

Integration of carbon risks into the investment process requires careful analysis of risk–return characteristics and factor exposures of resulting carbon-efficient portfolios. In this article, we propose a stylized framework to integrate traditional style factors with carbon-efficient portfolios for both U.S and developed Europe markets. The results show that although carbon-efficient factor portfolios do achieve the objective of lowering carbon intensity, they generally have lower risk-adjusted returns than the pure factor portfolios. In addition, carbon-efficient factor portfolios have lower exposure to the targeted factors, and the reductions in factor exposure are statistically significant.

Following the Followers: Mutual Fund Performance When Managers Follow Analyst Coverage

Mutual fund managers who adjust portfolio holdings based on analyst coverage and consensus recommendations achieve signi?cantly lower risk-adjusted returns, but perform better than when consensus recommendations are considered alone. In a rational expectations equilibrium setup, an unskilled investor places greater weight on a risky asset’s public signal, given an increase in the asset’s analyst coverage. A new measure of managerial skill based on analyst coverage is formulated and shown to be decreasing in mutual fund alphas.

How Does China’s Capital Market Respond to Green Investment? An Analysis Based on Green Funds

Guided by the principle of sustainable development, people have reached a consensus on ecological value of green investment. However, the challenge facing green investment is how to coordinate between profit-driven nature of the capital and environmental sustainability, in order to achieve a dual goal of environmental performance and financial returns. The green fund is one of the fastest-growing green investment vehicles in China’s green investment market, implying that Chinese institutional investors are beginning to incorporate environmental elements into their investment decisions. While the primary data in the green equity market is still quite limited and not comparable, green funds claimed as the door of green investment provide us a way to look into the performance of green investment. The benefits and risks of green funds under current market conditions can reflect the price discovery toward green asset investment in the Chinese capital market. This paper aims to explore returns and risks of green investment in the context of China, through the performance evaluation of green funds. It firstly systematically reviews the literature on green investment by following perspectives of environment finance, socially responsible investment and financial innovation. Then, based on a sample of 22 green funds which were founded during June 8th 2010 and Dec 31st 2016 for more than one year, it identifies the market benchmark and 22 non-green funds as a reference group, and assesses funds’ returns and risks, and risk-adjusted returns by using single factor and multifactor models （the Carhart four-factor model）. Furthermore, it analyzes profit sensitivity of fund investors （green investors）. It finds that: firstly, in the context of China, single-factor performance evaluation has suggested that green funds have lower risk-adjusted returns than market benchmark and traditional non-green funds; secondly, investment strategies and fund age have impacts on the performance of green funds; thirdly, as indicated by Carhart four-factor analysis, green funds’ profits are significantly worse than the market average; market risk, value and momentum factors can be more objective to explain the benefits of green funds; fourthly, profit sensitivity of green fund investors is not high. The contributions of this paper include as follows: firstly, it initiates a way to explore the development of green investment research from perspectives of environmental finance, socially responsible investment and financial innovation, aiming to facilitate a discussion on setting up a systematic research framework on emerging green investment; secondly, it is the first one in the literature to evaluate the performance of Chinese green funds; therefore, this paper has brought many new findings, contributing new and direct evidence for understanding green investment in China, as well as reference for policy making.

Are European Banks Still Too-Big-to-Fail? The Impact of Government Interventions and Regulatory Reform on Bailout Expectations in the EU

I investigate the implications of government interventions and regulatory reform on too-big-too-fail expectations in the European banking sector. Evidence from stock returns over the period 1993 to 2016 suggests that large European banks have long benefitted and continue to benefit from implicit government guarantees. I document that investors are willing to accept lower risk-adjusted returns for large bank stocks relative to small bank stocks, because they anticipate that governments absorb part of these stocks’ downside risk during financial crises. Recent regulatory reform introducing bail-in and a common standardized resolution framework for European banks were successful in reducing implicit guarantees at first, but became less credible after the effective implementation of these rules came into question in early 2016.

Altana buys Addcomp Holland

Active equity mutual funds managed by insurance companies underperform peer funds by over 1% per year. There is no evidence that insurance funds make less risky investments; instead they have lower risk-adjusted returns and their fund flows are less sensitive to performance when they perform poorly. Across insurance funds, those with heavy advertising, directly established by insurers or using parent firms' brandnames, and those whose managers simultaneously manage substantial non-mutual-fund assets, are more likely to underperform. We conclude that insurers' efforts to cross-sell mutual funds aggravate agency problems that erode fund performance.

Get Home Safely: Do Shifts in the U.S. Demand for Stocks Abroad Impact the Performance of U.S. Stocks at Home?

This paper studies the pricing impact of aggregate shifts in the U.S. demand for foreign stocks on the cross-section of U.S. stocks. Measuring the sensitivity of U.S. firm-level returns to innovations in international stock flows, I document that stocks with higher sensitivity to U.S. investor’s net purchases of foreign equity (outflows) earn significantly lower risk-adjusted returns. The return on the outflows mimicking portfolio is predictable and largely concentrated in periods when the demand for foreign equity is likely to fall, i.e. following reduced wealth, increased uncertainty, and reduced sentiment.

Suitability Checks and Household Investments in Structured Products

AbstractThe suitability of complex financial products for household investors is an important issue in light of consumer financial protection. The U.S. Dodd–Frank Act, for instance, mandates that distributors check suitability when selling structured products to retail investors. However, little empirical evidence exists on such transactions. Using data from Hong Kong, we find that investors purchase 8% more structured products, on average, when the suitability is not checked. The effect of suitability checks is more pronounced for less financially literate investors. Moreover, investors tend to buy products with lower risk-adjusted returns when product suitability is not checked.

Thirty Volatility Indexes: Worldwide Tools to Gauge Sentiment and Diversify Portfolios

In the two decades since the 1993 launch of the widely followed Chicago Board Options Exchange (CBOE) Volatility Index (VIX), dozens of new volatility indexes have been introduced. This article provides an overview of 30 volatility-related indexes; 25 of the indexes are indicators that gauge investor sentiment regarding expected volatility of traded instruments such as commodities, interest rates, currencies, or worldwide stock indexes, and 5 indexes are designed to serve as benchmarks for investable performance of strategies that use VIX futures or options. Volatility indexes are used as market signals in asset allocation programs. Over the past 14 years, many investors have struggled to cope with multiple bear markets for stocks, higher correlations among many investments, and lower risk-adjusted returns for their portfolios. Investors now use long-volatility strategies with the goal of diversifying their portfolios and short-volatility strategies with the goal of enhancing risk-adjusted returns. Increased interest in volatility indexes is reflected by the fact that average daily volume for VIX options rose from 23,491 contracts in 2006 to 442,959 in 2012.

Suitability Check and Household Investments in Structured Products

The suitability of complex financial products for household investors is an important issue in light of consumer financial protection. The U.S. Dodd-Frank Act, for instance, mandates that distributors check suitability when selling structured products to retail investors. However, little empirical evidence exists on such transactions. Using data from Hong Kong, we find that investors purchase 8% more structured products, on average, when the suitability is not checked. The effect of suitability checks is more pronounced for less financially literate investors. Moreover, investors tend to buy products with lower risk-adjusted returns when product suitability is not checked.

The January effect, does options trading matter?

This study examines the effect of options trading on the January effect in the period 1996–2009. The options market offers investors an alternative trading venue that circumvents several trading limitations in the equity market and hence enables a higher level of arbitrage activities. In a cross-sectional setting, we find that optioned stocks exhibit significantly lower risk-adjusted returns in January than non-optioned stocks. This effect is not attributed to firm size, illiquidity, or transaction costs. We also find that the January effect is not only smaller but also considerably more short-lived for optioned stocks than for non-optioned stocks. In a firm-specific setting, January risk-adjusted returns are found to be significantly lower in the post-options-listing period than in the pre-options-listing period. These findings support the proposition that options trading enhances information-based trading activities and hence improves the informational efficiency of the equity market. JEL classifications: G10, G11, G12, G14

Financial Advice: An Improvement for Worse?

This paper investigates whether financial advisors help clients improve their investment decisions. Using data from a large German universal bank, we address this key question from three perspectives. Does the consultation of financial advisors improve portfolio performance? Do financial advisors ameliorate their clients investment mistakes? Do advisor recommendations improve asset allocation? In our econometric analysis we go at great lengths to correct for the possible endogeneity of seeking professional advice. Our findings suggest the following: Firstly, involving financial advisors results in lower portfolio returns, higher risk, and thus, in lower risk-adjusted returns. Second, advisors correct for some but not all investment mistakes. Third, advisors do not generally improve the asset allocation in client portfolios. Overall, our analysis provides evidence that the advice oered by the sample bank lacks quality in some tangible dimensions. This implies that conventional types of financial advice may not be the best remedy for the widespread financial illiteracy of households.

Size Anomalies in U.S. Bank Stock Returns

The largest commercial bank stocks, ranked by the total size of the balance sheet, have significantly lower risk-adjusted returns than small- and medium-sized bank stocks, even though large banks are significantly more levered. We uncover a size factor in the component of bank returns that is orthogonal to the standard risk factors, including small-minus-big, which has the right covariance with bank returns to explain the average risk-adjusted returns. This factor measures size-dependent exposure to bank-specific tail risk. These findings are consistent with the existence of government guarantees that protect shareholders of large banks, but not small banks, in disaster states.

Do Currency Fundamentals Matter for Currency Speculators?

The answer seems affirmative. We compare currency carry trades with an investment strategy based on currency fundamentals: taking a long (short) position in undervalued (overvalued) currencies. Carry trades have high risk-adjusted returns, but are subject to risk. In contrast, the fundamental strategy has lower risk-adjusted returns, but is less prone to crash risk, because the realization of crash risk coincides with corrections towards fundamentals. In particular, the fundamental strategy outperformed carry trades during the recent global financial crisis. Building on these results, we present early warning indicators for potential turbulence in the currency market.

Do Currency Fundamentals Matter for Currency Speculators?

The answer seems affirmative. We compare currency carry trades with an investment strategy based on currency fundamentals: taking a long (short) position in undervalued (overvalued) currencies. Carry trades have high risk-adjusted returns, but are subject to risk. In contrast, the fundamental strategy has lower risk-adjusted returns, but is less prone to crash risk, because the realization of crash risk coincides with corrections towards fundamentals. In particular, the fundamental strategy outperformed carry trades during the recent global financial crisis. Building on these results, we present early warning indicators for potential turbulence in the currency market.

Real Estate Index Funds: Characteristics and Performance Evaluation

This paper examines operating characteristics, risk and performance measures of all available vehicles for index investing in U.S. real estate funds during the ten-year period from April, 1999, to March, 2009. The authors of this study find real estate index mutual funds and exchange-traded funds exhibit lower Expense Ratios, lower Turnover Rates, and mostly lower Tax Cost Ratios than category averages. As newcomers, real estate exchange-traded funds have had a good start, with the lowest Expense Ratios, lowest Turnover Rates, and lowest Tax Cost Ratios. Vanguard’s four index mutual funds over the past ten years have outperformed their counterpart category averages with higher Returns, higher Risks, and higher Risk-Adjusted Returns. On the contrary, Wells’ four index mutual funds over the past ten years have underperformed their counterpart category averages with lower Returns, higher Risks, and mostly lower Risk-Adjusted Returns. Four ETFs with at least three-year track record, however, have collectively underperformed index mutual funds over the past five with lower Returns, mostly higher Risks, and mostly lower Risk-Adjusted Returns. Nonetheless, Vanguard’s ETF has been able to mostly outperform Vanguard’s index mutual funds with higher Returns, lower (or same) Risks, and higher (or same) Risk-Adjusted Returns since its inception.

The Asset Growth Anomaly and the Role of Limits to Arbitrage

Several studies have documented that companies that increase capital investments or grow their total assets subsequently earn substantially lower risk-adjusted returns. While some studies attribute this phenomenon to investors' initial underreactions to overinvestments pursued by managers who are empire building, others attribute it to investors' initial overreactions to shifts in future business prospects implied by asset expansions. This paper examines the role of the limits to arbitrage in the negative effect of capital investment or asset growth on subsequent stock returns. We hypothesize that if the negative effect is due to investors' initial mis-reactions, the effect should be more pronounced when there are more severe limits to arbitrage. Our empirical evidence appears to support our hypothesis.

The Price of Ethics and Stakeholder Governance: The Performance of Socially Responsible Mutual Funds

Do investors pay a price for investing in socially responsible investments (SRI) funds, or do they obtain superior returns? This paper investigates these under- and overperformance hypotheses for all SRI funds across the world. Consistent with investors paying a price for ethics, SRI funds in the US, the UK, and in many continental European and Asia-Pacific countries underperform their domestic benchmarks by -2.2% to -6.5%. However, with the exception of some countries such as France, Japan and Sweden, the risk-adjusted returns of SRI funds are not statistically different from the performance of conventional funds. We also find that the underperformance of SRI funds is not driven by loadings on an ethics style factor. There is mixed evidence of a smart money effect: SRI investors are unable to identify the funds that will outperform in the future, whereas they show some fund-selection ability in identifying funds that will perform poorly. Finally, corporate governance and social screens yield lower risk-adjusted returns.