Short Investment Horizons Research Articles

Option Theory Does Not Refute Time Diversification

It is often recommended that asset allocation, in particular the proportion of stocks in a portfolio, should be influenced by the time for which the portfolio is expected to be held. Short investment horizons are seen as unsuitable for stocks. Long-term portfolios are regarded as suitable for high proportions of stocks. This is partly because long investment periods are seen as moderating the relative risk of stocks without distracting from the relatively high expected returns of stocks. Time diversification is one factor that ameliorates the long-run risk of stocks. Over the long term there will be periods of relatively good returns and periods of relatively poor returns; good periods and bad periods have a tendency to offset each other over long time spans. In consequence, risk increases less than proportionately with time, whereas returns have a compounding effect over time. Some academics have suggested that stock market risk increases as the investment horizon lengthens, thus refuting the concept of time diversification. That argument has been based on an apparent increase in the cost of hedging stock price risk, as indicated by theoretical put option prices, which appear to increase when the investment horizon extends. This article argues that those views are based on a restrictive use of the Black-Scholes option pricing model. When the model is used less restrictively, put option prices are found to decrease as the investment horizon lengthens when investment growth exceeds a particular rate. Risk, as measured by the cost of hedging, may decline as the holding period lengthens. Depending on expected investment growth, option theory supports time diversification rather than refuting it. <b>TOPICS:</b>Risk management, portfolio construction, performance measurement

Riding the Yield Curve: A Spanning Analysis

The average return on long-term bonds exceeds the return on short-term bills by a large amount over short investment horizons. A riding-the-yield-curve investment strategy takes advantage of the higher returns on longer term bonds. This strategy involves the purchase of bonds with maturities longer than the investment horizon and the sale of these bonds, before they mature, at the end of the investment horizon. Most of the literature that evaluates this strategy compares only ex post average returns or Sharpe ratios. In this paper, we use spanning tests to provide formal statistical evidence on the benefits of investing in long bonds when the investment horizon is short. The results for both the US and Canada indicate that an investor with a short horizon is better off investing in short-term debt instruments than long-term bonds.

Institutional ownership and monitoring: Evidence from financial misreporting

We find that the likelihood and severity of financial misreporting is positively related to aggregate institutional ownership and this effect can be largely attributed to ownership by institutions with short investment horizons — those with little incentive to engage in costly monitoring of firm activities and precisely those that sell at the announcement of a restatement. We also find that the concentration of holdings by these institutions offsets this effect, which suggests concentrated ownership induces greater monitoring and mitigates the incentives for firms to misreport. Our results suggest that any link between myopic firm decision making and institutional ownership may be related to the nature of institutional monitoring.

The Economic Value of Nonlinear Predictions in Asset Allocation

Predictions of asset returns and volatilities are heavily discussed and analyzed in the finance research literature. In this paper, we compare linear and nonlinear predictions for stock- and bond index returns and their covariance matrix. We show in-sample and out-of-sample prediction accuracy as well as their impact on asset allocation results for short-horizon investors. Our data comprises returns from the German DAX stock market index and the REXP bond market index as well as their joint covariance matrix over the period 01/1988 - 12/2007. The comparison of a linear and nonlinear prediction approach is the focus of this study. The results show that while out-of-sample prediction accuracies are weak in terms of statistical significance, asset allocation performances based on linear predictions result in significant Jensen's alpha measures and Sharpe-ratio and are further improved by nonlinear predictions.

Institutional investor and accounting restatement

This paper investigates the role that institutional investors play in the market reaction to accounting restatements. We show that transient institutional investors, defined as institutions with short investment horizons and high portfolio turnover, significantly reduce their holdings in a restating firm at least one quarter prior to the quarter of the restatement announcement. This result holds after controlling for factors such as return momentum, unexpected earnings, size, book-to-market, and the portfolio weight of the firm to the institution. Second, using previously identified predictors of earnings manipulation, we show that institutional investors react most negatively to an increase in the days sales in receivables and high accruals. Finally, we demonstrate that the market reaction to accounting restatements for firms with higher levels of transient institutional ownership is more negative in the period prior to the restatement announcement. Taken together, these results suggest that institutional investors act as though they partially anticipate potential accounting irregularities and adjust their holdings downward prior to the restatement announcement.

Heterogeneous institutional investors and CEO compensation

This paper examines the relationship between institutional ownership and executive compensation by taking into account the heterogeneity of institutional investors. The paper finds that ownership by transient institutional investors, who have short investment horizons and active trading, is positively related to the performance sensitivity of option grants for CEOs. However, no significant relationship holds for other types of institutions, including those dedicated institutional investors, who have longer horizon and concentrated holdings. Further tests suggest that the positive relationship between transient institutional ownership and the CEO pay-for-performance sensitivity is not driven by the trading behavior of transient institutional investors when stock performance is good. Instead, the paper documents preference of transient institutional investors for greater performance sensitivity of option grants for CEOs. After using an instrument approach to control for preference and endogeneity, transient institutional ownership is no longer significantly related to the CEO pay-for-performance sensitivity. Additionally, the paper does not find dedicated institutional investors serve a monitoring role in correcting overcompensation paid to CEOs. After controlling for preference and endogeneity, neither the level of salary nor the level of total direct compensation for CEOs is significantly related to dedicated institutional ownership. The findings suggest that on average the influence of institutional investors on CEO compensation occurs indirectly through their preference in line with their different investment types.

The effect of pension accounting on corporate pension asset allocation

We examine the impact of new pension disclosures and subsequent full pension recognition under FRS 17 and IAS 19 in the United Kingdom and SFAS 158 in the United States on pension asset allocation. These standards require recognition of net pension surplus/deficit on the balance sheet and actuarial gains/losses in other comprehensive income. Therefore, these standards introduce volatility into comprehensive income and balance sheets. We identify a disclosure period during which UK companies disclosed all the required data under FRS 17 in the notes without recognition. We also identify a full recognition period starting 1 year before until 1 year after the adoption of FRS 17/IAS 19 (UK) and SFAS 158 (US). We predict and find that UK companies, on average, shifted pension assets from equity to debt securities during both the disclosure and the full recognition periods. We also find that while before the adoption of SFAS 158 US companies maintained a stable allocation to equities and bonds, these companies, on average, shifted funds from equities to bonds around the adoption of SFAS 158. Cross-sectional analysis shows that the shift away from equities is related to changes in funding levels, shorter investment horizons, increased financial leverage, and the expected impact of the new standards on shareholders’ equity.

Do Redemption Fees Hurt Long-Term U.S. Mutual Fund Investors?

Redemption fees have been proposed as a way to curb trading on stale prices by short-horizon investors to make profits at the expense of long-horizon investors who only trade to rebalance back to their optimal allocations. For redemption fees to be a viable device to curb stale price trading, they must have a negligible impact on the utility of these long-horizon agents. To assess this impact, we examine how the imposition of redemption fees affects the utility of long-horizon agents, allowing for the possibility that the long-horizon investors are rebalancing to take advantage of return predictability. Restricting the imposition of the fee to sales of shares purchased within 6 months, the utility cost of the redemption fee is never more than 0.12% of wealth when returns are i.i.d. and never more than 0.54% of wealth when returns are predictable. These utility costs are very small. For redemption fees to be a viable device to curb stale price trading, they must also be large enough to deter short-horizon investors from taking advantage of the stale prices. We find that they are, based on the documented profitability of such strategies, at least for the typical domestic fund and for the typical large capitalization domestic fund.

Investment Horizon to Investment Decision and Mean Reversion: Indonesian Perspective

This study has two research objectives: (1) to find evidence whether investment decisions (allocation of funds in each asset in a portfolio) of Indonesian investors in the short investment horizon diverge with their investment decisions in the long investment horizon, and (2) to examine the belief of Indonesian investors in the mean reversion. This study analyzes the investment horizon from a behavioral point of view by examining the influence of investment horizon on investment decision and mean reversion in Indonesia. We employed the students of Master of Science, Master of Management, and Doctorate Programs at the Faculty of Economics and Business, Universitas Gadjah Mada, Indonesia as the sample in this research. Of the 217 questionnaires delivered, 172 questionnaires were completely filled and utilized in this study.The main findings of this study are as follows: (1) it is significantly proved that Indonesian investors are inclined to assume higher portfolio risk in the longer investment horizon than that in the shorter investment horizon; (2) it is very interesting to see that on average, the investors are inclined to increase their allocation in the risk-free asset in the longer investment horizon although the difference between the risk-free asset holding in the short investment horizon and that in the long investment horizon is not significant; (3) the framing effect significantly influences the investment decisions, both in short investment horizon and in long investment horizon; (4) there is a tendency for the respondents to show a willingness to assume higher portfolio risk when they received the questionnaires that provided the historical five-year returns on the first page; (5) investors predict an asset gaining 50 percent in the first year to continuously gain in the next four years while expecting an asset losing 25 percent in the first year to continuously loss in the next four years.

Analysing the performance of managed funds using the wavelet multiscaling method

We propose a new approach for investigating the performance of managed funds using wavelet analysis and apply it to an Australian dataset. This method, applied to a multihorizon Sharpe ratio, shows that the wavelet variance at the short scale is higher than that of the longer scale, implying that an investor with a short investment horizon has to respond to every fluctuation in the realized returns, while for an investor with a much longer horizon, the long-run risk associated with unknown expected returns is not as important as the short-run risk. Using multihorizon Sharpe ratios of six groups of managed funds, we find that none of the fund groups are dominant over all time scales.

Transient Institutional Investors' Response to Insider Trade following Earnings Announcements

This study examines how institutions respond to insider trade in addition to accounting information. I show that transient institutions defined as those with short investment horizon and high turnover, reduce holdings in the following quarters when insiders are net sellers following earnings announcements. Moreover, I show that transient institutions significantly reduce more holdings when insiders are net sellers and firms also meet or beat analyst forecasts. In addition, I show that the greater reduction in transient institutional holdings when insiders are net sellers and firms also meet or beat analyst forecasts do not appear to be affected by earnings management and expectation guidance. Finally, I show that insider trade profits in terms of future abnormal returns are lower when transient institutional holdings are higher. Overall, these findings provide evidence on the ability of institutions to process insider trade information in addition to accounting numbers.

On performance persistence in the Greek equity fund market

Utilising data for the Greek equity fund market, we empirically investigate the presence of persistence in performance. Persistence is defined as a phenomenon where relative (ranked) performance tends to repeat across successive time intervals. We apply various tests to a set of performance indicators in order to statistically assess the presence or not of persistence. Our analysis documents that persistence is stronger in shorter investment horizons, and becomes weaker as the investment horizon is increased. Overall, based on risk-adjusted returns, we conclude that persistence is sporadic and short-lived, indicating an underlying self-correcting mechanism in the Greek equity fund market, which does not allow continuation of extraordinary performances.

Search and endogenous concentration of liquidity in asset markets

We develop a search-based model of asset trading, in which investors of different horizons can invest in two assets with identical payoffs. The asset markets are partially segmented: buyers can search for only one asset, but can decide which one. We show the existence of a “clientele’’ equilibrium where all short-horizon investors search for the same asset. This asset has more buyers and sellers, lower search times, and trades at a higher price relative to its identical-payoff counterpart. The clientele equilibrium dominates the one where all investor types split equally across assets, implying that the concentration of liquidity is socially desirable.

The early performance of American depository receipts listed on the New York Stock Exchange

PurposeThis study examines the initial two‐week excess performance relative to the S&amp;P 500 Index of American Depository Receipts (ADRs) listed on the New York Stock Exchange from January 1987 to September 2001 to determine whether short‐term wealth effects exist.Design/methodology/approachStandard intial public offering methodology is used to test for significant excess performance.FindingsResults for the entire sample of 281 ADRs suggest the initial excess performance was not significant. However, after segmenting the sample, emerging market ADRs significantly outperformed the S&amp;P 500 by over three per cent while developed market ADRs underperformed by 0.92 per cent. Also, Latin American ADRs outperformed the market index by nearly five per cent during the first two weeks after issue while European ADRs underperformed the market by nearly one per cent. Asia Pacific ADRs underperformed the S&amp;P 500, but not significantly in the early trading.Research limitations/implicationsThe findings suggest emerging market ADRs, particularly those from the Latin American region, perform well in the early trading while developed market ADRs do not. Future research may identify variables that affect or explain ADR excess returns.Originality/valueThe paper provides insights into the types of ADRs that accumulate wealth in the short term investment horizon.

The Effects of Institutional Ownership and Monitoring: Evidence from Financial Restatements

We find a positive relation between ownership by institutions with active strategies and short investment horizons (transient institutions) and the occurrence and magnitude of financial restatements. Even ownership by institutions with enhanced incentives to monitor does not attenuate restatement activity. Looking at discretionary accruals, which are more easily monitored than practices that might result in a restatement, we again find an increased usage associated with transient institutions though, in this case, ownership by other institutions attenuates their usage. These results suggest that the presence of transient institutional investors creates strong incentives to manage earnings and that institutional monitoring does not mitigate these incentives.

Shareholder Characteristics and Accruals Manipulation to Meet Earnings Targets

This study examines how firms' tendency to manipulate accruals to meet quarterly earnings targets, as measured by abnormal accruals volatility, relates to transient and non-transient institutional shareholdings. Abnormal accruals volatility is found to increase with transient (short-term) institutional shareholdings, but decrease with non-transient (long-term) institutional shareholdings. Robust across Jones-type models commonly used to estimate abnormal accruals, this result can be interpreted as suggesting that relative to individual investors' shareholdings, transient (non-transient) institutional shareholdings put more (less) pressure on firms to manipulate accruals. The difference in pressure applied is understandable given the difference in investment horizons and trading strategies across institutions; while transient institutions have short investment horizons and trade on short-term earnings news, non-transient institutions have long investment horizons and are insensitive to short term earnings news. The study also finds that estimated abnormal accruals volatility increases with analyst following, research and development expenditures, and the value-relevance of earnings, but decreases with firm size and the long-term growth rate of earnings.

Institutional Investors, Financial Health and Equity Valuation

This paper investigates the relation between institutional ownership, financial health, and the market valuation weights on earnings and book value of equity. We find that firms with high levels of institutional ownership are financially healthier, or less financially distressed, than firms with low levels of institutional ownership. More importantly, we find that the market valuation weight on earnings (book value of equity) increases (decreases) with the level of institutional ownership for profit firms. In contrast, the valuation weight on book value of equity increases with the level of institutional ownership for loss firms. Our findings of the above valuation effect of institutional ownership are consistent with two potential roles of institutions documented in prior literature: (1) institutions merely play a fiduciary role and (2) they play a positive governance role. Additional tests suggest that the level of institutional ownership appears to be an ex ante parsimonious proxy for both current and future financial health and that the valuation effect of institutional ownership cannot be subsumed by incorporating current measures of financial health. Moreover, we show that the valuation effect of institutional ownership is mainly driven by institutions with long investment horizons and monitoring incentives rather than institutions with short investment horizons and little monitoring incentives. We conclude that our findings of the valuation effect of institutional ownership are more consistent with institutions playing a positive governance role than merely playing a fiduciary role.

The ABCs of Mutual Funds: On the Introduction of Multiple Share Classes

We study a significant innovation with widespread consequences for the mutual fund industry: The introduction of multiple-class funds that give investors a choice among alternative load and fee structures. The transition to a multiple-class structure represents an important step in the evolution of the mutual fund industry. It also provides a well-controlled setting for research on the structure of funds, on investor clienteles and their impact on fund performance and, more generally, about the manner in which financial innovations tend to be adopted. We develop a simple model of a fund’s decision on whether and when to introduce new classes and empirically investigate the model’s predictions that: (a) Funds with more skilled management, less sensitivity of flows to performance, smaller size, higher existing loads and membership in larger families are better positioned to benefit and, therefore, more likely to switch to a multiple-class structure earlier; (b) The new classes increase the level and volatility of fund inflow by attracting investors with short and uncertain investment horizons - which, in turn, can negatively impact fund performance. Our empirical results are generally supportive of the model’s predictions.

Short-Run Considerations for the Long-Term International Investor

The hallmark of international investing over the long run is portfolio diversification; its benefits are sometimes unclear over shorter investment horizons. A focus on the cyclical equity bull and bear markets that can obscure the long-term case for international investing shows that a portfolio diversified into foreign stocks has typically provided higher returns or lower volatility than a U.S.-only portfolio, although behavioral and practical considerations call for a smaller allocation than standard recommendations. In the end, investors must weigh the expectations of long-run risk-adjusted return against the potential regret of underperforming benchmarks or peer groups over shorter investment horizons.

Multihorizon Sharpe Ratios

Wavelet analysis represents a new approach to investigating the empirical relationship between the Sharpe ratio and the investment horizon for portfolios of small stocks, large stocks, and intermediate–term and long–term bonds. A wavelet multiscale approach decomposes a given time series on a scale–by–scale basis. Empirical results indicate that the wavelet variance declines as the wavelet scale increases, implying that an investor with a short investment horizon must respond to every fluctuation in realized returns, while an investor with a much longer horizon faces much less significant long–run risk associated with unknown expected returns. The long scale Sharpe ratio is much higher than the short scale, implying that the Sharpe ratio is not time–consistent. Finally, stock portfolios have higher Sharpe ratios than bond portfolios, except in certain–length periods, indicating that evaluation of the performance of stock and bond portfolios should account for investment horizon.