Passive Investment Research Articles

Rational Mispricing with Unpredictable Demand Shocks

Movements in prices depend both on innovations to cashflows and changes in investors' demands, which can be modelled as fluctuations in the cross-sectional distribution of wealth across a fixed set of investment objectives. This paper explores the risk that arises when investors do not have perfect information about the wealth distribution to accurately forecast demand shocks, and, as a result, cannot forecast prices accurately, despite having perfect information about cashflows. To take into account this risk, investors plan their consumption for all realisations of the wealth distribution that are possible according to their subjective beliefs about the wealth distribution. This makes markets highly incomplete, and derivative assets become non-redundant. Derivatives serve a dual purpose: they allow investors to adjust consumption for different realisations of the wealth distribution, and provide information required to implement optimal allocation decisions. Asset prices depend on the sensitivity of stochastic discount factor and assets' payoffs to the wealth distribution, creating differences in expected returns between assets that are unrelated to their cashflow risk. Prices of derivatives deviate from the expected cost of creating synthetic derivatives through dynamic trading, creating apparent mispricings between derivatives and primary assets. The imprecise information about the wealth distribution can also induce a demand for dynamic trading, leaving passive investment strategies no longer optimal. Our results also have implications for arbitrage activity, informational efficiency of prices, and the role of financial innovation.

Do Venture Capital Firms Play as Supportive Mentors or Free-riders? Evidence from China

This paper aims to investigate whether Venture Capital Firms in China play as active investors, who seize to provide the funded entrepreneurial firms monitoring assistance and value-adding service for the performance enhancement, or just act as passive investors, who care little about the growth of the funded firms but the opportunity of freeriding on the IPO process to gain fast and huge economic rents. Utilizing the panel data of listed companies on the Chinese SME Board, this paper employs the PSM methodology and the panel regression models with random effect to control the sample selection bias, and disentangle VC firm’s ex-ante screening effect from the ex-post effect. The analysis reveals that Venture Capital firms are able to select the entrepreneurial firms with superior performance before the first round of VC investment, but fail to enhance the development of funded ventures after the involvement. Although the venture backed firms present the performance superiority over the non-venture backed peers overall, this difference is just attributed to VC firm’s ex-ante screening effects. VC firms do not demonstrate the ex-post value-adding effect, rather to some extent they even exert hampering effect on the performance of funded firms after the investment was made.

Accounting for Marketable Securities

This note provides an overview of intercorporate investments, including passive investments (marketable securities), investments that result in significant influence, and investments that result in control. Then, the accounting for marketable equity and debt securities is described in detail. Excerpt UVA-C-2280 Rev. June 30, 2009 ACCOUNTING FOR MARKETABLE SECURITIES Managers invest in securities of other companies for a variety of reasons. First, a company may have cash it would like to invest in the stocks or bonds of another company simply to generate a return. Second, a company may invest in another company so that it can influence that company's policies and performance. Third, a company may invest in another company to obtain control of that company. From a financial reporting perspective, these diverse reasons result in three broad investment categories: (1) passive investments, (2) investments that result in significant influence, and (3) investments that result in control. Passive Investments Passive investments are investments in securities of another company simply for the purpose of earning a rate of return. They can include investments in debt and equity securities. All debt securities (e.g., bonds) are considered passive investments—they generally do not result in the investing company having any significant influence or control of the company whose securities it has purchased. Although there are exceptions, investments in equity securities (e.g., stocks) are considered passive investments if the investing company owns less than 20% of the outstanding voting shares of the investee. Note that since preferred stock is typically nonvoting stock, it is usually considered a passive investment. . . .

Off Target: Assessing the Fairness of Ottawa's Proposed Tax Reforms for 'Passive' Investments in CCPCs

In July 2017, the Department of Finance launched consultations on a series of tax proposals affecting owners of Canadian-Controlled Private Corporations (CCPCs). The proposals on the treatment of “passive income,” from investments such as equities and government bonds, have attracted particular controversy. The proposed regime would end passive investment income-tax refundability for CCPCs – ie., taxes paid on investment income in a CCPC would no longer be tracked and refunded upon dividend payments. Although there are other versions of proposed changes, this is seemingly the one the government favours. Private corporations – and by extension their owners – would be taxed on their passive investment income on the same basis as if they were individual investors in fully taxable accounts. There would be diminished incentives to defer business consumption, and less income and business saving available for spending on capital equipment. The same is true of small business income retained for personal purposes – there will be greater incentives for immediate personal consumption of business income rather than saving it for retirement or other purposes. But is the current system inequitable? Our tax simulations show, overall, it is not – when benchmarked against the tax treatment afforded to personal retirement savings. Saving for retirement in tax-assisted plans – on a “consumption-equivalent” tax basis with a steeply graduated tax rate structure – is widely accepted in principle and in practice, because such treatment does not discourage saving as a pure income tax would do. Considering that additional administration, accounting, and tax compliance costs need to be incurred in corporate accounts, one could reasonably conclude that passively reinvested small business earnings receive a tax treatment similar to that of RRSP/TFSAs in a variety of possible portfolio compositions. Besides, successful businesses earning income above the small-business threshold enjoy no significant tax “advantages” on passively reinvested earnings. As laid out, these proposals risk delivering a blow to the retirement planning of many small business owners, not to mention their potential negative impacts on entrepreneurship and risk taking. Further, the playing field with respect to tax-assisted saving opportunities is already largely unequal. Outdated current tax rules allow career defined-benefit (DB) pension plan participants, particularly in the public sector, to end their careers with tax-assisted retirement wealth worth multiples of that practically achievable in RRSPs. If the government proceeds with changes along the lines it has outlined, fairness suggests that it should level the playing field so business owners have tax-assisted retirement saving opportunities comparable to those available to most public-sector employees in DB plans and Members of Parliament. The most ambitious reform would establish a lifetime accumulation limit of personal tax-assisted savings, in lieu of the current system of annual limits. A lifetime accumulation limit would ease the transition to the new proposed regime, and provide needed contribution flexibility and room to everyone, including small business owners, to accumulate sufficient retirement wealth.

Is Index Trading Benign?

Passive investors allocate their capital between the market portfolio and the risk-free asset, whereas active investors invest in individual assets. In a rational expectation model, we show that a CAPM risk-return relation holds. Active investors are indistinguishable from closet indexers, while the constraint of passive investors to the capital market line is binding. Passive investors are not free riders. As more active traders become passive, the proportion of an asset's idiosyncratic risk to total risk increases, comovement in prices increases, comovement in returns decreases, and for any portfolio other than the market portfolio, the Sharpe ratio decreases and the conditional variance of payoff increases.

The Basics of Private Equity Funds

Private equity (PE) refers to illiquid investments or securities that are not publicly traded on an exchange, such as venture capital, mezzanine or distressed debt, leveraged buyouts, timber, oil and gas properties, and real estate. A limited partnership agreement (LPA) defines the terms of the relationship between the general partners (GPs) and the limited partners (LPs). The structure and compensation arrangements used by PE firms are highly standardized and a working knowledge of frequently employed terms and arrangements of LPAs is important to understanding the division of the profits and the drivers of returns in the industry. This note describes some of the basic features of LPAs with a particular focus on the basic terminology and compensation practices that relate to GPs and LPs. Excerpt UVA-F-1731 Rev. Sept. 15, 2015 The Basics of Private Equity Funds Private equity (PE) refers to illiquid investments or securities that are not publicly traded on an exchange. The investments can take many forms: venture capital (VC) (seed and early stage); mezzanine or distressed debt; leveraged buyouts; timber, oil, and gas properties; and real estate. The typical PE firm is organized as a limited partnership. The general partners (GPs) of the firm organize a fund and seek capital from the limited partners (LPs). A limited partnership agreement (LPA) defines the terms of the relationship between the GPs and LPs. The structure and compensation arrangements used by PE firms are highly standardized and a working knowledge of frequently employed terms and arrangements of LPAs is important to understanding the division of the profits and the drivers of returns in the industry. This note describes some of the basic features of LPAs with a particular focus on the basic terminology and compensation practices that relate to GPs and LPs. The Basics GPs invest in deals that they believe offer an opportunity to earn high risk-adjusted returns. To achieve this objective, they must find and evaluate deals and, when necessary, provide managerial and operational support to their investee companies. For the most part, GPs provide only a small portion of the funding for their investments (frequently 1% of the capital) and therefore they organize a fund and seek capital from LPs to fund their investments. Because of the high risk and illiquid nature of the assets, investors in PE funds are typically restricted to accredited investors. LPs include, among others, pensions and insurance companies, endowments, and high-net-worth individuals. GPs retain virtually all the important decision-making authority in a fund and, by comparison, LPs are usually passive investors with little say in the fund's direction. . . .

An empirical study on evaluation of ipos performance on NSE

Initial Public Offers (IPO) option of investment has become most preferred tool for investments now-a-days for the investors especially those who do not know much about the market or we may say the passive investors who just put the money and forget about their investment. It is a well-known fact that the interests of IPO investors are generally influenced by the current market trend and this in turn influence the performance of the IPOs. This paper attempts to evaluates the performance of 152 IPOs introduced during 2010–2016 on NSE. The paper shows listing day gain and one-month returns evaluation. It was analyzed that on an average 11.998% of day listed gain earned by these IPOs whereas these IPOs posted a loss of 3.78% for one-monthreturn. Out of 152 IPOs introduced on NSE, 63.15% were underpriced and 36.84% overpriced.

Front-Running and Market Quality: An Evolutionary Perspective on High Frequency Trading

We study front-running by high frequency traders (HFTs) in a limit order model with continuous trading. The model describes an evolutionary equilibrium of low frequency traders (LFTs) who compete in portfolio management services by offering investment styles. The introduction of front-runners inflicts heavy losses on speculators, while leaving passive investors relatively unscathed. This encourages investment in the market portfolio and markedly reduces overall turnover. Speculative trading persists despite its lower profitability. By most measures, market quality is not affected to any significant extent by front-running HFTs.

Refocusing capitalism on the long term: ownership and trust across the investment value chain

After the 2008–9 global financial crisis the capitalist system has largely rebounded. However, recent measures show a decline in public- and private-sector investment, growing income inequality, declining trust in institutions, and evidence of secular stagnation. These indicators point to a diagnosis of an excessive focus on short-term results at the expense of long-term value creation. The challenge of short-termism is not isolated, as it pervades the entire investment value chain—from savers (who are increasingly dependent on short-term metrics to assess investments) and institutional investors (who are increasingly moving to passive investments) to boards and executives (who are under pressure from shareholders to deliver consistent quarterly results). Ultimately, all actors in the investment value chain will need to play an active role in restoring our capitalist system to a proper balance between long-term ownership and performance and in repairing the fraying bonds of societal trust.

Is a Little Learning a Dangerous Thing? Ability-Complements But Not Ability-Substitutes Exacerbate Overconfidence

We investigate how overconfidence and production technology interact to influence decision making. We show that increasing a production factor can make an overconfident agent worse off. Two effects drive this result. First, if the production factor is a complement with ability, then the overconfident agent may overpay for the production factor. Second, acquiring the factor will increase excess entry into activities that are productivity dependent. In contrast, if the factor is a substitute with ability, the agent will undervalue the factor even though it may reduce excess entry. In a laboratory experiment we find that subjects overpay for ability-complements, and underpay for ability-substitutes, as predicted. Subjects provided with ability-complements earn less due to increased excess entry. In the context of investing, our findings suggest that human capital, if it is a complement with ability, will lead an overconfident investor to switch from a passive investment strategy to a lower-return active strategy.

The Growth and Changing Role of Passive Investments: A Critical Perspective on Index Mutual Funds and Exchange Traded Funds

Abstract Index Mutual Funds (IMF) and Exchange Traded Funds (ETF) have developed into widely-accepted and fast growing passive investment instruments, offering investors a low-cost investment alternative in well diversified portfolios. Allocating more into IMFs and ETFs is the investors’ natural response to the experience with and the disillusion about actively managed investment performance. Despite these positive effects, this shift in fund allocation raises substantial concerns about possible negative effects on securities market trading and market quality, on corporate governance and product market competition as well as on systemic risk. Most research so far does not provide significant evidence of negative effects on market quality, on securities market trading, and on systemic risk. Whether the shareholdings of IMF and ETF providers reduces product market competition and whether the concentration of voting rights negatively effects corporate governance requires further analysis. Some problems may occur if ETF and IMF providers team-up with active investors. Overall, the introduction of IMFs and ETFs on broad market indices should be viewed as a financial innovation that broadens the investment spectrum providing many benefits to investors especially when viewed relative to the meager performance and performance persistence of actively managed mutual funds.

On Modified DuPont Method: Analysis of Firms with Negative Net-Financial-Obligations

We find over 30% of public U.S. non-financial companies have negative net-financial-obligation (NFO) during the sample period of 1965 to 2014. According to the modified DuPont analysis, NFO is defined as total debt minus excess cash and passive investments. The prevalence of these observations casts doubt over the validity of the modified DuPont method, especially the treatment of holding excess cash and passive investments as financing rather than operating activities. We explore several reasons for this phenomenon, including weak corporate governance, equity financing, and tax deferral. Overall the evidence is most consistent with the equity financing and tax deferral hypotheses. Understanding the reason for having negative NFO helps us make proper adjustments/inferences when analyzing these firms. This study also provides a new explanation for the puzzling negative correlation between leverage and expected stock returns documented by prior research. Negative-NFO firms enjoy low-cost financing from the government, via long-term tax deferral, by retaining earnings overseas. These firms have incentive to reduce costly financing from traditional venues, especially debt. Negative-NFO firms also tend to have a high cost of capital due to their intangible-intensive asset structure. We show that these characteristics of the negative-NFO firms create a negative correlation between the observed leverage ratios and the average stock returns. Once we remove the negative-NFO firms, the correlation between leverage and stock returns becomes significantly more positive.

Investigating the Efficiency of the Indian Currency Market: A Persistence Perspective

The presence of long range persistence and its impact on policy decisions are examined in the Indian Forex market during the period between 2000 and 2015. Hurst-Mandelbrot's Classical R/S Statistic, Lo Statistic, Robinson's Estimate have been computed. Long memory in volatility and absolute return series of each currency pair were evidenced but the logarithmic return series of all these currency pairs indicate proclivity towards the “random walk” hypothesis. Therefore, currencies are not systematically over- or under-valued, which provides justification for passive index investment in these currencies. However, possibilities of speculation/hedging activities could not be ruled out which may call Reserve Bank’s intervention and interest smoothing behavior with potentials for impaired price discovery.

Actively managed mutual funds holding passive investments: What do ETF positions tell us about mutual fund ability?

Abstract We provide the first in-depth examination of exchange-traded funds (ETFs) within actively managed mutual fund (AMMF) portfolios to better understand why AMMFs make substantial investments in passive ETFs. We examine the association between holding ETF positions and AMMF performance, as well as indirect measures of performance, including market timing, flow management, and cash holdings. We find that over one-third of AMMFs take an ETF position between 2004 and 2015. Our results indicate that AMMFs allocating large portions of their portfolio to ETFs perform worse, by between 0.41% and 1.63% annually using various performance measures. These AMMFs also exhibit worse market timing and hold more cash. In contrast, AMMFs that hold ETFs in small amounts have similar characteristics to non-user AMMFs. Therefore, the act of holding an ETF does not signal inferior ability, however, taking large ETF positions does.

Genetic algorithms for the optimisation of the Schwartz–Smith two-factor model: a case study on a copper deposit

Mining companies typically seek ways to hedge risks affecting their production. One useful instrument to mitigate the financial risk is the futures contracts on commodity prices. Information from the transactions in futures markets is publicly available and can be analysed with the Schwartz–Smith two-factor model (SSTF). However, finding the parameters governing this model can be very challenging. This step is done using a deterministic optimisation approach called the Expectation–Maximisation algorithm (EM). The starting values of the model will have a significant effect on the convergence of the EM. To ensure the solution does not get stuck in a local maximum, the EM algorithm is performed multiple times with different starting values. This paper assesses the value of genetic algorithms (GA) to optimise the parameters of the SWTF model. Although they are slower than EM algorithms because they use random number generators to search for the optimal solution, GA optimise a population of solutions instead of working on only one solution at the time. Moreover, a constraint on the range parameter can be applied to ensure the parameter has a sound economic meaning. Once the SWTF parameters have been calibrated on the observation of futures contracts, the model can be used for the simulation of spot and futures prices. To demonstrate the performance of the proposed approach, a case study was conducted on a copper deposit. The simulations based on the SWTF model whose parameters are determined by GA are used. An active management strategy of the stockpile, dependent on discrepancies in commodity futures prices is tested. Results show that the active management strategy produces positive returns over the passive investment approach.

Frontier Market Investing: Active Versus Passive

Frontier markets began to attract attention 10 years ago. Since then, more than 30 active managers have established themselves, along with a handful of passive managers who track the indexes. The author believes it is worthwhile to examine the trade-offs in choosing active or passive frontier managers, including the elements of market definition, efficiency, results, and access. Although both active and passive investment approaches enable investors to gain exposure to frontier market equities, current research and data show that active management holds a decided edge. The ability of investors to focus their capital in the truly frontier non-Gulf Cooperation Concil countries and to benefit from the market inefficiencies presented by scarce liquidity, high bid–ask spreads, and low analyst coverage is severely diluted by the practical constraints faced by managers employing passive approaches.

Robo Advisers and Mutual Fund Stickiness

We document a puzzling finding that robo advisers, firms which pursue automated, passive investment strategies for their clients, outperform both self-managed and mutual fund portfolios on a risk adjusted basis, but mutual fund holders are significantly less likely to respond to underperformance by setting up a robo account. We provide evidence consistent with a theory where more risk averse investors hold mutual funds, and where trust in one's fund manager plus costly liquidation subsequently discourage delegating management to robo advisers. However, using a regression discontinuity design, we find that portfolio-specific financial advice about diversification and fees can mitigate this effect.

The Impact of Passive Investing on Market Fragility

A simple theoretical model with active and passive investors is proposed. The model implies that in the bullish time the presence of passive investors enhances the growth of prices while in the bearish time enhances the declines. Therefore the growing popularity of passive investment funds, especially highly liquid ETFs, can have negative consequences and increases market fragility what is supported by the empirical evidence.

Market timing in precious metals is detrimental to value creation

ABSTRACTFew number of days accounts for most of the returns delivered by precious metals (gold, silver, platinum and palladium). A passive buy and hold investment strategy in precious metals outperforms market timers who miss the best 5, 10 and 50 days by 51%, 71% and 98%, respectively. Likewise, long-term performance of precious metals is largely determined by the return of few outliers (black swans). Thus, investors should reconsider trying to predict when to be in and out of the precious metals markets and support investing in precious metals ETFs.

The role of commodities investments in the decumulation phase of retirement

This paper examines the role of commodity-related investments in the decumulation phase of retirement. Benchmarked against a balanced portfolio, the findings suggest that including commodities in a traditional portfolio improves the retirement outcomes at the lowest percentiles of wealth distribution. Furthermore, we demonstrate that downside protection is more pronounced by reducing allocation to equities (rather than bonds) to invest in alternatives. An equally weighted combination of passive and active commodity-related investments provides superior downside protection compared to a traditional portfolio at all levels of allocations used in the analysis. As a consequence, commodities may be employed as a portfolio diversification tool particularly in the decumulation phase of retirement. Keywords: alternatives, commodities, life cycle, superannuation, retirement. JEL Classification: G11, G23