Passive Investment Research Articles

Practical Applications of On the Optimal Mix of Active and Passive Investments

Determining exactly the dollar amount to allocate to active investments in a client’s portfolio has long been a problem faced by financial advisors and portfolio managers. Stephen Buser, Professor Emeritus at The Ohio State University, has come up with a solution. He proposes a modified version of the Treynor and Black appraisal ratio to identify the exact dollar amount of a portfolio to be allocated to active investments. In an interview with Institutional Investor Journals, Buser discusses incorporating theta to develop the adjusted measure of the appraisal ratio and outlines how the modified ratio provides opportunities for financial advisors, metrics providers and institutional managers.

What's in Your Smart Beta Portfolio? A Fundamental and Macroeconomic Analysis

The demand for transparent, rules-based investing has been one of the secular trends in the asset management industry over recent decades. Within the passive investment arena, alternatively weighted — or smart beta — strategies have witnessed remarkable growth and have amassed over USD 497 billion of assets in exchange-traded products alone.In their broadest sense, smart beta strategies can refer to a swath of strategies that are designed to provide access to a wide array of return-enhancing risk premia (or risk factors). Usually, return derived from these factors is unaccounted for by the basic capital asset pricing model, which embraces market beta as the sole measure of compensated risk. As of yet, there is no agreement on a definitive list of these risk premia in academia or in industry, and this remains the object of continued research and discussion. We have therefore elected to focus only on those factors for which empirical evidence exists to suggest that the factors may provide risk-adjusted returns in multiple markets and over the long run; namely, volatility, momentum, quality, value, dividend yield, and size.One may reasonably expect that methodologies for different indices that target the same factors would be similar, and that any divergence between indices would elicit interest in only academic circles rather than from practitioners or investors. Yet, index construction techniques can be poles apart. Where some techniques select a subset of securities with the most demonstration of the desired factor, others elect to vary only the weighting of the constituents within the entire universe so as to reflect the degree of the targeted exposure the companies satisfying the factor criteria exhibit.In the light of this, we will review some typical strategies that seek to track the more common factors (i.e., those mentioned above) in the U.S. market in order to understand better the characteristics of these strategies. With the aid of a risk model, Section 1 begins by examining both the primary and secondary exposures, the source of active historical return, and the risk of smart beta strategies used to access the six factors mentioned above. Then, Section 2 analyzes the macroeconomic environments in which the various strategies outperformed. Finally, Section 3 undertakes the foregoing analysis on four stylized multi-factor portfolios that are constructed based on a number of weighting schemes.

An Ownership Framework for Managers' Accelerated Seo Decisions: The Importance of Connected Institutional Investors in the REIT Industry

Executive Summary. In this paper, we present a mathematical simulation of a secondary equity offer (SEO) decision that captures the payoffs for investors with either low (e.g., actively managed funds) or high (e.g., passive index investors) monitoring costs. The calibrated solutions are consistent with overvalued SEOs being issued when institutions with high monitoring costs are present. Institutions with low monitoring costs either incentivize management to issue fairly priced SEOs or lead to greater ex post discipline of the CEO for value decreasing issuances. The existence of institutions with business relationships creates uncertainty regarding the value of SEOs. Ownership network alliances are beneficial.

How investors can enter new markets and the questions they should ask their custodian

For investment managers and asset owners, investing in global markets is an important source of diversification and alpha. Even for passive investment managers who seek to replicate an index, gaining access to markets around the globe is an important component of executing their investment strategies. From an oper­ational perspective, global market entry is a complex web of jurisdictions, local market conventions and regulatory requirements. How do investors gain sufficient understanding of local markets and how can they adequately assess the operational risk of investing in such markets? This raises another question: who should make the decision regarding country selection, the investment manager or the global custodian?

Benchmark buyer beware: How well do you know your index?

While benchmarks are important tools for portfolio managers and investors alike, we challenge the conventional wisdom that they are paradigms of investing excellence. Despite the effective marketing campaigns that have brought benchmarks into the public consciousness and attracted significant capital to passive investment strategies, few investors fully understand how these benchmarks are calculated or what they represent. We dissect the benchmark construction process and reveal how decisions made by index providers can lead to unintended factor exposures in various benchmarks. Using the Russell Midcap® Value Index as our primary example, we find evidence of size, momentum and sector tilts, as well as outsized exposure to interest rates, clientele effects and low-quality businesses. We demonstrate that without full understanding of benchmark construction, evaluations of active-manager performance are unreliable. Moreover, factors that have led to outperformance by index funds in recent years could easily reverse.

Cross-Company Effects of Common Ownership: Dealings between Borrowers and Lenders with a Common Blockholder

We study the effects of common ownership on syndicated loan market interactions. We find that borrowers and lenders that are commonly held by an institutional blockholder tended to do more business together going forward than those that are not commonly held. We hypothesize that the increased likelihood of striking a deal derives from conversations between borrowers and blockholders about financing plans, which, in turn, increases borrowers’ familiarity and perhaps opinion of commonly owned lenders. Consistent with this view, we find that the increase in dealings occurred only when the blockholder followed an active rather than a passive investment strategy.

U.S. Monetary Expectations and Emerging Market Debt Flows

This paper examines the effects that changes to U.S. monetary expectations have on debt flows to emerging markets since the Global Financial Crisis. First, daily interest rate expectations measured by federal fund futures and a shadow rate model are used to categorize Federal Reserve announcements as easing (unexpected), tightening (unexpected), easing (expected), and tightening (expected). Second, the announcements categorized by the shadow rate model are used for an event study on daily emerging market debt flows by currency (all currencies, hard currency, local currency, mixed currency), investor (all investors, active investors, passive investors), and region (Asia excluding Japan, Europe Middle East and Africa (EMEA), Latin America, and Global Emerging Markets (Global EM)). The results show that tightening (unexpected) announcements cause emerging market debt outflows, hard currency debt flows respond more to announcements than local currency debt flows, and that passive investors respond more than active investors. Debt flows to Latin America respond more to announcements than debt flows to Asia ex-Japan, EMEA, and Global EM.

Size Matters, Book Value Does Not! The Fama-French Empirical CAPM Revisited

The Fama and French (F&F) factors do not reliably estimate the size and book-to-market effects. Our paper shows that the former has been underestimated in the US market while the latter overestimated. We do so by replacing F&F's independent rankings by the conditional ones introduced by Lambert and Hubner (2013), over which we improve the sorting procedure. This new specification better reflects the properties of the individual risk premiums. We emphasize a much stronger size effect than conventionally documented. As a major related outcome, the alternative risk factors deliver less specification errors when used to price passive investment indices.

Active Versus Passive Investment Management Of State Pension Plans: Implications For Personal Finance

There are 19 million workers and retirees and $3 trillion of assets in state pension plans. However, questions have arisen about the long-run ability of the plans to pay promised benefits to retirees. Consequently, proposals have been made to reduce promised pension payments or alter other terms of the pension contracts. Yet another heretofore unexplored alternative is to reduce state pension plan management fees by moving from actively managed portfolios to low-fee passively managed accounts. Using state pension plan data for the 2003-2012 decade and returns from three alternative low fee portfolios, it is found that all states could have increased after-fee earnings and improved their long-run ability to pay retirees by moving to the low-fee investment accounts. While clearly relevant for workers and retirees in state pension plans, the findings also have implications for all investors regarding the ongoing debate between active and passive investment management strategies.

Practical Applications of On the Optimal Mix of Active and Passive InvestmentsOn the Optimal Mix of Active and Passive Investments Stephen A. Buser

Practical Applications of On the Optimal Mix of Active and Passive InvestmentsOn the Optimal Mix of Active and Passive Investments Stephen A. Buser

Long Term Passive Investment Strategies as a Part of Pension Systems

(ProQuest: ... denotes formulae omitted.)IntroductionThe effectiveness of long term investing has been a main topic of various theoretical as well as practical studies. A lot of academicians and financial professionals are supporters of passive investment strategies such as buy & hold or indexing. On other hand there are some studies that show that there are some active investment strategies based on stock picking or market timing, that are able to record superior results.Malkiel (2012) and Bogle (2010) came to conclusion that index investing is as effective as active managed funds in long term. It was proven that on a 16-year time horizon, index funds achieve same results as actively managed funds. These findings have been supported also by other publications. For example Siegel (2014) analysed whole history of U.S. share market and he came to conclusion that passive investment strategies are efficient despite some market collapses, but a long time horizon is needed. A similar conclusion was reached by Graham (2007, 2008).Most of authors support buy & hold strategy, although many of them claim that it should be supported by cost averaging effect. The cost averaging effect limits negative effects of market crashes. The investor buys stocks on a regular basis, regardless market development. If stock market collapses, investor buys stocks at lower prices which results in a lower average purchase cost. Positive results of long term investing using cost averaging effect were presented also by study of Edelson (2007).A detailed analysis of selected long term stock market investment strategies as well as comparison of passive and active investment strategies was conducted also by other authors. For example Pastor and Stambaugh (2012) focused on declining effectiveness of actively managed investment funds. French (2008) came to conclusion that the typical investor would increase his average annual return by 67 basis points over 1980-2006 period if he switched to a passive market Lye (2012) analysed differences between growth and value stocks. Cambell, Polk and Vuolteenaho (2010) analysed systematic risks of stock investing.One of newest contributions to discussion was presented by Fabozzi (2015) who analysed current state of U.S. Pension Benefit Guaranty Corporation (PBGC). He concluded that some changes in investment strategies of funds should be made. He also advises that PBGC should introduce a benchmark for pension fund investments.Some arguments in favour of passive investment strategies were presented by Wingenfeld (2013) who talks about five specific qualitative arguments that are eligible to be a theoretical proponent for passive portfolio management. This topic is in centre of attention of some of Chinese economists as well. For example Wang, Beland and Zhang (2014, 2014) warn that there is a pension system missing in China. It could become a huge problem due to rapidly aging Chinese population.1. MethodologyIn this paper, effects of long term investing over a 30-year time period are analysed. This time horizon enables inclusion of one of European share markets into analysis, as European share indices didn't exist before 80's. The 30-year time horizon is also a usual time of involvement of an individual in a pension scheme.The effects of long term saving and investing on time horizon of last 30 years are examined. The American S&P 500 stock index is used, as American stock market is most liquid one, with a well-documented history. It consists of various share companies across all of sectors of U.S. economy. It also reflects relation between U.S. share market and U.S. economy very well. It is very close to theoretical concept of optimal portfolio. The long term investing in S&P 500 will be compared to long term investing of risk-free short-term securities. …

Towards an Optimized Passive Commodity Investment

The paper explores different portfolio structures for a passive commodity investment. It finds that an equally-weighted portfolio of up to 30 commodities delivers a Sharpe ratio similar to that of equity indexes and Treasury bonds, with much lower volatility than popular commodity indexes. Furthermore, the paper analyzes the impact of changing the collateral of commodity futures from short term Treasury bills to Treasury bonds and notes of longer durations. In this case a substantial outperformance can be realized, coming not only from higher bond yields, but also from bonds rolldown, as well as higher rebalancing return.

A Fundamental Approach to Investing in US Stocks

The majority of research on active and passive investment approaches suggests individual investors should choose a passive index investment vehicle over an active management investment vehicle. This paper proposes utilizing fundamental stock data to develop an active fundamental approach to investing in US stocks to determine if utilizing the data in a systematic approach enables us to outperform a corresponding traditional index approach. The approach is back-tested and yields a 40% cumulative growth advantage over a traditional index approach.

OutDex™ to Outperform an Index: Incorporating the Best of Active and Passive Investment Strategies

The active versus passive investing debate has been ongoing since the mid-1970s with the introduction of index funds. The performance delivered by active managers does little to settle this debate. We propose an OutDex™ strategy that is designed to closely track market capitalization weighted indexes, while providing investors with factor based excess returns. The strategy incorporates the best of active and passive investment. Furthermore, the OutDex™ strategy employs a quantitative approach to active investing which is scalable and a less expensive form of active investment management. <b>TOPICS:</b>Mutual funds/passive investing/indexing, analysis of individual factors/risk premia, performance measurement

Pension Fund Efficiency: An International Comparison of Australian Performance

Using a sample of 256 pension funds from Australia, Canada, the United States and Europe for the period 2004 to 2012, we use data envelopment, cluster and multivariate analysis to compare performance. We find high efficiency scores for many smaller corporate funds and lower efficiency scores for larger Australian industry and retail funds. Among US, Canadian and European pension funds passive investment management outperforms active. Defined contribution and public offer fund types perform least well. We attribute the generally lower efficiency scores for Australian funds to the higher degree of separation between managers and beneficiaries which exists in Australia, where delegation of responsibility is widespread.

Asymmetric Decrease in Liquidity Before Announcements, and the Earnings Announcement Premium

Investors are reluctant to trade in the high-information-asymmetry days before earnings announcements. We show that the decrease in liquidity trading before announcements is asymmetric. We analyze buy and sell orders of investors with passive investment strategies, and find they do not reduce their sales as much as their purchases in the days before announcements. Investors needing liquidity sell stocks at a discount relative to the post-announcement price, and these preannouncement liquidity sales are a significant driver of the average positive returns, or return premium, known to characterize announcement days.

Asymmetric decrease in liquidity trading before earnings announcements and the announcement return premium

Investors are reluctant to trade in the high-information-asymmetry days before earnings announcements. We show that the decrease in liquidity trading before announcements is asymmetric. We analyze buy and sell orders of investors with passive investment strategies, and find they do not reduce their sales as much as their purchases in the days before announcements. Investors needing liquidity sell stocks at a discount relative to the post-announcement price, and these preannouncement liquidity sales are a significant driver of the average positive returns, or return premium, known to characterize announcement days.

Institutional investors’ activism and credit ratings

We study the link between institutional shareholdings and the quality of the credit ratings of the firms they hold in their investment portfolio. The study of the overall impact of institutional investor ownership yields mixed results while more consistent results are obtained when we take into account the heterogeneity of institutional investors. When we classify the institutional investors based on their degree of intervention and activism levels, we find that passive/inactive investors are associated with better-rated firms while active ones are associated with lower-rated firms. Thus, activist institutional investors believe that there is more value to be found at lowly rated firms. They are more likely to find cheap stocks among these firms that require both their financial and managerial inputs to progress. Passive investors, instead, tend to track market indices that consist of mostly highly rated firms.

Capital Preferences: International Capital and Government Partisanship

Many argue that government partisanship influences the size of investment flows into stocks and bonds. But existing literature tells us little about how international capital flows influence election outcomes. I argue that passive investment into stocks, bonds, and other debt instruments—in other words, portfolio investments—increases political contributions to right-wing parties. This investment generates resources for domestic capitalists. These owners of capital then channel these resources into political contributions to right-wing parties and enhance those parties' electoral position. Thus, passive investment bolsters the electoral chances of right-wing governments. I illustrate this process with a formal model of special interest politics in which lobbies operate under budget constraint. Using a new data set on political contributions and statistical analyses for a sample of states from 1980–2009, I find support for my general argument.

On the Optimal Mix of Active and Passive Investments

A modified version of the appraisal ratio developed by Treynor and Black in 1973 identifies a unique mix of active and passive investments that is optimal for every investor, regardless of his or her preferences for risk and return. This result suggests that financial advisors can consider recommending specific dollar amounts for clients to allocate to active investment strategies, rather than simply recommending qualitative assessments regarding such opportunities. The article identifies corresponding implications for services that provide estimates of analytic measures that are used to evaluate active investments, as well as for institutions that manage active portfolios on behalf of individuals.