EDHEC-Risk - All EDHEC-Risk Publications

All EDHEC-Risk Publications


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Risk Management

Robust Risk Estimation and Hedging: A Reverse Stress Testing Approach

Yaacov Kopeliovich, Arcady Novosyolov, Daniel Satchkov, Barry Schachter This paper proposes a novel method for reverse stress testing. The process starts with a multivariate normal distribution and uses Principal Components Analysis (PCA) along with Gram-Schmidt orthogonalization to determine scenarios leading to a specified loss level. The approach is computationally efficient. The method includes the maximum likelihood scenario, maximizes (a definition of) representativeness of the scenarios chosen, and measures the plausibility of each scenario. In addition, empirical results for sample portfolios show this method can provide new information beyond VaR and standard stress testing analyses. More...

18/06/13

Commodities

Long-Term Sources of Return in the Commodity Futures Markets: Evidence from the Grain Markets

Hilary Till This article provides some preliminary contributions to the debate over the sources of return in the commodity markets, based on work that is drawn from the 2007 Risk Book, Intelligent Commodity Investing. Essentially, Till (2007) and Feldman and Till (2006) find that in examining a 55-year period in three grain futures markets that the term-structure of an individual contract is the dominant source of return, but only over long (five-year) time-frames. During periods of price stability, grain commodity futures prices have been naturally mean-reverting, meaning that sources of return obviously could not be from trends in the spot price; instead, they had to be from secondary (non-obvious) factors like the shape of a commodity market’s futures curve. More...

18/06/13

Financial Modelling

Tempered Stable Ornstein-Uhlenbeck Processes: A Practical View

Michele Leonardo Bianchi, Svetlozar T. Rachev, Frank J. Fabozzi This paper studies the one-dimensional Ornstein-Uhlenbeck (OU) processes with marginal law given by the tempered stable and tempered infinitely divisible distributions proposed by Rosinski (2007) and Bianchi et al. (2010b), respectively. In general, the use of non-Gaussian OU processes is impeded by difficulty in calibration and simulation. Accordingly, we investigate the law of transition between consecutive observations of OU processes and - with a view to practical applications - evaluate the characteristic function of integrated tempered OU processes in three cases: classical tempered stable, variance gamma, and rapidly decreasing tempered stable. More...

13/06/13

Performance

Size Rotation in the US Equity Market

Keith L. Miller, Chee Ooi, Hong Li, Daniel Giamouridis This paper develops a hybrid model that relies on the nonlinear classification Decision Tree (DT) approach but also on multivariate predictive regressions to aid implement a size rotation strategy in the U.S. equity markets. Our investment prediction is derived with a two-stage algorithm. In the first stage we use a decision tree to determine whether large-cap or small-cap stocks will outperform in the subsequent quarter. In the second stage we use a multiple linear regression model to predict whether large-cap stocks will outperform or underperform small-cap stocks over the next quarter. A version of this paper was published in the Winter 2013 issue of the Journal of Portfolio Management. More...

11/06/13

Commodities

New Developments in the Commodity Markets

Hilary Till In 2007, the highly dynamic commodity markets had attracted new classes of participants such as algorithmic high-frequency traders; sophisticated product structurers; and Chinese entrepreneurs. This article will briefly cover the market developments that brought in these new participants. More...

11/06/13

Alternative Investments

Inferences about the Amaranth Case and the Emerging Maturity of the Hedge Fund Industry

Hilary Till The Amaranth case is surprising in many ways. It is definitely a surprise that a well-respected multi-strategy hedge fund could lose about $6-billion in little over a week. It is perhaps an even greater surprise that such a loss would have little knock-on effects on the hedge fund industry and the wider capital markets. This paper will focus on providing new inferences on the riskiness of Amaranth’s trading strategies. More...

11/06/13

Commodities

Into a Distant Mirror: the 1870s

Hilary Till On October 16th, 2010, the front page of the Wall Street Journal (WSJ) carried a story entitled, “Flashback to 1870 as Cotton Hits Peak” (Cancryn and Cui, 2010). The article noted that cotton prices had not been this high since at least 1870. Since this WSJ article was published, cotton prices have continued to reach new highs. If one looks into the distant mirror of the 1870s, one can spot other parallels to our current circumstances beyond the similarly explosive cotton price rally. As a result, one can find some very interesting, and potentially useful, historical lessons to draw on from that era. More...

11/06/13

Risk Management

Intelligent Commodity Trading and Risk Management

Hilary Till This paper discusses intelligent risk-management techniques and new product innovation in the commodity futures markets. However, it first reviews the century-plus debate on the role of commodity speculators, given the prevalent concerns that this activity may have a destabilizing impact on commodity prices. More...

07/06/13

Risk Management

Risk Management Lessons in Leveraged Commodity Futures Trading

Hilary Till This paper discusses the practical issues involved in applying a disciplined risk management methodology to futures trading and shows how to apply methodologies derived from both conventional asset management and hedge fund management to futures trading. It also discusses some of the risk management issues, which are unique to leveraged futures trading. More...

07/06/13

Asset Allocation

Asset Allocation with Shadow Assets

Bernd Scherer The wealth of most investors contains both financial assets as well as non-financial assets. This paper defines shadow assets as (mostly) non-financial and non-tradable assets that are exogenous to the investor’s asset allocation decision. Examples for shadow assets are human capital, non-financial sovereign assets (e.g. underground oil reserves) the present value of future alumni contributions for university endowments or the non-listed family business for the client of a family office. Allocations to these shadow assets can hardly be changed and yet their existence will change the investor’s perspective on total wealth at risk. A revisited version of this paper was published in the Winter 2012 issue of the Journal of Wealth Management. More...

04/06/13

Commodities

Commodity Futures Returns and Idiosyncratic Volatility

Joëlle Miffre, Ana-Maria Fuertes, Adrian Fernandez-Perez This paper studies the relationship between idiosyncratic volatility and expected returns in commodity futures markets. Measuring idiosyncratic volatility relative to traditional pricing models that fail to account for backwardation and contango leads to the puzzling conclusion that idiosyncratic volatility is negatively priced. In sharp contrast, idiosyncratic volatility is not priced when the fundamental backwardation and contango cycle of commodity futures markets is factored in an appropriate benchmark. Further evidence suggests that the idiosyncratic volatility inferred from traditional benchmarks acts as proxy for the risk associated with contangoed contracts. More...

03/06/13

Volatility

The Relevance of Country- and Sector-specific Model-free Volatility Indicators

Lixia Loh, Lionel Martellini, Stoyan Stoyanov This paper tests for the presence of local volatility factors using model-free volatility indicators in contrast to the classical model-dependent approach through GARCH-type processes. It employs three different model-free methodologies – model-free option implied volatility (MFOI), realised volatility, and cross-sectional volatility (CSV). More...

30/05/13

Alternative Investments

Skin in the Game versus Skimming the Game: Governance, Share Restrictions and Insider Flows

Gideon Ozik, Ronnie Sadka Hedge-fund managers justify share restrictions as means of protecting the common interest of the shareholders. However, this paper advances that such restrictions can adversely induce information asymmetry between managers and their clients about future fund flows. The paper demonstrates that share-restricted funds with recent outflows underperform funds with recent inflows by about 5.6% annually over 1998—2008. No such return spread is observed for funds with low-share restrictions. As managers may also act as investors in their own funds, the information asymmetry potentially allows them to profit by trading in advance of their clients. More...

28/05/13

Institutional Investment

Investment Solutions for East Asia's Pension Savings

Frédéric Blanc-Brude, François Cocquemas, Albena Georgieva Two of the most commonplace stylised facts about East Asia have to do with pension issues: the region's population is ageing fast and its household sector has high savings rates. Both ideas are intuitively related: as demographic transitions occur, more individuals should save in preparation for their retirement. This paper examines the relationship between savings and retirement income in East Asia, defined as North-East Asia and Greater China (Japan, Korea, Taiwan, China and Hong Kong). More...

16/05/13

Commodities

Commodity Strategies Based on Momentum, Term Structure and Idiosyncratic Volatility

Ana-Maria Fuertes, Joëlle Miffre, Adrian Fernandez-Perez This article demonstrates that momentum, term structure and idiosyncratic volatility signals in commodity futures markets are not overlapping, which motivates the design of a new triple-screen strategy. Over the period between January 1985 and August 2011, systematically buying contracts with high past performance, high roll-yield and low idiosyncratic volatility, while shorting contracts with poor past performance, low roll-yields and high idiosyncratic volatility generates an average Sharpe ratio that is five times that of the S&P-GSCI. The triple-screen strategy dominates each of the individual strategies and its risk-adjusted performance cannot be attributed to overreaction, liquidity risk or neglecting transaction costs. More...

14/05/13

Infrastructure Investment

Construction Risk in Infrastructure Project Finance

Frederic Blanc-Brude, Dejan Makovsek Using new data, this paper shows that construction risk in infrastructure project finance is well-managed and that project sponsors face very little construction risk compared to the well-documented, systematic and very large cost overruns found in traditional infrastructure project procurement. We know from the project management literature that construction risk is significant in public infrastructure projects delivered through traditional procurement methods. We also know that, when similar projects are procured using project financing, construction risk is passed on through date-certain, fixed price contracts. However, there is, to our knowledge, no available empirical research on the significance of construction risk once it has been passed on. More...

13/05/13

ALM and Asset Management

The Benefits of Sovereign, Municipal and Corporate Inflation-Linked Bonds in Long-Term Investment Decisions

Romain Deguest, Lionel Martellini, Vincent Milhau This paper proposes an empirical analysis of the opportunity gains involved in investing in inflation-linked bonds for long-term investors facing inflation-linked liabilities. Using formal intertemporal spanning tests, it finds that substantial welfare gains are obtained, especially over long-horizons. Introducing inflation-linked bonds allows investors to improve investor welfare because of their hedging and performance benefits; hence investors may attain the same welfare (risk-return trade-off) with a lower initial investment when inflation-linked bonds are available compared to investing in stocks and nominal bonds only. Even more substantial utility gains are obtained in situations where the regulatory value for investors’ liabilities contains a credit risk adjustment. More...

25/04/13

Asset Allocation and Alternative Diversification

An Analysis of the Convergence between Mainstream and Alternative Asset Management

Juha Joenväärä, Robert Kosowski This paper provides an academic analysis of the main techniques that are currently used by hedge fund managers and that could be transported to the mutual fund and alternative UCITS space in a straightforward manner so as to provide better forms of risk management in a regulated environment. It also examines the convergence between the mainstream and the alternative asset management industry by studying UCITS and non-UCITS hedge funds. More...

04/04/13

Asset Allocation and Alternative Diversification

Who is Afraid of Construction Risk?

Frédéric Blanc-Brude, Omneia R. H. Ismail This paper examines the known investment characteristics and portfolio diversification properties of infrastructure debt. The analysis is focused on project finance debt since it represents the bulk of existing and, in all likelihood, future infrastructure debt and also because, contrary to the notion of `infrastructure', it benefits from a clear and internationally recognised definition. The objective of the study is to highlight the credit risk characteristics of infrastructure debt for the purpose of institutional investing, in the context of pension funds and insurance companies' need for long-term assets creating predictable cash flows, both to manage their liabilities and also minimise their exposure to capital market volatility. More...

28/03/13

ALM and Asset Management

Hedging versus Insurance: Long-Horizon Investing with Short-Term Constraints

Romain Deguest, Lionel Martellini, Vincent Milhau This study provides comprehensive insights into all of EDHEC-Risk Institute’s research on dynamic allocation in asset-liability management. The publication builds on these previous findings and illustrates that failing to separate long-term risk-aversion and short-term loss-aversion may lead to poor investment decisions. More...

28/03/13

Exchange-Traded Funds

The EDHEC European ETF Survey 2012

Noël Amenc, Felix Goltz, Nicolas Gonzalez, Nikhil Shah, Eric Shirbini, Nikolaos Tessaromatis The EDHEC European ETF Survey 2012 presents the results of a comprehensive survey of 212 European ETF investors. The aim of the study is to analyse the usage of exchange-traded funds (ETFs) in investment management and to provide a detailed account of the current perceptions and practices of European investors in ETFs. Overall, the survey has revealed some interesting trends with regard to investor behaviour, investor perceptions and the general outlook for the ETF industry. More...

28/03/13

Indexes and Benchmarking

Smart Beta 2.0

Noël Amenc, Felix Goltz, Lionel Martellini This position paper seeks to draw the attention of investors to the risks of traditional smart beta equity indices and proposes a new approach to smart beta investing to take account of these risks. This new approach, referred to as “Smart Beta 2.0,” enables investors to measure and control the risks of their benchmark and revolutionises the offerings of advanced equity benchmarks. More...

19/03/13

Indexes and Benchmarking

Assessing the Quality of Asian Stock Market Indices

Narasimhan Padmanaban, Masayoshi Mukai, Lin Tang, Véronique Le Sourd There has been increasing demand for equity indices in Asia. This is because global investors wish to benefit from the region’s growth, and consequently from its financial markets. As many US- and Europe-based investors do not have the expertise to conduct stock picking in Asia, equity investments are often passive for Asian-oriented portfolios. Therefore, the question of index quality in Asia is an important issue. This study addresses that question by focusing on three aspects: efficiency, concentration and stability. More...

05/03/13

Indexes & Benchmarking

Reactions to “A Review of Corporate Bond Indices: Construction Principles, Return Heterogeneity, and Fluctuations in Risk Exposures”

Felix Goltz, Véronique Le Sourd, Masayoshi Mukai, Fahd Rachidy The results of a call for reaction conducted to help gather evidence on investor perceptions of the issues related to corporate bond indexing, further to the EDHEC-Risk Institute study published in 2011 that found highly unstable risk exposure, and notably highly unstable duration, across eight indices through time, in the eurozone and the US, and with heightened instability in two so-called “investable” indices. More...

26/02/13

Institutional Investment

The Impact of Solvency II on Bond Management

Liliana Arias, Philippe Foulquier, Alexandre Le Maistre Solvency II, which could come into effect in 2016, will have a significant impact on the way insurance companies, as well as financial markets, perceive risk. One of the major changes with Solvency II is the treatment of market risks, which represent an additional capital cost that now needs to be incorporated into the analysis of insurers’ investment choices. This study analyses the impact of the new prudential regulation on bond management. It considers the appropriateness of the bond Solvency Capital Requirement (SCR) as a risk measure, the effects of this risk measure on bond management within a return-volatility-Value-at-Risk-SCR universe, and whether Solvency II will give rise to a new bond hierarchy and arbitrage opportunities. More...

25/02/13

Regulation

Proposals for Better Management of Non-Financial Risks within the European Fund Management Industry

Noël Amenc, Frédéric Ducoulombier This paper concludes three years of research on better management of non-financial risks within the European fund management industry and puts forward a series of proposals to limit these risks which emerged during the 2007-2008 crisis and undermined the quality of the UCITS label. More...

28/01/13

Institutional Investment

Towards Better Consideration of Pension Liabilities in European Union Countries

François Cocquemas The goal of this study is to provide a broad picture of explicit and implicit pension liabilities in the EU-27 countries’ pension systems, together with an assessment of the risks each of them face. As structural deficits become a target in the Eurozone and beyond, it is fundamental to evaluate the extent to which the increasing funding needs, and the decreasing funding basis of public pensions, could add to public deficits. More...

24/01/13

Infrastructure Investment

Towards Efficient Benchmarks for Infrastructure Equity Investments

Frédéric Blanc-Brude This paper highlights a recent research quandary with respect to infrastructure equity investment which has also been a source of interrogation for final investors: while the economics of underlying infrastructure investment suggests a low and potentially attractive risk profile, the experience of investors and available research evidence have been different and rather mixed. More...

15/01/13

Risk Management

A Fully Integrated Liquidity and Market Risk Model

Attilio Meucci Going beyond the simple bid—ask spread overlay for a particular value at risk, this paper introduces a framework that integrates liquidity risk, funding risk, and market risk. We overlay a whole distribution of liquidity uncertainty on future market risk scenarios and we allow the liquidity uncertainty to vary from one scenario to another, depending on the liquidation or funding policy implemented. The result is one easy-to-interpret, easy-to-implement formula for the total liquidity-plus-market-risk profit and loss distribution. A revisited version of this paper was published in the November/December 2012 issue of the Financial Analysts Journal. More...

12/12/12

Institutional Investment

Improving Risk Management in DC and Hybrid Pension Plans

François Cocquemas This short paper highlights the key conclusions of Amenc et al. (2012) regarding the best practices for managing risks in defined-contribution (DC) and hybrid plans. More...

26/11/12

Asset Pricing

A New Method for Generating Approximation Algorithms for Financial Mathematics Applications

Frank J. Fabozzi, Arturo Leccadito, Radu S. Tunaru This paper describes a new technique that can be used in financial mathematics for a wide range of situations where the calculation of complicated integrals is required. The numerical schemes proposed here are deterministic in nature but their proof relies on known results from probability theory regarding the weak convergence of probability measures. We adapt those results to unbounded payoffs under certain mild assumptions that are satisfied in finance. Because our approximation schemes avoid repeated simulations and provide computational savings, they can potentially be used when calculating simultaneously the price of several derivatives contingent on the same underlying. This paper was published in the October 2012 issue of Quantitative Finance. More...

16/11/12

Commodities

Comparing First, Second and Third Generation Commodity Indices

Joëlle Miffre The rising interest of institutional investors for commodities since the early 2000s prompted remarkable financial engineering in the commodity index space which is now in its third generation. The purpose of this article is to review this evolution and to give an assessment of index performance. More...

14/11/12

Indexes and Benchmarking

Alternative Equity Beta Benchmarks

Noël Amenc, Felix Goltz, Ashish Lodh This paper clarifies that methodological choices can be made independently on two steps in the construction of alternative equity index strategies – the constituent selection and the choice of a diversification-based weighting scheme. By flexibly combining the different possible choices for these steps we create a large variety of strategies, and test their performance and risk results. Our results suggest that diversification approaches may be a superior alternative or at least a very important complement to pure stock selection approaches when it comes to reaching a risk/return objective. Moreover, while it is often argued that the risk and performance of diversification-based weighting schemes is solely driven by factor tilts, we show that it is straightforward to correct such tilts through the selection of stocks with appropriate characteristics, while maintaining the improvement in objective that is due to the respective diversification approach. A revisited version of this paper was published in the Fall 2012 issue of the Journal of Portfolio Management. More...

17/10/12

Asset Pricing

Asset Prices with Heterogeneity in Preferences and Beliefs

Harjoat S. Bhamra, Raman Uppal This paper studies asset prices in a dynamic, continuous-time, general-equilibrium endowment economy where agents have power utility and differ with respect to both beliefs and their preference parameters for time discount and risk aversion. It solves in closed form for the following quantities: optimal consumption and portfolio policies of individual agents; the riskless interest rate and market price of risk; the stock price, equity risk premium, and volatility of stock returns; and, the term structure of interest rates. More...

09/10/12

Business Analysis

Inferring the Value of Intangible Assets

Georgios Angelopoulos, Daniel Giamouridis, Orestes Vlismas This paper examines whether financial statement analysis can be effective in inferring the intangible value of firms. It measures the intangible value by means of a firm’s Intellectual Capital, which encompasses the intangible assets and the organizational knowledge of a firm that are not reported directly by financial statements. Our analysis decomposes Intellectual Capital into its three primary components: Human Capital, Structural Capital, and Relational Capital. More...

05/10/12

Institutional Investment

Response to the European Commission White Paper "An Agenda for Adequate, Safe and Sustainable Pensions"

Noël Amenc, François Cocquemas, Lionel Martellini, Samuel Sender On February 16th, 2012, the European Commission published a White Paper entitled “An Agenda for Adequate, Safe and Sustainable Pensions”. It proposes a series of measures related to information and monitoring, European harmonisation and portability, and pension design. The enclosed paper provides a short summary of some of the main challenges facing European pension systems, and then discusses the Commission’s proposals point by point. More...

01/10/12

Indexes and Benchmarking

The Risks of Volatility ETNs: A Recent Incident and Underlying Issues

Felix Goltz, Stoyan Stoyanov Getting volatility exposure has become easier for investors after the relatively recent introduction of volatility ETNs (exchange-traded notes) and volatility ETFs (exchange-traded funds) and some of these products have enjoyed a surge in popularity. This paper uses the recent crisis with TVIX – a volatility ETN – to underline important differences between ETNs and ETFs which appear to be at the source of the observed market distortion. More...

21/09/12

Performance

The Alpha of a Market Timer

Georges Hübner Portfolio managers claim to be able to generate abnormal returns through either superior asset selection or market timing. The Treynor and Mazuy (TM) model is the most used return-based approach to isolate market timing skills, but all existing corrections of the regression intercept can be manipulated by a manager who can trade derivatives. This paper revisits the TM model by applying the original option replication approach proposed by Merton. It exploits both the linear and the quadratic coefficients of the TM regression to assess the replicating cost of the cheapest option portfolio with the same convexity. The application of the new correction on two samples of market timing funds delivers particularly encouraging empirical results. More...

12/09/12

ALM and Asset Management

Long-Term Investing Strategies in Private Wealth Management

Noël Amenc, Romain Deguest, Lionel Martellini, Vincent Milhau This paper argues that improved long-term investing strategies can be designed for private wealth management. These dynamic allocation strategies exploit the presence of mean-reversion in interest rates, equity Sharpe ratio and equity volatility. The resulting asset allocation strategy is based on an industrialisation of three key paradigms that have recently emerged in institutional money management: liability-driven investing (LDI), for taking into account private clients’ consumption objectives, life-cycle investing (LCI), for taking into account private clients’ horizon, and risk-control investing (RCI), for taking into account private clients’ risk budgets. Our Monte Carlo experiments reveal a substantial benefit in terms of utility gains from using improved long-term investing strategies over existing industry standards. More...

12/09/12

Portfolio Management

Keynes Meets Markowitz: The Trade-off Between Familiarity and Diversification

Phelim Boyle, Lorenzo Garlappi, Raman Uppal, Tan Wang This paper develops a model of portfolio choice that nests the views of Keynes—who advocates concentration in a few familiar assets—and Markowitz—who advocates diversification across assets. It relies on the concepts of ambiguity and ambiguity aversion to formalize the idea of an investor's "familiarity" toward assets. More...

10/09/12

Asset Pricing

A New Measure of Equity Duration: The Duration-Based Explanation of the Value Premium Revisited

David Schröder, Florian Esterer This paper proposes a new methodology to estimate a share's equity duration by using analysts' cash-flow forecasts. It finds that short duration is associated with high expected and realised returns — which cannot be attributed to the shares' systematic risk exposure as implied by the market beta. Instead, the paper shows that this measure of a company's average cash-flow maturity is a priced risk factor that has similar properties as the Fama-French factor B/M ratio. Our analysis suggests that the value premium might be a compensation for the value firms' higher exposure to cash-flow risk. More...

07/08/12

Asset Allocation and Derivative Instruments

The Benefits of Structured Products in Asset-Liability Management

Lionel Martellini, Vincent Milhau This paper introduces a continuous-time dynamic asset allocation model for an investor facing liability constraints in the presence of inflation and interest rate risks. When funding ratio constraints are explicitly accounted for, the optimal policies, for which we obtain analytical expressions, are shown to extend standard Option-Based Portfolio Insurance (OBPI) strategies to a relative risk context, with the liability-hedging portfolio replacing the risk-free asset. We also show that the introduction of maximum funding ratio targets would allow pension funds to decrease the cost of downside liability risk protection while giving up part of the upside potential beyond levels where marginal utility of wealth (relative to liabilities) is low or almost zero. A revisited version of this paper was published in the October 2012 issue of the Journal of Pension Economics and Finance. More...

07/08/12

Indexes and Benchmarking

Direct and Indirect Effects of Index ETFs on Spot-Futures Pricing and Liquidity: Evidence from the CAC 40

Laurent Deville, Carole Gresse, Béatrice de Séverac This paper investigates how the introduction of an index security directly or indirectly impacts the underlying-index spot-futures pricing. Using intraday data for financial instruments related to the CAC 40 index, it does not find that the spot-futures price efficiency improvement observed after ETF introduction is explained either by the direct effect of ETF shares being used in arbitrage trades or by the indirect effect of ETF trading improving the liquidity of index stocks in the short run. A revisited version of this paper is forthcoming in European Financial Management. More...

07/08/12

Asset Allocation and Alternative Diversification

Robust Assessment of Hedge Fund Performance through Nonparametric Discounting

Caio Almeida, René Garcia This paper evaluates the performance of hedge funds through a new nonlinear risk adjustment of returns. The risk adjustment is such that it prices exactly the usual set of risk factors considered in the hedge fund literature. This nonlinear risk adjustment goes beyond the usual linear regression methodology used in many hedge fund performance papers, including nonlinear exposures based on option-like features. The approach proposed in this paper overcomes two important limitations of the linear methodology: it captures the nonlinear exposure of a hedge fund strategy to several risk factors, and it is not limited to nonlinear shapes resembling standard option payoff patterns. This methodology is applied to various hedge fund indices as well as to individual hedge funds, considering a set of risk factors including equities, bonds, credit, currencies and commodities. The main message that emerges from the analysis on the performance of hedge fund strategies is that exposure to higher-moment risks on the various factors matters. Analysing the performance of HFRI indices on primary strategies and sub-classes of primary strategies, the paper reports sizeable differences in performance, between the linear and the nonlinear risk adjustment. More...

13/07/12

Investment Management

What do Short Sellers Know?

Ekkehart Boehmer, Charles M. Jones, Xiaoyan Zhang Using proprietary short-sale order data, we investigate the sources of short sellers’ informational advantage. Heavier shorting occurs the week before negative earnings surprises, analyst downgrades, and downward revisions in analyst earnings forecasts. The biggest effects are associated with analyst downgrades. More...

05/07/12

ALM and Asset Management

Reactions to the EDHEC Study “Optimal Design of Corporate Market Debt Programmes in the Presence of Interest-Rate and Inflation Risks”

Noël Amenc, Felix Goltz, Vincent Milhau, Masayoshi Mukai EDHEC-Risk Institute has conducted extensive research into advanced debt management practices, including a study on the possibility of increasing firm value through the issuance of an optimal level of inflation-linked bonds, which would allow for a reduction in the variability of cash flows, net of debt costs. More...

26/06/12

Indexes and Benchmarking

Seeing through the Smoke Screen of Fundamental Indexers: What are the Issues with Alternative Equity Index Strategies?

With an ever-growing number of alternative index construction methods on offer, investors should, in principle, be thankful for comparative analysis. Such comparison has recently been provided in several articles written by promoters of fundamentally-based equity indices. More...

25/06/12

Commodities

"Who Sank the Boat?" Response to the Finance Watch paper "Investing Not Betting"

Hilary Till This EDHEC-Risk position paper specifically responds to a recent report by Finance Watch on regulatory proposals for commodity derivatives markets in Europe. The paper describes an alternative narrative for what caused the recent commodity price spikes and then notes what implications this narrative has for addressing Finance Watch’s regulatory proposals. More...

08/06/12

Indexes and Benchmarking

EDHEC-Risk North American Index Survey 2011

Noël Amenc, Felix Goltz, Lin Tang, Vijay Vaidyanathan As the choice of an index is a crucial step in both asset allocation and performance measurement, it is useful to investigate index use and perceptions about indices. The EDHEC-Risk North American Index Survey 2011 aims to analyse the current uses of and opinions on stock, bond and equity volatility indices. While information on index vehicles is widely available, particularly in the case of exchange-traded vehicles, the objective of the survey is to provide unique insight into the users’ perspective in the index industry, not only including a description of the current practices, but also user perceptions on different indices and on benefits and drawbacks of index construction methodologies. A paper based on this study was published in the March/April 2013 issue of the Journal of Indexes. More...

08/06/12

Asset Pricing

Bond Liquidity Premia

Jean-Sébastien Fontaine, René Garcia Asset pricing models of limits to arbitrage emphasize the role of funding conditions faced by financial intermediaries. In the US, the Treasury repo market is the key funding market and, hence, theory predicts that the liquidity premium of Treasury bonds share a funding liquidity component with risk premia in other markets. This paper identifies and measures the value of funding liquidity from the cross-section of bonds by adding a liquidity factor correlated with age to an arbitrage-free term structure model. A revisited version of this paper was published in the April 2012 issue of The Review of Financial Studies. More...

07/06/12

Asset Allocation and Derivative Instruments

The Benefits of Volatility Derivatives in Equity Portfolio Management

Renata Guobuzaite, Lionel Martellini The focus of this paper is to provide a formal analysis of the benefits of volatility derivatives in equity portfolio management from the perspective of a European investor. Its main contribution is to compare the risk/return characteristic of equity portfolios combined with long volatility exposure to those of a GMV equity portfolio – the conventional approach to managing equity volatility. This paper is in fact the first to provide an explicit comparison of managed volatility strategies based on GMV portfolios and managed volatility strategies based on volatility derivatives. The results unambiguously suggest that the latter approach is a more efficient way to manage equity volatility, especially in market downturns periods. More...

06/06/12

Socially Responsible Investment

Environmental corporate social responsibility and financial performance: Disentangling direct and indirect effects

Abraham Lioui, Zenu Sharma This paper assesses the impact of environmental corporate social responsibility (ECSR) on Corporate Financial Performance (CFP) measured by ROA and Tobin's Q. We show that the relationship between firms' return on assets (ROA) and ECSR, strengths and concerns, is negative and statistically significant. We also show that firms' Tobin Q and ECSR, strengths and concerns, are negatively correlated in a statistically significant way. However, accounting for the interaction between firms' environmental efforts and R&D yields a different perspective: while the direct impact of ECSR on CFP is still negative, the interaction of ECSR and R&D has a positive and significant impact on it. ECSR strengths and concerns harm CFP since they are perceived as a potential cost. However, this CSR activity fosters R & D efforts of firms which generates additional value (indirect effect). This paper was published in the June 2012 issue of Ecological Economics. More...

05/06/12

Indexes and Benchmarking

Liability Index Fund: The Liability Beta Portfolio

Ronald J. Ryan, Frank J. Fabozzi Historically, the practice of trustees of defined benefit programs has been to make the asset allocation decision based on prevailing risk-return relationship for asset classes without regard to the plan’s economic funded ratio, liability structure, and liability economic growth rate. Once the asset allocation decision is made, the market index that best represents that asset class is selected as the performance benchmark. Ignoring the liability structure has been the major reason for the failure of both private and public pension funds to achieve their true objective of funding the liability benefit payment schedule at a stable and low cost to the plan sponsor. For trustees to properly manage pension assets in light of the true objective, they need a liability index customized to the fund’s unique benefit payment schedule. This article explains how this should be accomplished and how Alpha and Beta portfolios should be redefined in order to work in harmony with the plan’s true objective. This paper was published in the November 2011 issue of the Journal of Financial Transformation. More...

30/05/12

Asset Pricing

Determinants of Primary Market Spreads on U.K. Residential Mortgage-Backed Securities and the Implications for Investor Reliance on Credit Ratings

Frank J. Fabozzi, Dennis Vink This paper provides empirical evidence about the credit factors that affect the pricing of newly issued residential mortgage-backed securities (RMBS) in the U.K. The findings add an important element to the current debate by regulators throughout the world regarding whether investors rely exclusively on credit ratings in making investment decisions. The results show that credit factors such as subordination level and collateral type that are taken into account by credit rating agencies when assigning a rating still have a significant impact on the new issuance spread even after accounting for the credit rating. The implication is that investors do not rely exclusively on ratings. This paper was published in the Winter 2012 issue of the Journal of Fixed Income. More...

30/05/12

Portfolio Management

Metrization of Stochastic Dominance Rules

Stoyan V. Stoyanov, Svetlozar T. Rachev, Frank J. Fabozzi This paper considers a new approach towards stochastic dominance rules which allows measuring the degree of domination or violation of a given stochastic order and represents a way of describing stochastic orders in general. Examples are provided for the n-th order stochastic dominance and stochastic orders based on a popular risk measure. It demonstrates how the new approach can be used for construction of portfolios dominating a given benchmark prospect. This paper was published in Volume 15, Issue 2 of the International Journal of Theoretical and Applied Finance. More...

30/05/12

Financial Modelling

A comparison of the Lee–Carter model and AR–ARCH model for forecasting mortality rates

Rosella Giacomettia, Marida Bertocchi, Svetlozar T. Rachev, Frank J. Fabozzi With the decline in the mortality level of populations, national social security systems and insurance companies of most developed countries are reconsidering their mortality tables taking into account the longevity risk. The Lee and Carter model is the first discrete-time stochastic model to consider the increased life expectancy trends in mortality rates and is still broadly used today. This paper proposes an alternative to the Lee–Carter model: an AR(1)–ARCH(1) model. More specifically, it compares the performance of these two models with respect to forecasting age-specific mortality in Italy. It fits the two models, with Gaussian and t-student innovations, for the matrix of Italian death rates from 1960 to 2003. It compares the forecast ability of the two approaches in out-of-sample analysis for the period 2004–2006 and finds that the AR(1)–ARCH(1) model with t-student innovations provides the best fit among the models studied in this paper. This paper was published in the January 2012 issue of Insurance: Mathematics and Economics. More...

30/05/12

Financial Economics

What’s Wrong with Today’s Economics? The Current Crisis Calls for an Approach to Economics Rooted More on Data Than on Rationality

Frank J. Fabozzi, Sergio M. Focardi The authors argue that current mainstream economics is not a science in the sense of the physical sciences, and they draw some conclusions from the point of view of asset management. Their key point is that economics as embodied in the general equilibrium theories describes an idealized rational economic world as opposed to one based on empirical data. Although this argument has already been made, it has been virtually ignored by economists. The current crisis, however, requires an economic understanding anchored on a solid empirical basis. This paper was published in the Spring 2012 issue of the Journal of Portfolio Management. More...

30/05/12

Indexes and Benchmarking

Introducing a New Form of Volatility Index: The Cross-Sectional Volatility Index

Felix Goltz, Renata Guobuzaite, Lionel Martellini This paper introduces a new form of volatility index, the cross-sectional volatility index. Through formal central limit arguments, it shows that the cross-sectional dispersion of stock returns can be regarded as an efficient estimator for the average idiosyncratic volatility of stocks within the universe under consideration. Among the key advantages of the cross-sectional volatility index measure over currently available measures are its observability at any frequency, its model-free nature, and its availability for every region, sector, and style of the world equity markets, without the need to resort to any auxiliary option market. A revisited version of this paper was published in Bankers, Markets & Investors, March 2012. More...

14/05/12

Indexes and Benchmarking

EDHEC-Risk Asian Index Survey 2011

Noël Amenc, Felix Goltz, Masayoshi Mukai, Padmanaban Narasimhan, Lin Tang This is the first comprehensive survey of Asian investment professionals that identifies the criteria investors use to assess and select stock and bond indices, measures satisfaction of Asian investors with existing indices, and documents their segmentation practices. It includes comparisons with results from sister surveys of European and North-American investors. This new survey-based evidence will be useful to Asian investors who wish to benchmark their indexation practices to research advances as well as to the practices of their peers in the region and globally. It will also provide much-needed information to providers of investment solutions who want to better address the needs of Asian investors. More...

10/05/12

Portfolio Management

Higher-Order Durations with Respect to Inflation and Real Rates and their Portfolio Management Applications

Frank J. Fabozzi, Yuewu Xu This study considers duration measures of any order with respect to inflation and real rates for both nominal bonds and real bonds (i.e., inflation-indexed bonds, or TIPS). The authors demonstrate that these duration measures, as well as the analysis of fixed-income portfolios, take a particularly simple form when examined from the viewpoint of continuously compounded rates. They show that, although the durations of all orders for nominal bonds with respect to inflation and real rates are exactly equal to the usual durations with respect to the nominal rates, the durations of all orders for TIPS with respect to inflation is exactly zero and the duration of all orders for TIPS with respect to real rates can be calculated in the usual way. Under general (non-infinitesimal) changes in the term structures of inflation and real rates, they derive the formulas for the percentage changes in bond prices using higher-order duration measures. Applications to portfolio management such as hedging (or speculating) on the inflation rate using portfolios of nominal bonds and TIPS are discussed. This paper was published in the Spring 2012 issue of the Journal of Fixed Income. More...

24/04/12

Asset Pricing

Option pricing and hedging under a stochastic volatility Lévy process model

Frank J. Fabozzi, Young Shin Kim, Zuodong Lin, Svetlozar T. Rachev In this paper, we discuss a stochastic volatility model with a Lévy driving process and then apply the model to option pricing and hedging. The stochastic volatility in our model is defined by the continuous Markov chain. The risk-neutral measure is obtained by applying the Esscher transform. The option price using this model is computed by the Fourier transform method. We obtain the closed-form solution for the hedge ratio by applying locally risk-minimizing hedging. This paper was published in Volume 15, Issue 1 of the Review of Derivatives Research. More...

24/04/12

Financial Modelling

Approximation of Skewed and Leptokurtic Return Distributions

Frank Fabozzi, Young Shin Kim, Svetlozar Rachev, Matthias Scherer There is considerable empirical evidence that financial returns exhibit leptokurtosis and nonzero skewness. As a result, alternative distributions for modelling a time series of the financial returns have been proposed. A family of distributions that has shown considerable promise for modelling financial returns is the tempered stable and tempered infinitely divisible distributions. Two representative distributions are the classical tempered stable and the Rapidly Decreasing Tempered Stable (RDTS). In this article, we explain the practical implementation of these two distributions by (1) presenting how the density functions can be computed efficiently by applying the Fast Fourier Transform (FFT) and (2) how standardization helps to drive efficiency and effectiveness of maximum likelihood inference. This paper was published in Volume 22, Issue 16 of Applied Financial Economics. More...

24/04/12

Asset Pricing

A Pricing Framework for Real Estate Derivatives

Frank J. Fabozzi, Radu Tunaru, Robert Shiller New methods are developed here for pricing the main real estate derivatives - futures and forward contracts, total return swaps, and options. Accounting for the incompleteness of this market, a suitable modelling framework is outlined that can produce exact formulae, assuming that the market price of risk is known. This framework can accommodate econometric properties of real-estate indices such as predictability due to autocorrelations. The term structure of the market price of risk is calibrated from futures market prices on the Investment Property Databank index. The evolution of the market price of risk associated with all five futures curves during 2009 is discussed. This paper was published in the November 2012 issue of European Financial Management. More...

24/04/12

Asset Pricing

Looking Beyond Credit Ratings: Factors Investors Consider in Pricing European Asset-Backed Securities

Frank Fabozzi, Dennis Vink In this paper, we empirically investigate what credit factors investors rely upon when pricing the spread at issue for European asset-backed securities. More specifically, we investigate how credit factors affect new issuance spreads after taking into account credit rating. We do so by investigating primary market spreads for tranches of non-mortgage-related asset-backed securities issued from 1999 to the year prior to the subprime mortgage crisis, 2007. We find that although credit ratings play a major role in determining spreads, investors appear to not rely exclusively on these ratings. Our findings strongly suggest that investors do not ignore other credit factors beyond the assigned credit rating. This paper was published in the September 2012 issue of European Financial Management. More...

24/04/12

Indexes and Benchmarking

Optimal Market Estimates of French Office Property Performance

Pierre Schoeffler In the world of institutional investment, the performance of the office property sector has traditionally been valued using indices constructed from appraisal values, rather than values derived from transactions. These indices constructed from appraised values are obtained by gathering in a single database property experts’ valuations of the largest possible number of institutional portfolios invested in office properties. This analysis is carried out in a comprehensive manner so as to diversify away the idiosyncratic risk of each property. Appraisals requiring a lot of information and technical resources can only be performed at long intervals – typically at the end of each year. A considerable amount of time is required to gather and process them, resulting in the indices being released after several months of delay. More...

04/04/12

Institutional Investment

Shifting Towards Hybrid Pension Systems: A European Perspective

Samuel Sender This paper examines recent developments and the major risks of retirement systems, from both the sponsor and pension risk perspective, while focusing on European pension schemes. The study looks at plan design and governance, with the aim of moving towards an ideal retirement plan, and analyses the challenges for the financial management of hybrid pension plans. More...

02/04/12

ALM and Asset Management

What Asset-Liability Management Strategy for Sovereign Wealth Funds?

Frédéric Ducoulombier, Lixia Loh, Stoyan Stoyanov This publication presents the industry reactions to an EDHEC-Risk Institute study entitled “Asset-Liability Management Decisions for Sovereign Wealth Funds”. That study put forward a model to optimise the investment and risk management practices of sovereign wealth funds, which can be regarded as the extension to sovereign wealth funds of the liability-driven investing paradigm recently developed in the pension fund industry. The model suggested that the investment strategy of a sovereign wealth fund should involve a state-dependent allocation to three main building blocks: a performance-seeking portfolio, an endowment-hedging portfolio, and a liability-hedging portfolio. The objective of the current publication is to compare these research conclusions with current perceptions by sovereign investment professionals. More...

02/04/12

Exchange-Traded Funds

The EDHEC European ETF Survey 2011

Felix Goltz, Lin Tang The EDHEC European ETF Survey 2011 presents the results of a comprehensive survey of 174 institutional investment managers and private wealth managers. In addition to analysing ETF investment, the survey sheds light on the role of ETFs in asset allocation and compares ETFs and other investment products traditionally used as indexing vehicles – namely futures, index funds and total return swaps. More...

02/04/12

ALM and Asset Management

Dynamic Investment Strategies for Corporate Pension Funds in the Presence of Sponsor Risk

Lionel Martellini, Vincent Milhau, Andrea Tarelli This paper aims to go beyond simple forms of dynamic strategies, and to show that more sophisticated dynamic allocation strategies could usefully be implemented by pension funds. For instance, it shows that imposing a cap on the funding ratio, in addition to a floor, has a positive impact on both pensioners and bondholders, while only having a minor negative effect on equity value. The paper also introduces novel forms of dynamic strategies that recognise that pension risk is not only driven by the funding ratio of the pension fund, but also by the financial strength or weakness of the sponsor company. These strategies aim to control sponsor risk by avoiding states of the world where the pension fund is underfunded and the sponsor is unable to make up for the gap. More...

02/04/12

Risk Management

Shedding Light on Non-Financial Risks – a European Survey

Noël Amenc, François Cocquemas, Samuel Sender This survey analyses the views of European fund industry professionals on non-financial risk and performance in a changing regulatory framework. It analyses the risks those in the industry face as a result of regulation and of their practices, assesses their importance and impact in terms of solvency and business models, and proposes methods to attenuate them. The survey is based on replies from 163 high-level professionals of diverse horizons from the European fund management industry. The results show that at the top of the list of concerns are transparency, information and governance, followed by the financial responsibility of the fund management industry. The survey also covers themes such as restitution and depositary liabilities, distribution and judicial powers of investors. A revisited version of this paper was published in the March 2012 issue of Bankers, Markets & Investors. More...

02/04/12

Performance

Why Does an Equal-Weighted Portfolio Outperform Value- and Price-Weighted Portfolios?

Yuliya Plyakha, Raman Uppal, Grigory Vilkov This paper compares the performance of equal-, value-, and price-weighted portfolios of stocks in the major U.S. equity indices over the last four decades. It finds that the equal-weighted portfolio with monthly rebalancing outperforms the value- and price-weighted portfolios in terms of total mean return, four factor alpha, Sharpe ratio, and certainty-equivalent return, even though the equal-weighted portfolio has greater portfolio risk. More...

23/03/12

Risk

Market Risks in Asset Management Companies

Bernd Scherer This paper shows that revenues from a sample of publicly traded US asset management companies carry substantial market risks. Not only does this challenge the academic risk management literature about the predominance of operative risks in asset management. It also is at odds with current practice in asset management firms. Asset managers do not hedge market risks even though these risks are systematically built into the revenue generation process. A revisited version of this paper was published in Quantitative Finance, Volume 12, Issue 10, 2012. More...

08/03/12

Institutional Investment

Introducing the EDHEC-Risk Solvency Benchmarks – Maximising the Benefits of Equity Investments for Insurance Companies facing Solvency II Constraints

Noël Amenc, François Cocquemas, Romain Deguest, Philippe Foulquier, Lionel Martellini, Samuel Sender This study proposes a methodological framework, based on objective and thoroughly tested academic references, to design dynamic risk management strategies in the form of benchmarks that allow for exposure to equity markets, while maintaining a target solvency capital requirement. More...

24/02/12

Alternative Investments

Pension Fund Investment in Social Infrastructure: Insights from the 2012 reform of the private finance initiative in the United Kingdom

Frédéric Blanc-Brude In February 2012, EDHEC-Risk Institute responded to the UK Treasury’s Call for Evidence about the reform of the Private Finance Initiative (PFI) with a particular reference to the opportunity for pension funds to invest in infrastructure assets, which the UK Treasury has earmarked as a priority theme. In this publication, we extend our response to the issues relating to pension fund investment in social infrastructure. More...

24/02/12

Risk Management

Case Studies and Risk Management in Commodity Derivatives Trading

Hilary Till Until recently, one could only gain expertise in commodity-derivatives relationships if one had worked in niche commodity-processor companies or in banks that specialised in hedging project risk for natural-resource companies. The contribution of this article is to help fill the knowledge gap in the risk management of commodity derivatives trading. More...

23/01/12

Portfolio Management

Stock Return Serial Dependence and Out-of-Sample Portfolio Performance

Victor DeMiguel, Francisco J. Nogales, Raman Uppal This paper studies whether investors can exploit stock return serial dependence to improve the out-of-sample performance of their portfolios. To do this, it first shows that a vector-autoregressive (VAR) model estimated with ridge regression captures daily stock return serial dependence in a stable manner. Second, it characterizes (analytically and empirically) expected returns of VAR-based arbitrage portfolios, and shows that they compare favorably to those of existing arbitrage portfolios. Third, it evaluates the performance of VAR-based investment (positive-cost) portfolios. The paper shows that, subject to a suitable norm constraint, these portfolios outperform the traditional (unconditional) portfolios for transaction costs below 10 basis points. More...

23/01/12

Exchange-Traded Funds

What are the Risks of European ETFs?

Noël Amenc, Frédéric Ducoulombier, Felix Goltz, Lin Tang This paper outlines EDHEC-Risk Institute's positions on the major concerns of counterparty risk, liquidity risk, confusion between ETFs and other ETPs, risks associated with special types of ETFs, and potential impact of ETFs on the underlying markets and systemic risks. The focus is solely on European ETFs, the bulk of which are regulated by UCITS Directives. Prior to looking at the potential risks of ETFs, the paper presents ETFs and sizes-up the European ETF landscape. More...

17/01/12

Alternative Investments

Solvency II: A unique opportunity for hedge fund strategies

Mathieu Vaissié There is growing empirical evidence that the complexity of financial markets makes it increasingly challenging for institutional investors to manage their asset/liability profile efficiently. Changes in the regulatory framework and in accounting rules make it even trickier for insurance companies. Against this backdrop, insurers have no choice but to rethink their overall investment policy. A revisited version of this paper was published in the Fall 2012 issue of the Journal of Alternative Investments. More...

16/01/12

Risk Management

Sensitivity of portfolio VaR and CVaR to portfolio return characteristics

Stoyan V. Stoyanov, Svetlozar T. Rachev, Frank J. Fabozzi Risk management through marginal rebalancing is important for institutional investors due to the size of their portfolios. This paper considers the problem of marginally improving portfolio VaR and CVaR through a marginal change in the portfolio return characteristics. It studies the relative significance of standard deviation, mean, tail thickness, and skewness in a parametric setting assuming a Student's t or a stable distribution for portfolio returns. A revisited version of this paper was published in the May 2013 issue of Annals of Operations Research. More...

13/01/12

Credit Default Swaps

The Link between Eurozone Sovereign Debt and CDS Prices

Dominic O’Kane This paper performs a theoretical and empirical analysis of the relationship between the price of Eurozone sovereign-linked credit default swaps (CDS) and the same sovereign bond markets during the Eurozone debt crisis of 2009-2011. It first presents a simple model which establishes the no-arbitrage relationship between CDS and bond yield spreads. A revisited version of this paper was published in the March 2012 issue of Bankers, Markets & Investors. More...

13/01/12

Asset Allocation and Alternative Diversification

Structured Equity Investment Strategies for Long-Term Asian Investors

Stoyan Stoyanov This publication show that a structured target-volatility strategy significantly improves both the downside and the upside of the return distribution relative to a fixed-mix strategy and also allows investors to benefit more from the upside potential when a capital guarantee overlay is applied. It shows how the explicit management of volatility reduces the cost of the capital protection. It also documents utility gains for risk-averse investors, with and without capital guarantee overlay, and makes the case for significant allocations to structured equity investment strategies with volatility targeting. More...

15/12/11

Risk Management

The Changing Face of Real Estate Investment Management

Jim Clayton, Frank J. Fabozzi, S. Michael Giliberto, Jacques N. Gordon, Susan Hudson-Wilson, William Hughes, Youguo Liang, Greg MacKinnon, Asieh Mansour The real estate investment management industry has been undergoing a process of change over the last two decades. The market is far more transparent than it once was due to the availability of far more, and more detailed, market information. Combined with the increasing integration of real estate with the broader capital markets, this has led to a market that reacts more quickly to events, exhibits more volatility, and in which the nature of risk has changed. These ongoing changes in the market, combined with the lessons of the financial crisis, have resulted in risk management becoming a topic of primary importance in real estate investment. This paper was published in the Special Real Estate Issue 2011 of The Journal of Portfolio Management. More...

07/11/11

Private Wealth Management

Life-Cycle Investing in Private Wealth Management

Romain Deguest, Lionel Martellini, Vincent Milhau This paper argues that financial innovation is needed to design better target date funds based on stochastic life cycle investing, taking into account the presence of risk factors that impact not only asset returns, but also private investors’ wealth levels. One key element in private wealth management is the presence of income risk, which has a substantial impact on the optimal asset allocation strategy. More...

02/11/11

Commodities

Long-Short Commodity Investing: Implications for Portfolio Risk and Market Regulation

Joëlle Miffre A number of policy-makers have blamed the decade-long rise in commodity prices and recent market volatility on the growing influence of financial investors and called for new regulation restricting their participation in commodity markets. Market financialisation has also led investors to worry about higher integration between commodity and traditional financial markets weakening the portfolio benefits of commodity investment. This study, produced with market data and support from CME Group, first examines the performance and risk characteristics of long-only commodity index investments favoured by passive investors and of long/short commodity strategies of the kind implemented by hedge fund managers. More...

25/10/11

Regulation

Response to ESMA Consultation Paper to Implementing Measures for the AIFMD

Noël Amenc, Samuel Sender Several regulatory initiatives are being taken in Europe and recommendations that will reshape the investment fund industry are being made. Existing regulations, such as UCITS, are being reshaped; the need for a regulation of depositaries has been acknowledged, and since the G20 there has been more focus on the monitoring of hedge funds. Many of these regulatory needs have converged in the alternative investment fund managers’ directive (AIFMD), which means that the AIFMD could become a unique framework that settles most of the questions related to the common framework for funds, fund managers and depositaries. However, it must avoid the risk of the AIFMD not being applicable if it appears as a patchwork of diverging goals that have been grouped into a single directive solely for political reasons. The present position paper addresses the measures for implementation of the AIFMD. More...

24/10/11

Indexes & Benchmarking

EDHEC-Risk European Index Survey 2011

Noël Amenc, Felix Goltz, Lin Tang As the choice of an index is a crucial step in both asset allocation and performance measurements, it is useful to investigate index use and perceptions about indices. The EDHEC-Risk European Index Survey 2011 analyses the current uses of and opinions on stock, bond and equity volatility indices with the aim of providing unique insight into the users’ perspective in the index industry. An article based on this survey was published in the Summer 2012 issue of the Journal of Index Investing. More...

13/10/11

Household Finance

Household Search Choice: Theory and Evidence

Yosef Bonaparte, Frank J. Fabozzi Since the work by Stigler (1961) on the economics of information in the early 1960s, economists have paid closer attention to the role of search for information. However, search methods are not considered in the theory of portfolio choice. We present a model of investor search behaviour in order to provide a framework by which to evaluate our empirical evidence on the role of search in portfolio selection and performance. We study two types of search methods: informal and professional. We show that the income, wealth and risk preference of households influence their search choice. This paper was published in the October 2011 issue of Applied Economics. More...

27/09/11

Socially Responsible Investment

Performance of Socially Responsible Investment Funds against an Efficient SRI Index: The Impact of Benchmark Choice when Evaluating Active Managers - An Update

Véronique Le Sourd This paper conducts a performance measurement of SRI funds and assesses the impact of changing the reference from a standard SRI index to an efficient SRI index. The analysis of fund performance shows that an efficient SRI index raises the bar for actively managed SRI funds. While about 62% of funds have a positive information ratio when compared to the cap-weighted EuroStoxx Sustainability Index, only about 36% of funds do so with respect to the Efficient SRI Index. It is also interesting to note that the median information ratio across funds is slightly positive (0.04) when using the standard SRI index, but it is more clearly negative (-0.12) when using the Efficient SRI index. A revisited version of this paper was published in the March 2012 issue of Bankers, Markets & Investors. More...

23/09/11

Performance

Improving Portfolio Selection Using Option-Implied Volatility and Skewness

Victor DeMiguel, Yuliya Plyakha, Raman Uppal, Grigory Vilkov The objective of this paper is to examine whether one can use option-implied information to improve the selection of portfolios with a large number of stocks, and to document which aspects of option-implied information are most useful for improving their out-of-sample performance. Portfolio performance is measured in terms of four metrics: volatility, Sharpe ratio, certainty-equivalent return and turnover. A revisited version of this paper is forthcoming in the Journal of Financial and Quantitative Analysis. More...

09/09/11

Derivatives

Force-fitting CDS Spreads to CDS Index Swaps

Dominic O’Kane Issues of contemporaneity, liquidity, different restructuring clauses and market supply and demand, all contribute to the fact that the market quoted term structure of CDS index spreads does not always agree with the term structure of CDS index spreads implied by the CDS term structures of the constituent credits. A revisited version of this paper was published in the Spring 2011 issue of the Journal of Derivatives. More...

07/09/11

Portfolio Management

Correlation vs. Trends: A Common Misinterpretation

François-Serge Lhabitant Two common beliefs in finance are that (i) a high positive correlation signals assets moving in the same direction while a high negative correlation signals assets moving in opposite directions; and (ii) the mantra for diversification is to hold assets that are not highly correlated. This paper explains why both beliefs are not only factually incorrect, but can actually result in large losses in what are perceived to be well diversified portfolios. More...

07/09/11

Risk Management

Risk Parity – Rewards, Risks and Research Opportunities

Barry Schachter, S. Ramu Thiagarajan Mean-Variance optimisation has come under great criticism recently, based on the poor performance experienced by asset managers during the global financial crisis. In response, an alternative approach, called Risk Parity, which proceeds by equalising risk contributions, has garnered much interest. This paper summarises the work of a group of leading researchers on Risk Parity. A revisited version of this paper was published in the Spring 2011 issue of the Journal of Investing. More...

07/09/11

Risk Management

A Moment Expansion of Downside Risk Measures

Stoyan V. Stoyanov This paper introduces a decomposition of a sub-class of spectral risk measures in terms of L-moments accounting for geometric characteristics of the return distribution similar to the ones described by the ordinary moments. The decomposition completely characterises the spectral risk measures with square-integrable risk aversion functions and can be regarded as a link between higher-order moment risk and downside risk measures. Coherent approximations based on only a few L-moments can be successfully constructed for continuous risk aversion functions and can be applied to problems in portfolio theory to analyse the incremental impact of higher order moments on optimal allocations. More...

07/09/11

Alternative Investments

A Hedge Fund Investor’s Guide to Understanding Managed Futures

Hilary Till, Joseph Eagleeye Managed futures strategies are a niche-within-a-niche in the capital markets. Despite this status, managed futures have become of particular interest to hedge fund investors. This paper discusses why this has become the case by focusing on this strategy’s unique diversification properties. It also briefly covers the main characteristics of this investment category, its underlying sources of return, and alternative statistical measures that are appropriate for comparing managed futures investments with hedge fund investments. More...

07/09/11

Risk Management

How to Construct Fundamental Risk Factors?

Georges Hübner, Marie Lambert This paper proposes an alternative way to construct the Fama and French (1993) empirical risk factors. Without losing in significance power, in beta consistency or in factor efficiency compared to the Fama and French factors, our technique insulates the effects of other sources of risk as much as possible when evaluating one risk factor. More...

07/09/11

Commodities

A Review of the G20 Meeting on Agriculture: Addressing Price Volatility in the Food Markets

Hilary Till This paper examines food price volatility in the context of the G20 meeting of agriculture ministers. In reviewing the evidence so far regarding the impact of commodity trading, speculation, and index investment on price volatility, the report finds that the evidence for the prosecution does not seem particularly compelling at this point. More...

04/08/11

Regulation

A Short Note on the Tobin Tax: The Costs and Benefits of a Tax on Financial Transactions

Raman Uppal Almost each time volatility in equity, debt, or currency markets increases, there are cries to introduce a tax of financial transactions, first proposed in Tobin (1974). This tax is motivated by the view that the excess volatility in financial markets is the result of trading by "speculators"; thus, even a small tax on financial transactions would "throw some sand in the wheels" of financial markets, and hence, by slowing down the trading activity of speculators would reduce volatility. More...

13/07/11

Risk Management

Capturing the Market, Value, or Momentum Premium with Downside Risk Control: Dynamic Allocation Strategies with Exchange-Traded Funds

Elie Charbit, Jean-René Giraud, Felix Goltz, Lin Tang There is extensive evidence that investment strategies based on momentum and value are attractive for portfolio managers who seek higher performances. Momentum and value are among the most robust return drivers in the cross section of expected returns. Dynamic risk budgeting methodologies such as Dynamic Core Satellite strategies (DCS) are used to provide risk-controlled exposure to different asset classes. We examine how to exploit the value and momentum anomalies using a DCS investment model. This paper shows that the DCS approach can boost portfolio returns while keeping downside risk under control. The implementation of the portfolio strategies is enabled by exchange-traded funds which are natural investment vehicles since they offer a broad exposure to the markets and provide the necessary liquidity to the frequent rebalancing of the DCS model. More...

08/07/11

Portfolio Management

A New Look At Minimum Variance Investing

Bernd Scherer Disappointed with the performance of market-weighted benchmark portfolios yet skeptical about the merits of active portfolio management, investors in recent years turned to alternative index definitions. Minimum variance investing is one of these popular rule driven, i.e. new passive concepts. This paper shows theoretically and empirically that the portfolio construction process behind minimum variance investing implicitly picks up risk-based pricing anomalies. In other words the minimum variance tends to hold low beta and low residual risk stocks. Long/short portfolios based on these characteristics have been associated in the empirical literature with risk-adjusted outperformance (alpha). This paper shows that 83% of the variation of the minimum variance portfolio excess returns (relative to a capitalization-weighted alternative) can be attributed to the FAMA/FRENCH factors as well as to the returns on two characteristic anomaly portfolios. All regression coefficients (factor exposures) are highly significant, stable over the estimation period and correspond remarkably well with our economic intuition. A revisited version of this paper was published in the September 2011 issue of the Journal of Empirical Finance. More...

08/07/11

Risk Management

An Integrated Approach to Sovereign Wealth Risk Management

Bernd Scherer Sovereign wealth funds (SWFs) typically have no direct earmarked liabilities. Nor should they, as the financial asset they represent is only part of total sovereign assets, which in turn guarantee all sovereign liabilities. The objective of this paper is to incorporate the economic balance sheet of the sovereign sponsor into the optimal asset allocation problem of the SWF. This paper outlines an easy to implement solution that nests well in the literature on SWFs. We show that economic leverage will reduce speculative demand but leave hedging demand (against fluctuations in the net fiscal position of the sovereign state) unchanged. We also show how to extend our one-period methodology to a multi-period context by solving a dynamic stochastic programme. More...

07/07/11

Alternative Investments

Diversification in Funds of Hedge Funds: Is it Possible to Overdiversify?

Stephen J. Brown, Greg N. Gregoriou, Razvan Pascalau Samuelson (1967) argues that as a general matter it is easy to show that investors should be maximally diversified. For this reason many institutions are attracted to diversified portfolios of hedge funds, referred to as Funds of Hedge Funds (FOFs). In this paper we examine a new database that separates out for the first time the effects of diversification (the number of underlying hedge funds) from scale (the magnitude of assets under management). We find with others that the variance reducing effects of diversification peter out once FOFs hold more than 20 underlying hedge funds. Yet the majority of FOFs are more diversified than this. We find a new and surprising result that this excess diversification actually increases the left tail risk exposure of FOFs particularly once we account for the extent to which hedge fund returns are smoothed. A revisited version of this paper was published in the June 2012 issue of the Review of Asset Pricing Studies. More...

01/07/11

Portfolio Management

The Sophisticated and the Simple: The Profitability of Contrarian Strategies from a Portfolio Manager’s Perspective

Daniel Giamouridis, Chris Montagu Valuation signals have been among the most popular with equity portfolio managers and have recently attracted significant interest from cross-asset managers. Given a large variation of techniques and theories with regard to how value is measured, this paper investigates the efficacy of alternative value measures. It considers a cross-section of simple and sophisticated alternative measures and focuses on comparison metrics that are of primary interest for equity portfolio managers. A revisited version of this paper is forthcoming in European Financial Management. More...

29/06/11

Asset Pricing

Idiosyncratic Risk and the Pricing of Poorly-Diversified Portfolios

Chris Brooks, Xiafei Li, Joëlle Miffre A vast body of literature has documented the value premium and the small firm effect as pervasive stylized facts in empirical asset pricing and yet research has been largely unable to provide entirely convincing explanations of these phenomena. This paper examines the role of idiosyncratic risk in explaining the cross-sectional variation of stock returns in the context of a set of size- and value-sorted portfolios. More...

29/06/11

Indexes & Benchmarking

A Review of Corporate Bond Indices: Construction Principles, Return Heterogeneity, and Fluctuations in Risk Exposures

Felix Goltz, Carlos Heitor Campani This paper analyses two sets of four corporate investment-grade bond indices each, one for the US market and the other for the euro-denominated bond market. First, we review the uses of bond indices as well as the challenges involved. We then analyse the risk-return properties and the heterogeneity of the indices in each set. Although the indices in each market resemble each other, there are still some differences. Moreover, an analysis of the stability of the indices’ risk exposures (interest rate and credit risks) reveals very unstable measures over time and, perhaps most importantly, this instability is accentuated in the two indices with the smallest number of bonds: the more investable the index is meant to be, the less reliable it is. Finally, we find great differences between US and euro-denominated indices: US corporate bond indices showed higher credit risk, with longer terms to maturity and hence longer durations. More...

24/06/11

ALM and Asset Management

Optimal Design of Corporate Market Debt Programmes in the Presence of Interest-Rate and Inflation Risks

Lionel Martellini, Vincent Milhau This paper provides a joint quantitative analysis of capital structure decisions and debt structure decisions within a standard continuous-time capital-structure model. In the presence of interest rate and inflation risks, we are able to obtain quasi-closed form expressions for the price of various forms of indexed- and non-indexed bonds issued by the firm, which allows us to generate computationally efficient estimates for the optimal debt structure. Our analysis shows that debt-structure decisions have a strong impact on capital structure decisions. It also suggests that substantial increases in firm value can be generated by optimal debt structures. More...

12/05/11

Commodities

Capturing the Risk Premium of Commodity Futures: The Role of Hedging Pressure

Devraj Basu, Joëlle Miffre This paper constructs long-short factor mimicking portfolios that capture the hedging pressure risk premium of commodity futures. It considers single sorts based on the open interests of hedgers or speculators, as well as double sorts based on both positions. The long-short hedging pressure portfolios are priced cross-sectionally and present Sharpe ratios that systematically exceed those of long-only benchmarks. Further tests show that the hedging pressure risk premiums rise with the volatility of commodity futures markets and that the predictive power of hedging pressure over cross-sectional commodity futures returns is different from the previously documented forecasting power of past returns and the slope of the term structure. More...

12/05/11

Risk

A Post-crisis Perspective on Diversification for Risk Management

Noël Amenc, Felix Goltz, Stoyan Stoyanov Since the global financial crisis of 2008, improving risk management practices—management of extreme risks, in particular—has been a hot topic. The postmodern quantitative techniques suggested as extensions of mean-variance analysis, however, exploit diversification as a general method. Although diversification is most effective in extracting risk premia over reasonably long investment horizons and is a key component of sound risk management, it is ill-suited for loss control in severe market downturns. Hedging and insurance are better suited for loss control over short horizons. In particular, dynamic asset allocation techniques deal efficiently with general loss constraints because they preserve access to the upside. Diversification is still very useful in these strategies, as the performance of well-diversified building blocks helps finance the cost of insurance strategies. More...

02/05/11

Business Analysis

Short Selling and the Price Discovery Process

Ekkehart Boehmer, Julie Wu This paper shows that stock prices impound more information when short sellers are more active. First, in a large panel of NYSE-listed stocks, high-frequency informational efficiency of prices improves with greater daily shorting flow. Second, at monthly and annual horizons, more shorting flow accelerates the incorporation of public information into prices. Third, greater shorting flow reduces post-earnings announcement drift for negative earnings surprises. Fourth, we demonstrate that short sellers change their trading around extreme return events in a way that aids price discovery. These results are robust to various econometric methodologies and model specifications. Overall, the results highlight the important role that short sellers play in the price discovery process. A revisited version of this paper is forthcoming in European Financial Management. More...

06/04/11

Risk

The Time-Varying Liquidity Risk of Value and Growth Stocks

Ferhat Akbas, Ekkehart Boehmer, Egemen Genc, Ralitsa Petkova This paper studies the liquidity exposures of value and growth stocks over business cycles. In the worst times, value stocks have higher liquidity betas than in the best times, while the opposite holds for growth stocks. Small value stocks have higher liquidity exposures than small growth stocks in the worst times. Small growth stocks have higher liquidity exposures than small value stocks in the best times. The results are consistent with a flight-to-quality explanation for the countercyclical nature of the value premium. More...

06/04/11

Alternative Investments

The Survival of Exchange-Listed Hedge Funds

Greg N. Gregoriou, François-Serge Lhabitant, Fabrice Douglas Rouah This paper attempts to determine whether exchange-listed hedge funds experience longer lifetimes than non-listed funds, even after factors known to affect survival, such as size and performance, are considered. The Kaplan-Meier estimator is used to compare survival times of listed and non-listed funds. The Cox proportional hazards model is used to make the same comparison, but by controlling for additional factors. The accelerated failure time (AFT) regression model is used to estimate the median survival time of hedge funds, based on values of explanatory variables. A revisited version of this paper was published in the December 2009 issue of the Journal of Applied Research in Accounting and Finance. More...

06/04/11

Real Estate

Conditional Correlations and Real Estate Investment Trusts

James Chong, Joëlle Miffre, Simon Stevenson This paper studies the temporal variations in the conditional correlations between REIT returns and equity, bond and commodity returns. While REITs are often presented as useful tools for diversification, little is known of the way their returns correlate with the returns of other asset classes over time and in periods of high volatility. This paper addresses this issue and draws two conclusions. First, the correlations between REITs and equity returns rose over the period analyzed, while the correlations with bonds and commodities fell. This indicates to equity portfolio managers that real estate has lost some of its diversification properties, but to bond and commodity portfolio managers it has become attractive for strategic asset allocation. Second, the correlations with REITs rose especially in periods of above average volatility in equity and bond markets. This is unfortunate as it is precisely in periods of high volatility that investors need the benefits of diversification the most. A revisited version of this paper was published in the April 2009 issue of the Journal of Real Estate Portfolio Management. More...

06/04/11

Derivatives

Idiosyncratic Risk and the Cross-Section of Stock Returns

Rene Garcia, Daniel Mantilla-Garcia, Lionel Martellini Idiosyncratic volatility has received considerable attention is the recent financial literature. Whether average idiosyncratic volatility has recently risen, whether it is a good predictor for aggregate market returns and whether it has a positive relationship with expected returns in the cross-section are still matters of active debate. We revisit these questions from a novel perspective, by taking the cross-sectional variance of stock returns as a measure of average idiosyncratic variance. More...

29/03/11

Institutional Investment

The Elephant in the Room: Accounting and Sponsor Risks in Corporate Pension Plans

Samuel Sender EDHEC surveyed corporate pension funds, their sponsors, and advisers to assess how sponsors manage pension risk and how pension funds manage sponsor risk. There are 100 respondents to the survey; they manage pension funds assets of more than €730 billion (the assets of sponsoring companies are greater than €5.5 trillion). Sponsors that give their employees pension plans are subject to the risk of having to make additional contributions to make up for shortfalls in pension funds as well as to a more specific accounting risk that arises because of the arbitrary accounting assumptions that differ from those typical of financial economics. More...

25/03/11

Regulation

Never the Twain Shall Meet? Addressing the Disconnect between Banks’ Financial and Regulatory Reporting

Paul Klumpes, Peter Welch This paper reviews the arguments for and against the decoupling of capital ratio calculations based on IFRS from those based on Basel II. We analyse recent trends in both accounting and regulatory supervision after the financial crisis and identify areas where there are still deficiencies in the transparency of IFRS-based financial reports and regulatory-based capital disclosures and calculations. We find that the variation in disclosure practices across IFRS and BIS-based capital estimations is significant for a sample of major European banks. More...

21/02/11

Asset Pricing

Option Pricing and Hedging in the Presence of Basis Risk

Lionel Martellini, Vincent Milhau This paper addresses the problem of option hedging and pricing when a futures contract, written either on the underlying asset or on some imperfectly correlated substitute for the underlying asset, is used in the dynamic replication of the option payoff. In the presence of unspanned basis risk modeled as a Brownian bridge process, which explicitly accounts for the convergence of the basis to zero as the futures contract approaches maturity, we are able to obtain an analytical expression for the optimal hedging strategy and corresponding option price. Empirical analysis suggests that the hedging demand against basis risk is an important ingredient of the hedging strategy. For reasonable parameter values, we also find the replication error implied by the optimal strategy to be substantially lower than that implied by heuristic strategies routinely used in practice. More...

21/02/11

Regulation

The European Fund Management Industry Needs a Better Grasp of Non-financial Risks

Noël Amenc, Samuel Sender This publication looks at how non-financial risks and failures have impacted the regulatory agenda in Europe and traces the management of liquidity, counterparty, compliance, misinformation, and other financial risks in the fund industry. By identifying the distribution of risks and responsibilities in the industry, it examines how convergence between country regulations could be achieved. Finally, it assesses how fund unit-holders can best be protected with appropriate regulations, improved risk management practices, and greater transparency. More...

24/01/11

Private Equity

Giants at the Gate: On the Cross-Section of Private Equity Investment Returns

Florencio Lopez-de-Silanes, Ludovic Phalippou, Oliver Gottschalg This paper examines the determinants of private equity returns using a newly constructed worldwide database of 7,500 investments made over forty years. The median investment IRR (PME) is 21% (1.3), gross of fees. One in ten investments goes bankrupt, whereas one in four has an IRR above 50%. Only one in eight investments is held for less than two years, but such investments have the highest returns. The scale of private equity firms is a significant driver of returns: investments held at times of a high number of simultaneous investments underperform substantially. More...

18/01/11

Alternative Investment

Media and Investment Management

Gideon Ozik, Ronnie Sadka This paper measures the differential impact of alternative media outlets. We classify news items about equity hedge funds over 1999 to 2008 into three source groups: General newspapers, Specialized magazines, and Corporate Communication. Applying a textual analysis to news items, we uncover three types of media biases. First, a reporting style bias, that is, when a fund is covered by multiple sources at the same time, the sentiment is most positive in Corporate coverage and least in General coverage. The differences in source sentiment are more significant in cases of exclusive coverage, indicating a second bias, editorial selection. Finally, examining post-coverage, sentiment-adjusted fund performance, we document that Corporate-covered funds outperform and General-covered funds underperform, with a performance difference of about 11% annually. More...

17/12/10

Asset-Liability Management

An Integrated Approach to Asset-Liability Management: Capital Structure Choices, Pension Fund Allocation Decisions and the Rational Pricing of Liability Streams

Lionel Martellini, Vincent Milhau Correctly assessing the value of a pension plan in deficit with a weak sponsor company is a real challenge given that no comprehensive model is currently available for the joint quantitative analysis of capital structure choices, pension fund allocation decisions and their impact on rational pricing of liability streams. More...

07/12/10

Socially Responsible Investment

Adoption of Green Investing by Institutional Investors: A European Survey

Noël Amenc, Felix Goltz, Lin Tang This document reviews the concept of green investing and reports the results of a European survey of investment management professionals. The objective is to provide background on industry and academic research into green investing and assess the views and uses of green investing. Our survey shows that green investing is a significant movement in which survey respondents are heavily involved. Nearly 90% of respondents consider environmental protection an investment theme and the same percentage plans to do more green investing in the future. More...

30/11/10

Private Wealth Management

EDHEC-Risk European Private Wealth Management Survey

Noël Amenc, Sergio Focardi, Felix Goltz, David Schröder, Lin Tang A survey drawing on responses from 159 European private wealth managers, the three main findings of which are: Private wealth managers see the relationships they forge with their clients as the principle source of the value they add but they fail to exploit this close relationship to customise the services they offer their clients (when portfolios are designed for clients, market factors are taken into account more frequently than are the individual characteristics of the clients); Private wealth managers fail, on the whole, to provide state-of-the art means of horizon-dependent asset allocation. In fact, when human capital, the time and state dependency of investment opportunities, and other causes of horizon effects are not recognised, one can conclude that horizon-based allocations are approximate rather than optimal; Private wealth managers see the great potential of taking into account client-specific spending objectives, but only a small minority actually attempts to realise this potential. More...

30/11/10

Alternative Investments

A Suggestion for Remedying the Overstated Performance of Non-Investable Hedge Fund Indices

Investable indices tend to recursively underperform their non-investable versions. In light of recent events, we can wonder whether the liquidity crisis that occurred in the wake of the Lehman collapse and had a significant impact on the performance of hedge fund strategies (more particularly on the strategies that are exposed to credit risk) has increased this excess return or not. In this respect, it would be interesting to compare the excess returns of non-investable indices and those of their investable counterparts before and after 2008. More...

08/11/10

Performance

French Corporate Social Responsibility: Which Dimension Pays More?

Laetitia Drusch, Abraham Lioui We use a sample of 148 events related to corporate social responsibility (CSR) to assess the impact of CSR on corporate financial performance. There is considerable heterogeneity in market reaction to different dimensions of CSR. Not all dimensions offer a positive reward; some yield a negative and even statistically significant impact on the firms’ stock returns. One main conclusion of this study is that socially responsible investment is not an excuse for passive management. There is still room for timing and stock picking within the socially responsible universe of stocks. More...

08/11/10

Investment Management

Asset-Liability Management Decisions for Sovereign Wealth Funds

Lionel Martellini, Vincent Milhau This paper proposes a quantitative dynamic asset allocation framework for sovereign wealth funds, modelled as large long-term investors that manage fluctuating revenues typically emanating from budget or trade surpluses in the presence of stochastic investment opportunity sets. The optimal asset allocation strategy takes into account the stochastic features of the sovereign fund endowment process (where the money is coming from), the stochastic features of the sovereign fund's expected liability value (what the money is going to be used for), and the stochastic features of the assets held in its portfolio. More...

26/10/10

Risk Management

Risk Reduction in Style Rotation

Rodrigo Dupleich, Daniel Giamouridis, Chris Montagu This paper investigates the potential improvement in the implementation of style rotation strategies by techniques addressing estimation errors. We select two approaches that have recently stood out in the statistics and econometric literature and have been applied to portfolio construction literature. One builds on regularization methods which address estimation error by focusing on the weights of the constructed portfolios. And a second method that uses pooled forecasts obtained across different observation windows. Thus it focuses on minimizing estimation error in the moments of the return distribution that may arise due to structural breaks. We conclude that overall there are benefits from departing from naïve approaches which can be as significant as an improvement in the information ratio of about 54%, i.e., from 0.65 (naïve) to about 1 (dynamic). A revisited version of this paper was published in the Winter 2012 issue of the Journal of Portfolio Management. More...

22/10/10

Equity Markets

Capital Structure, Derivatives and Equity Market Quality

Ekkehart Boehmer, Sudheer Chava, Heather E. Tookes This paper examines how the existence of individual equity options, publicly traded corporate bonds and credit default swap (CDS) contracts affects equity market quality for a panel of NYSE-listed firms during 2003-2007. We find that firms with listed equity options have more liquid equity and more efficient stock prices. By contrast, firms with traded CDS contracts have less liquid equity and less efficient stock prices, especially when these firms or their capital structures are complex (i.e., hard to value). The impact of having a publicly traded bond market is somewhat mixed; however, we observe a signicantly negative role for all trading activity in the related markets (i.e., in both bonds and options) for efficiency and liquidity. Taken together, these results imply an overall negative effect of related markets when those markets are tied to debt in a firm's capital structure. More...

19/10/10

Institutional Investment

Alternative Measurement Bases in Pension Accounting: A Simulation Analysis

Paul Klumpes This paper explores the financial statement implications of alternative measurement bases underlying defined benefit pension accounting rules via a simulation analysis. Simulation analysis can be used to examine the effect of alternative discount rate assumptions on the strength of associations between an economic or generational accounting basis, an actuarial funding basis of measurement and two alternative accounting measurement bases of pension assets and liabilities; value-in-use and value-in-exchange. Accounting measures are found to be more highly correlated with economic unfunded pension liabilities when they are discounted using market instead of value in use rates. The value at use rates are also more highly sensitive to differences in funding method, real versus nominal interest rates and plan initiation dates. The findings suggest that the use of alternative measurement bases for pension reporting and funding involves a trade-off between the relevance and reliability of the resulting pension disclosures. A revisited version of this paper was published in "Insurance Markets and Companies: Analyses and Actuarial Computations", Issue 1, 2010. More...

19/10/10

Risk Management

Index-Exciting CAViaR: A New Empirical Time-Varying Risk Model

Frank J. Fabozzi, Sergio Focardi, Masao Fukushima, Dashan Huang, Zudi Lu, Baimin Yu Instead of assuming the distribution of return series, Engle and Manganelli (2004) propose a new Value-at-Risk (VaR) modeling approach, Conditional Autoregressive Value-at-Risk (CAViaR), to directly compute the quantile of an individual asset’s returns which performs better in many cases than those that invert a return distribution. This paper explores more flexible CAViaR models that allow VaR prediction to depend upon a richer information set involving returns on an index. Specifically, we formulate a time-varying CAViaR model whose parameters vary according to the evolution of the index. A revisited version of this paper was published in the March 2010 issue of Studies in Nonlinear Dynamics & Econometrics. More...

19/10/10

Alternative Investments

Optimal Hedge Fund Allocation with Improved Estimates for Coskewness and Cokurtosis Parameters

Asmerilda Hitaj, Lionel Martellini, Giovanni Zambruno Since hedge fund returns are not normally distributed, mean-variance optimisation techniques, which would lead to substantial welfare losses from the investor’s perspective, need to be replaced by optimisation procedures incorporating higher-order moments and comoments. In this context, optimal portfolio decisions involving hedge fund style allocation require not only estimates for covariance parameters but also estimates for coskewness and cokurtosis parameters. This is a formidable challenge that severely exacerbates the dimensionality problem already present with mean-variance analysis. This paper presents an application of the improved estimators for higher-order co-moment parameters, recently introduced by Martellini and Ziemann (2010), in the context of hedge fund portfolio optimisation. A revisited version of this paper was published in the Winter 2012 issue of the Journal of Alternative Investments. More...

13/10/10

Commodities

Strategic and Tactical Roles of Enhanced-Commodity Indices

Ana-Maria Fuertes, Joëlle Miffre, Georgio Rallis This article compares the risk and performance of two traditional commodity indices with enhanced long-only versions that exploit signals based on momentum, term structure and the time-to-maturity of the contracts. Regarding risk diversification and inflation hedging properties, the enhanced indices are as effective tools for strategic asset allocation as the traditional ones. More...

08/10/10

Risk Management

New Frontiers in Benchmarking and Liability-Driven Investing

Noël Amenc, Lionel Martellini, Felix Goltz, Vincent Milhau Meeting the challenges of modern investment practice involves the design of novel forms of investment solutions, as opposed to investment products, customised to meet investors' long-term objectives while respecting the short-term (regulatory or otherwise) constraints they have to face. This paper argues that such new forms of investment solutions should rely on the use of improved performance-seeking and liability-hedging building-block portfolios, as well as on the use of improved dynamic allocation strategies. More...

08/10/10

Alternative Investments

Do Funds of Hedge Funds Really Add Value: A Post-Crisis Analysis

Serge Darolles, Mathieu Vaissié In spite of a somewhat disappointing performance throughout the crisis, and a series of high-profile scandals, investors are showing interest in hedge funds. Still, funds of hedge funds keep on experiencing outflows. Can this phenomenon be explained by the failure of fund of hedge fund managers to deliver on their promise to add value through active management, or is it symptomatic of a move toward greater disintermediation in the hedge fund industry? Little attention has been paid so far to the added value, and the sources of the added value, of funds of hedge funds. A revisited version of this paper was published in the April 2012 issue of the Journal of Banking and Finance. More...

08/10/10

Investment Management

From Deterministic to Stochastic Life-Cycle Investing: Implications for the Design of Improved Forms of Target Date Funds

Lionel Martellini, Vincent Milhau In an attempt to address the concern over financially illiterate individuals being increasingly responsible for investment decisions related to retirement risk, the financial industry has started to design dedicated mutual fund products known as target date funds. These funds, whose aim is to provide investors with one-stop solutions to their life-cycle investment needs, typically propose a deterministic decrease of equity allocation until a date called the target date of the fund. This approach, however, has been found inconsistent with the prescriptions of standard life-cycle investment models (Viceira and Field 2007). A revisited version of this paper was published in the November-December 2010 issue of Bankers, Markets & Investors. More...

01/10/10

Indexes and Benchmarking

Improved Beta? A Comparison of Index-Weighting Schemes

Noël Amenc, Felix Goltz, Lionel Martellini, Shuyang Ye This paper analyses a set of equity indices whose aim is to improve on capitalisation weighting and thus to provide “improved beta”. Four main weighting schemes are analysed: efficient indices, fundamental indices, minimum-volatility indices, and equal-weighted indices. Empirical results for US and Developed World data on these indices show that the average returns of all four alternative index construction methods are superior to those of cap-weighted equity indices in both universes and that, by several measures of risk-adjusted performance, they are likewise superior. A revisited version of this paper was published in the January/February 2011 issue of the Journal of Indexes. More...

22/09/10

Performance

The Performance of Socially Responsible Investment and Sustainable Development in France: An Update after the Financial Crisis

Noël Amenc, Véronique Le Sourd In an initial study done in 2008, EDHEC-Risk Institute established that socially responsible (SRI) funds—those funds made by selecting securities that meet ESG (environmental, social, governance) criteria—distributed in France did not produce both positive and statistically significant alpha. That study, which relied on the Fama-French three-factor model, covered a six-year period ending in December 2007, thus not including the recent financial crisis. The purpose of the present study was to update these results by extending the analysis to the years 2008 and 2009. More...

13/09/10

Alternative Investments

Selecting Prior Year’s Top Fund of Hedge Funds as This Year’s Choice

Greg N. Gregoriou, Razvan Pascalau Can investors select winning funds of hedge funds (FOFs) by merely assuming a simple trading strategy? Can historical information present insight on future returns? Financial theory presumes that stock markets are efficient and using any type of trading strategy will not be successful in the long-run. This article investigates a pure simple trading strategy to see if selecting last year’s top-performing FOFs as this year’s choice can outperform three FOF indexes and the S&P 500 Index. It further applies the strategy to the top-performing onshore and offshore funds, respectively, and compares them to the HFR Onshore and HFR Offshore indices, respectively. This paper was published in the Fall 2010 issue of the Journal of Wealth Management. More...

01/09/10

Capital Markets

Banking on Liquidity: Liquidity, Collateral and Derivatives

Con Keating, Barry Marshall Changes in the nature and magnitude of banking activities over the past few decades are fundamental to comprehension of the failings that resulted in the financial crisis. The provision of financial risk management services and products by banks on the scale documented appears problematic. Derivatives contracts are the principal instruments used in financial risk management. The role and extent of liquidity and collateral security in facilitating these developments is investigated and policy recommendations advanced. More...

07/07/10

Institutional Investment

EDHEC-Risk Survey of the Asset and Liability Management Practices of European Pension Funds

Samuel Sender EDHEC-Risk Institute took a recent survey of pension funds, their advisers, regulators, and fund managers. One hundred twenty-nine of these asset/liability management (ALM) specialists, representing assets under management (AUM) of around €3 trillion, responded to the survey. Pension funds and their sponsors account for approximately €0.9 trillion. More...

30/06/10

Indices and Benchmarking

Does Finance Theory Make the Case for Capitalisation-Weighted Indexing?

Felix Goltz, Véronique Le Sourd Proponents of cap-weighted stock market indices often argue that such indices provide efficient risk/return portfolios. This paper reviews the evidence in the academic literature and concludes that only under very unrealistic assumptions would such indices be efficient investments. In the presence of realistic constraints and frictions, cap-weighted indices cannot, according to the academic literature, be expected to be efficient investments. A revisited version of this working paper was published in the Fall 2011 issue of the Journal of Index Investing. More...

29/06/10

Exchange-Traded Funds

The EDHEC European ETF Survey 2010

Felix Goltz, Adina Grigoriu, Lin Tang The EDHEC European ETF Survey 2010 presents the results of a comprehensive survey of 192 institutional investors, asset managers and private wealth managers conducted between January and March 2010. It analyses the possible uses of ETFs (exchange-traded funds) in investment management and gives a detailed account of current perceptions and practices of European investors in ETFs. More...

18/06/10

Asset Pricing

Option Pricing and Hedging in the Presence of Cross-Hedge Risk

Lionel Martellini, Vincent Milhau This paper addresses the question of option pricing and hedging when the underlying asset is not available for dynamic trading, and some other asset is used as a substitute. It first provides an overview of the various hedging methodologies that can be used in this incomplete market setting, distinguishing between self-financing and non-self-financing strategies. Focussing on a local risk-minimization criterion, it presents an analytical expression for the optimal hedging strategy and the corresponding option price. It also provides a quantitative measure of the residual risk over the life of the option. More...

14/06/10

Regulation

On the Suitability of the Calibration of Private Equity Risk in the Solvency II Standard Formula

Liliana Arias, Mohamed El Hedi Arouri, Philippe Foulquier, Stéphane Gregoir This publication studies the calibration of private equity risk in the Solvency II standard formula by analysing the correlation of listed share performance, measured through an MSCI index (Europe or the United States, depending on the region we consider in our study) and private equity performance. More...

28/05/10

Business Analysis

Spillover Effects of Counter-cyclical Market Regulation: Evidence from the 2008 Ban on Short Sales

Abraham Lioui The ban on shorting had negative effects on the hedge fund industry. It also had a negative impact on the returns and the market quality of the stocks placed off limits by the ban. This paper examines the impact of the ban on broad market indices in the US and in Europe (the United Kingdom, France, and Germany). Since these indices and their performance are of great concern to the asset management and hedge fund industries, it is important for practitioners and policy-makers to understand the impact of changing the rules of the game (banning short sales) on the return distribution of these indices and to assess the potential spillover effects of a counter-cyclical regulation affecting only one segment of the financial market. The paper shows that the ban had a broad impact on the markets. A revisited version of this paper was published in the Winter 2011 issue of the Journal of Alternative Investments. More...

06/04/10

Alternative Investments

Are Hedge-Fund UCITS the Cure-All?

Noël Amenc, Samuel Sender As part of the CACEIS research chair on non-financial risks in investment funds, EDHEC surveyed UCITS and alternative asset managers, their service providers, external observers, and investors for their views of structuring hedge fund strategies as UCITS. The 437 respondents report assets under management (AUM) of more than €13 trillion. Investment fund managers account for roughly €7 trillion of these assets. In general, the survey suggests that institutional investors bound by quantitative restrictions will ask fund managers and distributors to repackage hedge fund strategies as UCITS. For their part, managers of alternative funds are concerned by the uncertainties surrounding the directive on alternative investment fund managers (AIFMs) and may consider packaging their strategies as UCITS. Most respondents, however, fear that structuring hedge fund strategies as UCITS will distort strategies and diminish returns. A paper based on this study was published in the Journal of Alternative Investments, Fall 2012. More...

26/03/10

Asset Pricing

State Dependence Can Explain the Risk Aversion Puzzle

Fousseni Chabi-Yo, René Garcia, Eric Renault Risk aversion functions extracted from observed stock and option prices can be negative as shown by Aït-Sahalia and Lo (2000) and Jackwerth (2000). We rationalize this puzzle by a lack of conditioning on latent state variables. Once properly conditioned, risk aversion functions and pricing kernels are consistent with economic theory. A revisited version of this working paper was published in the April 2008 issue of the Review of Financial Studies. More...

02/03/10

Indexes and Benchmarking

Efficient Indexation: An Alternative to Cap-Weighted Indices

Noël Amenc, Felix Goltz, Lionel Martellini, Patrice Retkowsky This paper introduces a novel method for the construction of equity indices that, unlike their cap-weighted counterparts, offer an efficient risk/return tradeoff. The index construction method goes back to the roots of modern portfolio theory and focuses on the tangency portfolio, the portfolio that weights index constituents so as to obtain the highest possible Sharpe ratio. The major challenge is to generate the required input parameters in a robust manner. A revisited version of this working paper was published in the Fourth Quarter 2011 issue of the Journal of Investment Management. More...

25/02/10

Investment Management

Shackling Short Sellers: The 2008 Shorting Ban

Ekkehart Boehmer, Charles M. Jones, Xiaoyan Zhang In September 2008, the U.S. Securities and Exchange Commission (SEC) surprised the investment community by adopting an emergency order that temporarily banned most short sales in nearly 1,000 financial stocks. In this paper, we study changes in stock prices, the rate of short sales, the aggressiveness of short sellers, and various liquidity measures before, during, and after the shorting ban. We match banned stocks to a control group of non-banned stocks in order to identify these effects. More...

23/02/10

Asset Pricing

Production-Based Asset Pricing in a Monetary Economy: Theory and Evidence

Abraham Lioui, Patrice Poncet This paper develops a capital asset pricing model based on the production side of a monetary economy. Relying on a general version of the standard Real Business Cycle model with cash and credit goods, we find that the factors determining the mean excess returns on financial assets are i) real capital growth, ii) the nominal interest rate and iii) the capital-to-wealth ratio. Our model is parsimonious in that the results rely neither on any particular specification of the production function nor on capital adjustment costs. Empirical evidence gives strong support to the presence of the elicited factors in the cross section of excess returns on portfolios sorted i) by firm characteristics and ii) by industry. More...

23/02/10

Alternative Investments

Improved Estimates of Higher-Order Comoments and Implications for Portfolio Selection

Lionel Martellini, Volker Ziemann In the presence of non-normally distributed asset returns, optimal portfolio selection techniques require estimates for variance-covariance parameters, along with estimates for higher-order moments and comoments of the return distribution. This is a formidable challenge that severely exacerbates the dimensionality problem already present with mean-variance analysis. This paper extends the existing literature, which has mostly focused on the covariance matrix, by introducing improved estimators for the coskewness and cokurtosis parameters. A revisited version of this paper was published in the April 2010 issue of the Review of Financial Studies. More...

19/02/10

Asset Allocation

Some Insiders Are Indeed Smart Investors

Daniel Giamouridis, Manolis Liodakis, Andrew Moniz Not all insiders are the same; some are more effective than others in processing the information they have access to, and invest their own wealth accordingly. We used a database with transactions from the U.K. market to identify insiders with superior market timing abilities. For the period 1994 to 2006 we showed that informative insider trades can be identified ex ante through certain characteristics of the transactions and the firm itself. Moreover, we showed how outsiders could benefit from this information. More...

02/02/10

Regulation

Regulating Private Financial Institutions: How to Kill the Goose That Laid the Golden Eggs

François-Serge Lhabitant Following the 2008 financial crisis, private financial institutions such as hedge funds and private equity funds have been faced with multiple calls for their regulation, both for consumer protection and systemic reasons. Various proposals for a new regulation have been made and are currently under discussion. The hedge fund community is also open to reasonable regulations. In this paper, we discuss some of the key aspects of the SEC and the European Union proposals and argue that both of them suffer from severe shortcomings. A revisited version of this paper was published in the Journal of Financial Transformation, volume 27 (2009). More...

02/02/10

Performance

Empirical Properties of Straddle Returns

Felix Goltz, Wan Ni Lai Recent studies find that a position in at-the-money (ATM) straddles consistently yields losses. This is interpreted as evidence for the non-redundancy of options and as a risk premium for volatility risk. This paper analyses this risk premium in more detail by i) assessing the statistical properties of ATM straddle returns, ii) linking these returns to exogenous factors and iii) analysing the role of straddles in a portfolio context. A revisited version of this paper was published in the Fall 2009 issue of the Journal of Derivatives. More...

02/02/10

Risk Management

Risk Control through Dynamic Core-Satellite Portfolios of ETFs: Applications to Absolute Return Funds and Tactical Asset Allocation

Noël Amenc, Felix Goltz, Adina Grigoriu This paper examines the ways dynamic asset allocation techniques can be used to manage portfolios of exchange-traded funds (ETFs). First, dynamic allocation to stock and bond ETFs and traditional static diversification are compared. Second, tactical allocation to stock and bond ETFs and risk-controlled allocation—with both forms of allocation informed by the same return forecasts—are compared. The paper shows that dynamic asset allocation techniques that can be used with frequently traded and broadly diversified instruments such as ETFs make it possible better to address investor concerns over drawdown and intra-horizon risk, whether or not the manager wishes to make return predictions. A revisited version of this working paper was published in the Fall 2010 issue of the Journal of Alternative Investments. More...

27/01/10

Commodities

Has There Been Excessive Speculation in the US Oil Futures Markets? - What Can We (Carefully) Conclude from New CFTC Data?

Hilary Till Because many facets of the global oil markets have not been sufficiently transparent, it is unclear how much of the oil-price rally that peaked in July 2008 can be put down to speculation. This uncertainty has led to concerns that there was actually excessive speculation in the oil derivatives markets. In an effort to make the oil markets more transparent, the U.S. Commodity Futures Trading Commission has recently launched the “Disaggregated Commitments of Traders” report. This report includes three years of enhanced market-participant data for twenty-two commodity futures contracts. This report makes it possible to examine whether, over the last three years, speculative position-taking in the exchange-traded oil derivatives markets has been excessive relative to commercial hedging needs. More...

30/11/09

Risk

Fees at Risk

Bernhard Scherer Hull (2007) writes: “For an asset manager the greatest risk is operational risk”. In 2008, however, asset management companies came under severe pressure not from operational risk, but from market risk. What had been seen as an annuity stream that was thought to expose firms to little or no earnings risk turned out to be directional stock market exposure combined with high operational leverage. A revisited version of this working paper was published in the Fall 2010 issue of the Journal of Applied Corporate Finance. More...

30/11/09

Risk

Prudence with Multiplicative Risk

Octave Jokung In this paper we analyze the conditions under which the presence of a multiplicative background risk induces a more “prudent” behavior. We show that the results from Kimball (1990) concerning the convexity of the marginal utility are no longer sufficient with multiplicative risk. An agent is multiplicative risk prudent when the coefficient of relative prudence is greater than two. We introduce the concept of quintessence in order to guarantee the decrease of relative temperance. Both decreasing relative prudence and decreasing relative temperance are sufficient to guarantee more “prudent” behavior with a multiplicative risk-prudent agent. More...

18/11/09

Transaction Cost Analysis

Fairness in Trading — A Microeconomic Interpretation

Stephen Satchell, Bernhard Scherer We show that non-linear transaction costs generate external effects between accounts due to trade volume dependent marginal transaction costs. For an asset manager with multiple clients this raises the question of fairness. How do I ensure I treat all clients fairly? In general, two possible solutions exist. A revisited version of this paper was published in the Winter 2010 issue of the Journal of Trading. More...

18/11/09

Performance

An Alternative Route to Performance Hypothesis Testing

Bernhard Scherer A wide variety of risk–return ratios is routinely reported in sales pitches as well as academic publications. Few attempts have been made, however, to look at the small sample distributions of these estimators in order to derive confidence bands. The reason for this has been the extreme difficulty of working out the required statistics for most risk–return ratios. More...

18/11/09

Asset Allocation

Optimal Investment Decisions When Time Horizon is Uncertain

Christophette Blanchet-Scalliet, Nicole El Karoui, Monique Jeanblanc, Lionel Martellini Many investors do not know with certainty when their portfolio will be liquidated. Should their portfolio selection be influenced by the uncertainty of exit time? In order to answer this question, we consider a suitable extension of the familiar optimal investment problem of Merton (1971), where we allow the conditional distribution function of an agent’s time horizon to be stochastic and correlated to returns on risky securities. In contrast to existing literature, which has focused on an independent time horizon, we show that the portfolio decision is affected. A revisited version of this paper was published in the December 2008 issue of the Journal of Mathematical Economics. More...

18/11/09

Sovereign Wealth Funds

A Note on Portfolio Choice For Sovereign Wealth Funds

Bernhard Scherer The vast current account surpluses of commodity-rich nations, combined with record current account deficits in developed markets (US, Britain), have created a new type of investor. Sovereign wealth funds (SWFs) are instrumental in deciding how these surpluses will be invested. A revisited version of this paper was published in Financial Markets and Portfolio Management, Vol. 23, 2009, Nº 3. More...

04/11/09

Sovereign Wealth Funds

Portfolio Choice for Oil-Based Sovereign Wealth Funds

Bernhard Scherer Given recent interest in the activities of sovereign wealth funds (SWFs), this paper reviews the financial economics of portfolio choice for oil-based investors. It views the optimal asset allocation problem of a sovereign wealth fund as the decision-making problem of an investor with non-tradable endowed wealth (oil reserves). Optimal portfolios combine speculative demand (optimal growth) as well as hedging demand (hedging resource fluctuation risk) and the level of risk taking should depend both on the fraction of financial wealth to resource wealth and on the oil shock hedging properties of the investments. A revisited version of this working paper was published in the Winter 2011 issue of the Journal of Alternative Investments. More...

27/10/09

Sovereign Wealth Funds

Macroeconomic Risk Management for Oil Stabilization Funds in GCC Countries

Bernhard Scherer The existence of oil stabilization funds as the largest category of sovereign wealth funds relies on oil prices as a main source of macroeconomic risk for oil exporting countries. Given the often contingent spending policies of oil stabilization funds (accumulating wealth when oil prices are rising and spending wealth to support the local economy when GDP is shrinking) it is important to understand the magnitude and relative importance of oil price shocks relative to other sources of macroeconomic risk. A revisited version of this working paper was published in issue nº 109 (December 2010) of Bankers, Markets & Investors. More...

27/10/09

Institutional Investment

Reactions to an EDHEC Study on the Impact of Regulatory Constraints on the ALM of Pension Funds

Samuel Sender EDHEC surveyed pension funds, their advisers, their regulators, their fiduciary managers, and their asset managers for their reactions to an EDHEC study entitled "Impact of regulations on the ALM of European pension funds. The call for reaction elicited 142 non-blank responses and is the first international survey in which both regulatory constraints and the means of managing them—modern ALM techniques—are assessed jointly. More...

27/10/09

Regulation

A Welcome European Commission Consultation on the UCITS Depositary Function, a Hastily Considered Proposal

Noël Amenc, Samuel Sender The European Commission is seeking to harmonise the depositary fonction and to strengthen protection mechanisms. EDHEC believes that beforehand there should be an in-depth study of the practices of the parties in the value chain and the regulations to which they are subject and that, beyond a minimum protective threshold, complementary protection should be optional, which supposes clear disclosures of the degree of protection and of its cost. More...

15/10/09

Institutional Investment

IAS 19: Penalising changes ahead

Samuel Sender Financial reporting standards for pension funds are of great topical interest. The current crisis points to the need for clearer regulations, both accounting and prudential, and for regulations that provide better incentives for pension funds to manage risk and to contribute to a more stable pension system. Poorly designed regulations will lead to the closure of defined-benefit pension plans. The International Accounting Standards Board (IASB) has proposed a revision of IAS 19. In the current paper we show that the immediate recognition of the volatility of pension surpluses and deficits in the profit and loss accounts of the sponsor may lead pension funds to shed risky assets. More...

15/10/09

Risk

Forecasting changes in equity risk premia of international markets: An error correction approach

Juliana Caicedo-Llano, Thomas Dionysopoulos This paper uses an error correction model in order to predict the changes in equity risk premia for a set of emerging markets and the US market. It analyses the period 2001-2006 for different forecasting horizons and considers different sub-samples. Using fundamental financial ratios and including variables such as the implied volatility of the S&P 500 index, the paper finds some evidence of predictability of equity risk premia for these markets. Other preliminary results include the tests of stationarity for all the variables and evidence is found of cointegration among some of the variables. More...

07/10/09

Performance Measurement

How Do Performance Measures Perform?

Georges Hübner The relevance of the information ratio and the alpha, two leading performance measures for multi-index models, depends on the type of portfolio held by investors. This paper compares these measures with the generalized treynor ratio (GTR) on the quality of the rankings they produce. A precise measure yields similar rankings with alternative benchmarks. A revisited version of this paper was published in the Summer 2007 issue of the Journal of Portfolio Management. More...

07/10/09

Monetary Policy

Optimal Interest Rate Smoothing under Model Ambiguity

Abraham Lioui, Patrice Poncet This paper solves for the equilibrium of a standard real business cycle model with money under model ambiguity. It first shows that monetary certainty is a sufficient condition for an interest rate smoothing rule to be optimal even under preferences for model robustness on the part of private agents. It then derives the necessary and sufficient condition for a stochastic (but stationary) monetary policy to reproduce the equilibrium of the real economy and compute the optimal (constant) level of the nominal interest rate. A revisited version of this paper was published in the December 2012 issue of the Journal of Macroeconomics. More...

07/10/09

Commodities

A Long-Term Perspective on Commodity Futures Returns

Hilary Till This paper reviews 75 years of literature on the commodity futures markets, examining various theories on what motivates participants in the futures markets, including hedgers, speculators, and now investors. It then discusses how term structure should be the primary driver of (historical) long-term commodity futures returns. More...

07/10/09

Institutional Investment

Solvency II: An Internal Opportunity to Manage the Performance of Insurance Companies

Philippe Foulquier Since the turn of the millennium, a profound shift in the management of insurance companies has been underway. The main catalysts of this shift are the growing complexity of risks, the sophistication of the means of measuring them, and the demands made by investors for greater transparency and for higher-quality management. In this environment, prudential (Solvency II) and accounting (IFRS) requirements must also adapt to create new frameworks offering a better view of the risks borne by companies. All insurers, regardless of their characteristics (public companies, mutual insurers, provident societies) will be subject to the new prudential rules and will thus have to make heavy investments in the data collection, risk measurement, and simulations required by the supervisor. This study shows how, by having these investments respond to objectives more inherent to the company, these Solvency II constraints can be capitalised on. More...

07/10/09

Private Wealth Management

Asset-Liability Management in Private Wealth Management

Noël Amenc, Lionel Martellini, Vincent Milhau, Volker Ziemann While the private banking industry is in general relatively well equipped on the tax planning side, with tools that can allow private bankers to analyse the situation of high net worth individuals operating offshore or in multiple tax jurisdictions, the software packages used on the financial simulation side often suffer from significant limitations and cannot satisfy the needs of a sophisticated clientele. In fact, most financial software packages used by private bankers to generate asset allocation recommendations rely on single-period mean-variance asset portfolio optimisation, a tactic that, for at least two reasons, cannot lead to proper strategic allocation. This study provides a formal framework suggesting that asset-liability management can ensure that private wealth managers are able to offer their clients investment programmes and asset allocation advice that truly meet their needs. A revisited version of this paper was published in the Fall 2009 issue of the Journal of Portfolio Management. More...

07/10/09

Corporate Governance

Corporate governance reform and firm value in Mexico: an empirical assessment

Alberto Chonga, Jorge Guillenb, Florencio Lopez-de-Silanes Based on a newly assembled firm-level data set on corporate governance and firm performance for Mexico, we show that better firm-level corporate governance practices are linked to higher valuations, better performance and more dividends disbursed to investors. These results hold after controlling for endogeneity. Overall, the evidence shows that the Mexican legal environment poses serious problems for access to capital. This paper was published in the September 2009 issue of the Journal of Economic Policy Reform. More...

04/10/09

Alternative Investments

Performance of Passive Hedge Fund Replication Strategies

Noël Amenc, Lionel Martellini, Jean-Christophe Meyfredi, Volker Ziemann In this paper we extend Hasanhodzic and Lo (2007) by assessing the out-of-sample performance of various non-linear and conditional hedge fund replication models. We find that going beyond the linear case does not necessarily enhance the replication power. On the other hand, we find that selecting factors on the basis of an economic analysis can lead to a substantial improvement in out-of-sample replication quality, whatever the underlying form of the factor model. A revisited version of this paper was published in the March 2010 issue of European Financial Management. More...

07/09/09

Best Execution

MiFID: One Year On

Jean René Giraud This position paper looks at the changes that have been effected in the European capital markets more than one year after the implementation of MiFID (Markets in Financial Instruments Directive). These changes are hard to quantify, but initial fears of the rise of so-called dark pools of liquidity have proven well founded. In addition, the best execution obligation remains ambiguous. The paper examines other features of the post-MiFID trade execution landscape and recommends that post-trade reporting be standardised, that a single measure of execution quality be adopted, and that the debate on regulating transactions in less liquid asset classes and giant OTC derivatives markets be re-opened. More...

06/07/09

Exchange-Traded Funds

The EDHEC European ETF Survey 2009

Noël Amenc, Felix Goltz, Adina Grigoriu, David Schröder The EDHEC European ETF Survey 2009 presents the results of a comprehensive survey of 360 institutional investors and private wealth managers conducted in January and February 2009. It also provides an overview of the ETF market and of the mechanisms behind ETFs, and shows how advanced techniques involving dynamic allocation strategies can be carried out with ETFs, in particular to implement the beneficial core-satellite approach to investment. More...

18/06/09

Institutional Investment

The European Pension Fund Industry Again Beset by Deficits

Samuel Sender In 2003, the pension fund industry was severely affected by the steep fall in equity prices and the fall in interest rates. This fall and its consequences led to broad regulatory changes and spurred work on asset and liability management theory and techniques. But it seems that these new regulations and techniques have not enabled the pension fund industry to weather the current return of the perfect storm? This study examines recent publications and looks into the reasons for the fall in funding ratios. More...

15/05/09

Institutional Investment

The Impact of Regulations on the ALM of European Pension Funds

Noël Amenc, Lionel Martellini, Samuel Sender This study analyses the impact of prudential and accounting constraints on the asset-liability management (ALM) of European pension funds in the Netherlands, the UK, Germany, and Switzerland. More...

04/05/09

Asset-Liability Management

Measuring the Benefits of Dynamic Asset Allocation Strategies in the Presence of Liability Constraints

Lionel Martellini, Vincent Milhau The recent pension crisis has triggered a fierce debate in most developed countries between advocates of a tighter regulation designed to provide explicit incentives for pension funds to increase their focus on risk management, and those arguing that imposing short-term funding constraints and solvency requirements on such long-term investors would only increase the cost of pension financing. We analyse this question in the context of a formal continuous-time dynamic asset allocation model for an investor facing liability commitments subject to inflation and interest rate risks. In an empirical exercise, we find that the presence of short-term funding ratio constraints indeed involves a positive welfare cost, but that cost is not found to be prohibitive for reasonable parameter values. More...

24/04/09

Business Analysis

The Undesirable Effects of Banning Short Sales

Abraham Lioui An in-depth study of the short-selling market calls into question both the reasons for the decision to ban short selling and the prejudices that weigh on those who short. According to recently published data (for the United States in particular), a large majority of short sellers are market makers who are hedging their bets on the options markets. They were not affected by the ban, which means that those who were using options to take synthetic short positions continued to do so. The others involved in short selling are mainly hedge funds. More...

24/04/09

Asset Management

A Long Road Ahead for Portfolio Construction: Practitioners' Views of an EDHEC Survey

Felix Goltz The EDHEC European Investment Practices Survey 2008 (EDHEC 2008) sheds light on current practices in the industry and compares these practices with the recent state of the art as described in the investment literature. The results of the survey show that the industry does not fully exploit a number of proven portfolio optimisation techniques that research has made readily available, such as management of extreme risks, improved covariance estimation or Bayesian and resampling techniques. We called for reactions to these results; the objective was to get feedback from the European industry on the results of the survey. This feedback seems important to us for two reasons. First, we would like to know how the results of the survey and their usefulness are perceived by industry practitioners. Second, we are interested in explanations and perspective on our results. More...

31/03/09

Alternative Investments

Unbundling common style exposures, time variance and style timing of hedge fund beta

Rodrigo Dupleich, Daniel Giamouridis, Spyros Mesomeris, Nima Noorizadeh This article is concerned with the systematic exposures of equity hedge fund managers. In particular, we seek common systematic exposures of equity hedge funds through rigorous model selection techniques. We study their time variance to determine whether the style characteristics of equity hedge funds are stable over time. Most importantly, we explore the informational role of manager decisions in shifting their exposures to certain styles. Our results suggest that equity fund managers are exposed to three dominant style strategies, namely, ‘market’, ‘value’ and ‘momentum’. We also discover that there is a considerable degree of variability in the factor exposures over time for the various dominant sources of systematic risk/return. Finally, we provide evidence that managers vary their exposures to the ‘market’ in time to exploit favourable market moves. However, a similar pattern is not observed for their ‘value’ or ‘momentum’ exposures. This paper was published in the April 2010 issue of the Journal of Asset Management. More...

22/03/09

Alternative Investments

Alternative Investments for Institutional Investors: Risk Budgeting Techniques in Asset Management and Asset-Liability Management

Noël Amenc, Lionel Martellini, Volker Ziemann This paper presents an empirical analysis of the benefits of alternative forms of investment strategies from an asset-liability management perspective. Using a vector error correction model (VECM) that explicitly distinguishes between short-term and long-term dynamics in the joint distribution of asset returns and inflation, we identify the presence of long-term cointegration relationships between the return on typical pension fund liabilities and the return of various traditional and alternative asset classes. A revisited version of this paper was published in the Summer 2009 issue of The Journal of Portfolio Management. More...

20/03/09

Indices

Real Estate Indexing and the EDHEC IEIF Commercial Property (France) Index

This paper serves as background literature to the new index and outlines its features and characteristics. First, the importance and the specific characteristics of the real estate market as well as the available real estate investment vehicles are presented. Second, the challenges and problems involved in real estate indexing are discussed. Third, the French real estate market, as the market underlying the index, is described. Fourth, the construction methodology of and the rationale for the EDHEC IEIF Commercial Property (France) Index are discussed in more detail. Fifth and last, this paper provides a set of empirical tests of the properties of the index. More...

11/03/09

Alternative Investments

Hedge Fund Performance in 2008

Véronique Le Sourd This paper analyses twelve years of data on EDHEC Alternative Indexes for different hedge fund strategies to provide some perspective on their performance. The extraordinary events of 2008 were not without an impact on hedge fund returns. Funds of hedge funds lost 17% in 2008, posting their worst annual returns since we began keeping records in 1997. Hedge fund investments lost value across the board. Except for CTAs and Short Sellers, all strategies posted their worst losses in 2008. Even after the impact of a calamitous year, half the strategies still post cumulative returns above 100% for the past ten years, that is, a compound annual return above 7%. More...

17/02/09

Alternative Investments

Madoff: A Riot of Red Flags

Greg N. Gregoriou, François-Serge Lhabitant For more than seventeen years, Bernard Madoff operated what was viewed as one of the most successful investment strategies in the world. This strategy ultimately collapsed in December 2008 in what financial experts are calling one of the most detrimental Ponzi schemes in history. Many large and otherwise sophisticated bankers, hedge funds, and funds of funds have been hit by his alleged fraud. In this paper, we review some of the red flags that any operational due diligence and quantitative analysis should have identified as a concern before investing. We highlight some of the salient operational features common to best-of-breed hedge funds, features that were clearly missing from Madoff’s operations. A revisited version of this paper was published in the Summer 2009 issue of The Journal of Wealth Management. More...

09/02/09

Alternative Investments

EDHEC Hedge Fund Reporting Survey 2008

Felix Goltz, David Schröder Like any investors, investors in hedge funds are naturally interested in knowing how hedge fund managers allocate their initial investment, and whether this allocation yields positive returns or not. It is not only information on past investment returns that is of particular interest; prospects for future gains or losses are relevant to investors as well. Yet, unlike mutual funds, hedge funds are reluctant to provide detailed information on their investment portfolios. Since many hedge funds use highly speculative investment strategies, fund managers fear that a thorough disclosure of their portfolio holdings would significantly decrease their chances of winning their bets, and thereby reduce investors' returns. But incomplete disclosure can have some undesirable side effects. A revisited version of this research was published in the Spring 2010 issue of the Journal of Alternative Investments. More...

05/02/09

Regulation

The Basel II Reform That Would Have Made Most Injections of Public Funds Unnecessary

Noël Amenc, Samuel Sender The financial crisis has put great pressure on banks and led to a number of emergency measures intended to restore confidence in the banking system: tentative changes to accounting standards, recapitalisation of the banking industry, and higher capital requirements. Each measure targets a specific concern that has arisen during the crisis. Governments and regulators, however, have yet to deal with one of the essential causes of systemic risk: the inflexibility of prudential regulation for banking. As it happens, a single minor change would make it possible to restore much of the confidence in the banking sector without requiring any capital injections in the short term: acknowledging that banking capital ratios fall during downturns would have made most of the injections of public funds unnecessary. Making this change today would give governments far more room to support the real economy. More...

30/01/09

Regulation

Reactions to an EDHEC Study on the Fair Value Controversy

Noël Amenc, Frédéric Ducoulombier, Philippe Foulquier A "call for reaction" was sent by EDHEC to international institutional investors and asset managers to compare investor views of the amendments to the IAS39 and IFRS 7 standards not just with the conclusions of an initial EDHEC study ("The Fair Value Controversy: Ignoring the Real Issue"), but also with the ambitions of these reforms prepared and adopted in great haste. The call for reaction received more than 800 responses and represents the first international survey on the relevance of the reforms carried out by the IASB under pressure from the European Commission. The results of this study correspond to EDHEC’s initial arguments. Fewer than a quarter of the respondents believe that these amendments are necessary and well suited to resolving the problems of bank solvency. Moreover, three-quarters of respondents believe that they are likely to lead to new problems. More...

23/01/09

Performance

Socially Responsible Investment Performance in France

The results of this EDHEC position paper show that none of the sixty-two funds in the sample, covering various investment zones, manage to produce both positive and significant alpha (outperformance) over a six-year period and that the few significant alpha values are negative. Moreover, most of the funds generate negative, non-significant alpha. The study also shows that alpha values estimated over one year change greatly from one year to the next. The use of a period of various lengths shows that results can vary greatly from one length to another. More...

20/01/09

Transaction Cost Analysis

Transaction Cost Analysis A-Z: A Step towards Best Execution in the Post-MiFID Landscape

Catherine D'Hondt, Jean-René Giraud This publication covers a broad range of material related to TCA and best execution. As understanding transaction costs is crucial to properly assessing the quality of implementation decisions and complying with the best execution obligation in the post-MiFID environment, it provides a state of the art of TCA fundamentals, undertakes a critical review of existing post-trade TCA techniques, and defines a new and complete approach. More...

15/01/09

Private Wealth Management

Reactions to an EDHEC Study on Asset-Liability Management Decisions in Private Wealth Management

With the great economic growth of the past decade, private wealth management has become a very profitable business for banks worldwide. As a result, more and more asset management firms have jumped into the fray and competition has increased steadily. These industry changes have led to renewed attempts to improve client relationships and to develop tools and methods to enhance advisor effectiveness. Catering to the client’s specific needs is thus a central concern of private wealth managers. To take the client objectives into account, investments are frequently adapted to the client’s risk aversion, tax situation, and investment horizon. A revisited version of this paper was published in the Winter 2009 issue of the Journal of Wealth Management. More...

17/12/08

Commodities

Oil Prices: the True Role of Speculation

To analyse the significant variations in oil prices over the past year, EDHEC have produced a new position paper entitled "Oil Prices: the True Role of Speculation," which argues that, despite the appeal of blaming speculators, supply-and-demand imbalances, the fall in the dollar and low spare capacity in the oil-producing countries are the major causes of this sharp rise. More...

26/11/08

Alternative Investments

The Pros and Cons of Passive Hedge Fund Replication

Noël Amenc, David Schröder In July of 2007, we published a major position paper on the subject of hedge fund replication, entitled "The Myths and Limits of Passive Hedge Fund Replication: An Attractive Concept… Still a Work-in-Progress." That paper examined from both a theoretical and an empirical standpoint the respective benefits and limits of the two different approaches to hedge fund replication, "factor-based replication" and "payoff distribution replication." The present publication covers the industry reactions to last year’s position paper. The objective of the current paper is to compare the results of the analysis of hedge fund replication by EDHEC’s researchers with industry perceptions of the products and techniques that are currently available. More...

26/11/08

Fair Value Accounting

The Fair Value Controversy: Ignoring the Real Issue

In the context of the measures being taken to put an end to the current financial crisis, the extent to which fair value accounting can be blamed—or whether it can be blamed at all—for the intensification of the slump has been widely debated. This new EDHEC position paper shows that this debate, which ignores the real issues, has led to accounting changes that are at odds with their objectives. We examine the relevance of the accusations levelled at fair value and of the responses proposed in an attempt to improve the use of fair value accounting and make it more relevant to the economic realities faced by banks as well as by companies in general. More...

25/11/08

Commodities

What really drives oil prices?

In US dollar terms, crude oil prices increased 525% from the end of 2001 through July 31st, 2008. Was this rally yet another speculative bubble? Specifically, was the oil-price rally based on speculative excess rather than fundamental supply-and-demand factors? In a new position paper, “The Oil Markets: Let the Data Speak for Itself”, we argue that when the oil supply-and-demand balance becomes sufficiently tight and that when effective OPEC spare capacity becomes sufficiently low that it is logical to see very high prices to ration demand and/or encourage additional supply. That is the job and message of price, even if this message is unpopular. More...

07/11/08

Institutional Investment

How Costly Is Regulatory Short-Termism for Defined-Benefit Pension Funds?

Lionel Martellini, Vincent Milhau The recent pension crisis has triggered a fierce debate in most developed countries between advocates of tighter regulation designed to provide explicit incentives for pension funds to increase their focus on risk management and those arguing that imposing short-term funding constraints and solvency requirements on such long-term investors would only increase the cost of pension financing. More...

06/11/08

Best Execution

MiFID Pre-Trade Transparency Rules: An Investor's Perspective

Catherine D'Hondt, Jean-René Giraud In this paper, EDHEC emphasises an important issue that is probably not the expected outcome of MiFID. Even though we recognise that the intentions of the Directive are clearly both to ensure market integrity and protect end investors, we have serious concerns about the results one can expect from the newly introduced requirements related to pre-trade transparency. This paper was published in the Spring 2008 issue of the Journal of Trading. More...

04/11/08

Commodities

Timing Commodity Momentum

Devraj Basu, Joëlle Miffre This paper examines simple timing strategies for commodity momentum, based on whether the market is in backwardation or contango. It finds that these timed strategies outperform winner, loser and momentum strategies. The analysis thus provides evidence that commodity momentum is a dynamic phenomenon, and has implications for commodity managers as it provides simple active strategies that outperform passive momentum benchmarks. More...

31/10/08

Regulation

Banking: Why does regulation alone not suffice? Why must governments intervene?

If all institutional investors are bound by regulations that force them to sell risky assets during downturns, these assets will ultimately be absorbed by unregulated long-term investors. Additional examination shows that, in the current environment, sovereign wealth funds and governments are the possible buyers of these assets. As public intervention entails moral hazard, it follows that for the stability of the financial system throughout the business cycle regulations must be improved. More...

28/10/08

Alternative Investments

Overlay Hedging in a Fund of Funds

David E. Kuenzi, Remy Chaudhuri, Zhihui Dong Hedge funds are often referred to as absolute return strategies, yet investors are aware that most hedge funds do in fact take on a variety of systematic and quasi-systematic exposures. If a manager of a fund of hedge funds (FoF) finds that the exposure of the FoF to a certain systematic exposure or the risk level broadly has become excessive, then the FoF manager may want to hedge. The purpose of this article is to outline the major issues involved with overlay hedging in a fund of funds portfolio and to provide relevant solutions to these issues. These include the determination of whether to hedge, exposure estimation, hedging single exposures with futures, options, and other instruments, and hedging exposures broadly using a multi-factor approach. More...

24/10/08

Indices

A Comparison of Fundamentally Weighted Indices: Overview and Performance Analysis

This paper analyses a set of characteristics-based indices that have recently been launched on the US market and have been said to outperform standard market cap-weighted indices over particular backtest samples. The EDHEC authors, Noël Amenc, Felix Goltz and Véronique Le Sourd, analyse the performance of an exhaustive list of such indices and show that the outperformance over value-weighted indices may be negative over long time periods and that characteristics-based indices do not significantly outperform simple equal-weighted indices. Furthermore, an analysis of both the style exposures and the sector exposures of characteristics-based indices reveals a significant value tilt. When properly adjusting for this tilt, these indices do not show any abnormal performance. A revisited version of this paper was published in the March 2009 issue of European Financial Management. More...

03/09/08

Asset Management

EDHEC European ETF Survey 2008

The EDHEC European ETF Survey 2008 is part of the EDHEC Risk and Asset Management Research Centre’s Indices and Benchmarking research programme. This programme has led to extensive research on indices and benchmarks in both the hedge fund universe and the more traditional investment classes. In 2006, EDHEC published a study of the quality of major stock market indices. Following up on this study, EDHEC is carrying out work that assesses the advantages and disadvantages of various new forms of equity indices. In view of the growth and development of ETFs in Europe, and in view of their growing popularity as investment media for both index management and the construction of benchmarks, it is only natural that EDHEC should devote significant resources to research into ETFs. In 2006, with the support of iShares, we published the first EDHEC European ETF survey. The present survey, an update and extension of the 2006 survey, sheds light on recent developments and trends in ETF investing. An article based on this survey was published in the Summer 2009 issue of the Journal of Alternative Investments. More...

23/07/08

Governance

Transparency and Accountability

Simeon Djankov, Rafael La Porta, Florencio Lopez-de-Silanes, Andrei Shleifer This paper is part of a broader project examining the rules of political disclosure and their consequences. It presents new measures of disclosure by MPs in 126 countries, and examines their determinants as well as consequences for corruption. The measures distinguished between disclosure by law and in practice, between public and non-public disclosure, as well as between more and less comprehensive disclosure. These distinctions motivated the creation of several indices of disclosure in sample countries. More...

01/07/08

Asset Management

EDHEC European Investment Practices Survey 2008

As part of its ongoing policy of monitoring asset management practices and comparing them with the results of academic research, the EDHEC Risk and Asset Management Research Centre undertook an in-depth survey of the risk management, portfolio construction, strategic allocation, and performance measurement practices of European asset managers and investors. The EDHEC European Investment Practices Survey is built on a sample of 229 institutional investors and asset managers who, with respect both to the nationality of survey respondents and to the amount of assets under management, are largely representative of the European asset management industry. In all, respondents to the survey have more than €10 trillion of assets under management and include the major European firms in the industry (nearly fifty respondents manage more than €100 billion each). An article based on some of the findings of this survey was published in the May/June 2011 issue of the Financial Analysts Journal. More...

25/06/08

Indexes

The Performance of Fundamentally Weighted Indices

Noël Amenc, Felix Goltz, Véronique Le Sourd This paper analyses a set of characteristics-based indices that were recently launched on the US market and that, it has been argued, outperform standard market cap-weighted indices over particular backtest samples by a considerable margin. It analyses the performance of an exhaustive list of these indices and shows that i) the outperformance over value-weighted indices may be negative over long time periods, and ii) that there is no significant outperformance over simple equal-weighted indices. Furthermore, an analysis of both the style and sector exposures of characteristics-based indices reveals a significant value tilt. When properly adjusting for this tilt, these indices do not show any abnormal performance. Therefore, the paper argues that the main value these indices add may be to provide investors with a liquid, systematic, and relatively cheap alternative to other value-tilted strategies. However, if one recognises the possibility to implement tilts of exposures to sector or style factors, constructing factor portfolios that beat the characteristics-based indices in the sense of mean-variance efficiency is straightforward. More...

23/06/08

Commodities

Tactical Allocation in Commodity Futures Markets: Combining Momentum and Term Structure Signals

Ana-Maria Fuertes, Joëlle Miffre, Georgios Rallis This paper examines the combined role of momentum and term structure signals for the design of profitable trading strategies in commodity futures markets. With significant annualized alphas of 10.14% and 12.66% respectively, the momentum and term structure strategies appear profitable when implemented individually. A revisited version of this working paper was published in the October 2010 issue of the Journal of Banking and Finance. More...

10/06/08

Commodities

Conditional Return Correlations between Commodity Futures and Traditional Assets

James Chong, Joëlle Miffre The article studies the temporal variations in the conditional return correlations between commodity futures and traditional asset classes (global stock and fixed-income indices). It reveals that the conditional correlations between commodity futures and S&P500 returns fell over time, a sign that commodity futures have become better tools for strategic asset allocation. The correlations with equity returns also fell in periods of above average volatility in equity markets. We see this as welcome news to long institutional investors as they need the benefits of diversification most in periods of high volatility in equity markets. Similarly, falls in return correlations between commodity futures and Treasury-bills go hand in hand with rises in short-term interest volatility, suggesting that adding commodity futures to Treasury-bill portfolios reduces risk further in volatile interest rate environments. A revisited version of this working paper was published in the Winter 2010 issue of the Journal of Alternative Investments. More...

20/05/08

Performance

Dependence Structure and Extreme Comovements in International Equity and Bond Markets with Portfolio Diversification Effects

René Garcia, Georges Tsafack Equity returns are more dependent in bear markets than in bull markets. Previous studies have argued that a multivariate GARCH model or a regime switching (RS) model based on normal innovations could reproduce this asymmetric extreme dependence. This paper shows analytically that it cannot be the case. It proposes an alternative model that allows for tail dependence in lower returns and keeps tail independence for upper returns. This model is applied to international equity and bond markets to investigate their dependence structure. A revisited version of this paper was published in the August 2011 issue of the Journal of Banking and Finance. More...

20/05/08

Alternative Investments

Assessing and Valuing the Non-Linear Structure of Hedge Fund Returns

Antonio Diez de los Rios, René Garcia Several studies have put forward that hedge fund returns exhibit a non-linear relationship with equity market returns, captured either through constructed portfolios of traded options or piece-wise linear regressions. This paper provides a statistical methodology to unveil such non-linear features with the returns on any selected benchmark index. It estimate a portfolio of options that best approximates the returns of a given hedge fund, accounts for this search in the statistical testing of the contingent claim features, and tests whether the identifed non-linear features have a positive value. A revisited version of this paper was published in the March 2011 issue of the Journal of Applied Econometrics. More...

07/05/08

Alternative Investments

Risk Management and Portfolio Construction in a Commodity Futures Programme

Joseph Eagleeye, Hilary Till This article focuses on risk management within the context of a total-return futures program centered on commodities. The following issues are addressed: the evaluation of normal versus eventful risk, the sizing of trades and strategy buckets, and the construction of a portfolio, which takes into consideration these risk and sizing metrics. The article provides examples from three historical portfolios in order to make this discussion concrete and practical. More...

06/05/08

Asset Allocation

Static Allocation Decisions in the Presence of Portfolio Insurance

Felix Goltz, Lionel Martellini, Koray D. Simsek This paper attempts to determine what fraction a static investor should optimally allocate to investment strategies with convex exposure to stock market returns in a general economy with stochastically time-varying interest rates and stock market excess returns. The results obtained using Monte Carlo analysis show that investors should allocate between 45% and 63% of their portfolio to such portfolio insurance strategies. Moreover, the inclusion of portfolio insurance strategies leads to important utility gains. The results are robust with respect to the choice of the objective, the presence of realistic levels of market friction, heterogeneous expectations on volatility, and various parametric assumptions. A revisited version of this paper was published in the Journal of Investment Management, Vol. 6 Nº. 2, Second Quarter 2008. More...

06/05/08

Corporate Governance

The Law and Economics of Self-Dealing

Simeon Djankov, Rafael La Porta, Florencio Lopez-de-Silanes, Andrei Shleifer This paper presents a new measure of legal protection of minority shareholders against expropriation by corporate insiders: the anti-self-dealing index. Assembled with the help of Lex Mundi law firms, the index is calculated for 72 countries based on legal rules prevailing in 2003, and focuses on private enforcement mechanisms, such as disclosure, approval, and litigation, governing a specific self-dealing transaction. This theoretically-grounded index predicts a variety of stock market outcomes, and generally works better than the previously introduced index of anti-director rights. A revisited version of this paper was published in the June 2008 issue of the Journal of Financial Economics. More...

22/04/08

Finance and Economics

The Economic Consequences of Legal Origins

Rafael La Porta, Florencio Lopez-de-Silanes, Andrei Shleifer In the last decade, economists have produced a considerable body of research suggesting that the historical origin of a country's laws is highly correlated with a broad range of its legal rules and regulations, as well as with economic outcomes. This paper summarizes this evidence and attempts a unified interpretation. It also addresses several objections to the empirical claim that legal origins matter. Finally, it assesses the implications of this research for economic reform. A revisited version of this paper was published in the June 2008 issue of the Journal of Economic Literature. More...

22/04/08

Indexes

Fundamental Differences? Comparing Alternative Index Weighting Mechanisms

While an ever increasing share of equity assets is invested in indexing strategies, the standard practice of using capitalisation weighting to construct stock market indices has been the object of much criticism. In response to this criticism, equity indices with different weighting schemes have emerged. Some indices use "fundamental" metrics (Arnott, Hsu, and Moore 2005) to weight the component stocks. In recent years, the market for such characteristics-based indices has grown tremendously, with more and more providers launching and offering them. Institutional investors have allocated significant amounts to these alternatives to value-weighted indices. Likewise, a wide range of exchange-traded funds on these new indices is now available. More...

18/04/08

Corporate Governance

The Divergence of Legal Procedures

Aron Balas, Rafael La Porta, Florencio Lopez-de-Silanes, Andrei Shleifer Djankov et al. (2003a) propose and measure for 109 countries in the year 2000 an index of formalism of legal procedure for two simple disputes: eviction of a non-paying tenant and collection of a bounced check. For a sub-sample of 40 countries, that authors compute this index every year starting in 1950, which allows them to study the evolution of legal rules. They find that between 1950 and 2000 the formalism of legal procedure did not converge, and possibly diverged, between common law and French civil law countries. At least in this specific area of law, the results are inconsistent with the hypothesis that national legal systems are converging, and support the view that legal origins exert long-lasting influence on legal rules. A revisited version of this paper was published in the August 2009 issue of The Amercian Economic Journal: Economic Policy. More...

09/04/08

Alternative Investments

Hedge Fund Analysis — Reading the Multi-Factor Tea Leaves

David E. Kuenzi During the last few years, there has been growing interest in the use of factor models for performing risk and exposure analysis of hedge funds. While interpreting directional and spread related factors in this context is fairly straightforward, interpreting non-linear options exposures often is not. Given the variety of activities that can produce options exposures, the interpretation of multi-factor output in this regard can be more of an art than a science. This paper explores the variety of hedge fund manager activities that can drive options exposures in multi-factor analysis More...

16/03/08

Indices

Towards the Design of Better Equity Benchmarks: Rehabilitating the Tangency Portfolio from Modern Portfolio Theory

Lionel Martellini Following recent research on the relevance of idiosyncratic risk in asset pricing models, this paper proposes to use total volatility as a model-free estimate of a stock's excess expected return, and analyze the implications in terms of the design of improved equity benchmarks. It finds that maximum Sharpe ratio portfolios consistent with such expected return proxies, and built upon improved estimates of the correlation parameters, significantly outperform market cap weighted schemes on a risk-adjusted basis. This analysis, which rehabilitates the role of the tangency portfolio from modern portfolio theory, suggests that better equity benchmarks can be designed, provided that a sophisticated portfolio optimization procedure is used that relies on robust estimates of moments and co-moments of stock return distributions. This paper has important potential implications for the ongoing debate on appropriate weighting schemes for equity indices. A revisited version of this paper was published in the Summer 2008 issue of the Journal of Portfolio Management. More...

06/03/08

Institutional Investment

QIS4: significant improvements, but the main risk for life insurance is not taken into account in the standard formula

In its response to the CEIOPS consultation on the preliminary technical specifications for the fourth quantitative impact survey (QIS4), EDHEC argues that the main risk faced by life insurance companies is not taken into account in the standard formula. This risk is that following market (or other significant) losses, a wave of surrenders leaves shareholders bearing the entirety of losses. This is the phenomenon that led to such bankruptcies as that of Executive Life, where losses made public by rating agencies and the media triggered a wave of surrenders and bankruptcy–even though the losses alone were thought bearable for some time. More...

14/02/08

Alternative Investments

Hedge Fund Performance in 2007

In a context of moderate performance in the stock and bond markets in 2007, Funds of Hedge Funds, which are often taken to give an aggregate view of the industry’s performance, returned 10.07% on average for the year, compared to 3.53% for the S&P 500 and 4.14% for the Lehman Global US Treasury Bond index.

In “Hedge Fund Performance in 2007”, Véronique Le Sourd, Senior Research Engineer with the EDHEC Risk and Asset Management Research Centre provides a strategy-by-strategy account of the performance of each hedge fund strategy included in the EDHEC Alternative Indexes. While all hedge fund strategies posted positive returns, a majority saw a slight fall-off in performance compared to 2006. Only five of the thirteen strategies obtained higher returns than in 2006: CTA Global, Emerging Markets, Equity Market Neutral, Global Macro, and Short Selling. More...

14/02/08

Alternative Investments

The Myths and Limits of Passive Hedge Fund Replication: An Attractive Concept… Still a Work-in-Progress

Noël Amenc, Walter Géhin, Lionel Martellini, Jean-Christophe Meyfredi Following recent initiatives by major investment banks such as Merrill Lynch and Goldman Sachs, EDHEC researchers have undertaken a detailed critical analysis of the various methodologies involved in hedge fund replication offers, examining the benefits and limits of the “factor-based” and “pay-off” distribution approaches. In the study, “The Myths and Limits of Passive Hedge Fund Replication,” co-written by Lionel Martellini with Noël Amenc, Walter Géhin and Jean-Christophe Meyfredi, the authors find that overall, one could only possibly hope to achieve truly satisfying results by combining the best of the two competing approaches. A revisited version of this paper was published in the Fall 2008 issue of the Journal of Alternative Investments. More...

22/01/08

Real Estate

EDHEC European Real Estate Investment and Risk Management Survey

The EDHEC Risk and Asset Management Research Centre has released a new survey that is drawn from its research programme in asset allocation and alternative diversification. This programme has led to extensive research on the benefits, risks, and integration methods of alternative classes and instruments in asset allocation.

Real estate, probably the most traditional of alternative classes, is enjoying renewed favour as institutional investors search for diversification benefits and competitive yields. Institutional demand for real estate exposure has brought about improvements in market transparency and the development of new indirect and synthetic investment tools. With target allocations to real estate increasing, research into real estate as an asset class must enable industry participants to refine traditional approaches and to consider real estate within the bounds of asset management and asset-liability management. It is in this way that research can help real estate take its place in multistyle, multi-class portfolios, contribute to the design of integration methods that optimise its risk/return trade-off, and, finally, enable the class to deliver on its full potential.

The EDHEC European Real Estate Investment and Risk Management Survey, the first phase of this research, takes stock of developments in the real estate investment market, reviews academic evidence on allocation to and management of real estate, and analyses the results of a large-scale, pan-European survey of institutional practices. More...

14/12/07

Performance

Rating the Ratings: A Critical Analysis of Fund Rating Systems

Noël Amenc, Véronique Le Sourd. Fund ratings are a widely used tool for fund promoters and fund subscribers. They serve to evaluate fund performance on a risk and return basis in an easily understandable way, and allow the performance of different funds to be compared. In this context, the quality and the robustness of the ratings is a critical subject for both investment management firms and investors. Though the predictive capability of fund ratings has not been proved, numerous studies performed on US mutual funds have concluded that fund subscribers are widely influenced by fund ratings in making their choice. A revisited version of this paper was published in the Summer 2007 issue of the Journal of Performance Measurement. More...

15/10/07

Alternative Investments

Extending Black-Litterman Analysis Beyond the Mean-Variance Framework

Lionel Martellini, Volker Ziemann This paper introduces a suitable extension of the Black-Litterman Bayesian approach to portfolio construction in the presence of non-trivial preferences about higher moments of asset return distributions. It also presents an application to active style allocation decisions in the hedge fund universe. Overall the results suggest that significant value can be added in a hedge fund portfolio through the systematic implementation of active style allocation decisions provided that a sound investment process is implemented that accounts for both non-normality and parameter uncertainty in hedge fund return distributions. A revisited version of this paper was published in the Summer 2007 issue of the Journal of Portfolio Management. More...

01/10/07

Risk Management

A Copula Approach to Value-at-Risk Estimation for Fixed-Income Portfolios

Lionel Martellini, Jean-Christophe Meyfredi This paper introduces a multivariate copula approach to Value-at-Risk estimation for fixed income portfolios. Using a parsimonious model to extract time-varying parameters used as proxies for factors affecting the shape of the yield curve, and a Student copula to model the dependence structure of these factors, we are able to generate VaR estimates that strongly dominate standard VaR estimates in formal out-of-sample tests. A revisited version of this paper was published in the Summer 2007 issue of the Journal of Fixed Income. More...

01/10/07

Alternative Investments

Revisiting the Limits of Hedge Fund Indices: a Comparative Approach

Noël Amenc, Felix Goltz Hedge fund indices have been criticised for a lack of representativity and for their biases, to the point that serious doubts about the usefulness of hedge fund indices have been raised by investors and regulators. This paper examines whether the problems that are outlined for hedge fund indices also exist for other indices that seem to be widely accepted. The drawbacks of hedge fund indices pointed out in the literature do indeed exist. However, in this paper, the authors point out that there are possible solutions to these problems. A revisited version of this paper was published in the Spring 2008 issue of the Journal of Alternative Investments. More...

18/09/07

Indices

EDHEC survey shows that professionals agree with the conclusions of a study on the shortcomings of stock market indices

A recent publication by the EDHEC Risk and Asset Management Research Centre has drawn conclusions that highlight the shortcomings of well known capitalisation- or price-weighted stock market indices and argues that the choice of benchmark for asset allocation or performance measurement is a task requiring particular care. In a call for reactions to this publication, EDHEC finds that the answers of the more than eighty respondents (asset management firms, pension funds, insurance companies, private banks, etc.) tend to reinforce the conclusions drawn by the original publication. Although it would at first appear that the majority of respondents are not, in general, dissatisfied with the indices they use as benchmarks (18.82% of respondents express degrees of dissatisfaction), further examination soon reveals that the shortcomings of these indices, such as inefficiency, lack of stability, and susceptibility to price bubbles, are widely recognised by the industry professionals responding to EDHEC’s call for reactions. The call for reactions also shows that a considerable majority of respondents plan to review the indices they use as benchmarks, either immediately or in the future. More...

17/09/07

Alternative Investments

Hedge Funds and the Subprime Crisis: a French Answer to French Criticism

European leaders, eager for an explanation absolving them of responsibility, have once again laid blame on the seemingly detrimental role played by hedge funds in this summer’s crisis. This crisis is the result of a sudden fall in asset prices, combined with increased aversion to risk on the part of investors. To suggest that hedge funds are to blame for this crisis is simplistic but tempting, as their speculative, unregulated, and opaque nature make them easy targets - all the while, more delicate market and regulatory issues are avoided. So, as a counterpoint to these accusations that often come from France, it seemed necessary to us to provide a French perspective on the lessons to be learned with respect to financial regulation in France. More...

17/09/07

Alternative Investments

The Amaranth Collapse: What Happened and What Have We Learned Thus Far?

Hilary Till. On September 18th, 2006, market participants were made aware of a large hedge fund’s distress. On that date, Nick Maounis, the founder of Amaranth Advisors, LLC, had issued a letter to his investors, informing them that the fund had lost an estimated 50% of their assets month-to-date. By the end of September 2006, these losses amounted to $6.6-billion, making Amaranth’s collapse the largest hedge-fund debacle to have thus far occurred. There were (and are) many surprising aspects of this debacle. A revisited version of this paper was published in the Spring 2008 issue of the Journal of Alternative Investments. More...

06/09/07

Performance Measurement

Low-Cost Momentum Strategies

Xiafei Li, Chris Brooks, Joëlle Miffre The article analyses the impact of trading costs on the profitability of momentum strategies in the UK and concludes that losers are more expensive to trade than winners. The observed asymmetry in the costs of trading winners and losers crucially relates to the high cost of selling loser stocks with small size and low trading volume. Since transaction costs severely impact net momentum profits, the paper defines a new low-cost relative-strength strategy by shortlisting from all winner and loser stocks those with the lowest total transaction costs. A revisited version of this paper was published in the February 2009 issue of the Journal of Asset Management. More...

22/08/07

Alternative Investments

Trading Strategies in the Current Commodity Market Environment

Hilary Till. This brief article suggests three approaches for how to benefit from structural opportunities in the commodity markets, drawing from the recently published book, “Intelligent Commodity Investing.” The author notes how over long time horizons, the term structure of a commodity futures curve becomes the dominant driver of return for individual futures contracts. For shorter time horizon opportunities, the author discusses mean-reverting commodity spread trades that have approximately seasonal frequencies. More...

02/08/07

Alternative Investments

In QIS3, CEIOPS sets a surprising 45% capital charge for all alternative investments and hedge funds

Within the equity risk sub-module of the third Quantitative Impact Study (QIS3) undertaken by the Committee of European Insurance and Occupational Pension Supervisors (CEIOPS), a preamble to the Solvency II supervisory standard, all alternative investments are subject to a capital charge of 45%, nearly 50% higher than the 32% applied to regular equity exposures. In this article, we briefly go over the calculations required for equity risk, and then include a reminder of why hedge funds on average are certainly not the riskiest bet an investor can make. More...

23/07/07

Alternative Investments

Natural Resources Fund-of-Funds: Active Management, Risk Management, and Due Diligence

Rian Akey, Hilary Till, Aleks Kins. This article comprehensively covers the new field of natural-resources fund-of-funds investing. The authors first explain why the demand for such an investment has emerged, and then discuss the opportunities that an actively-managed natural-resources fund-of-funds can potentially exploit. More...

23/05/07

Order Execution

Hide-and-Seek in the Market: Placing and Detecting Hidden Orders

Rudy De Winne, Catherine D’Hondt This paper investigates why traders hide their orders and how other traders respond to hidden depth. Using a logit model, the authors provide empirical findings suggesting that traders use hidden orders to manage both exposure risk and picking off risk. Using probit models, they show that hidden depth increases order aggressiveness. The authors' interpretation of this empirical evidence is threefold. First, hidden depth detection is possible and frequent. Second, when traders detect hidden volume at the best opposite quote, they strategically adjust their order submission to seize the opportunity for depth improvement. A revisited version of this paper was published in the September 2007 issue of Review of Finance (formerly European Finance Review). More...

09/05/07

Performance Measurement

The Value Premium and Time-Varying Volatility

Xiafei Li, Chris Brooks, Joëlle Miffre Numerous studies have documented the failure of the static and conditional capital asset pricing models to explain the differences in returns between value and growth stocks. This paper examines the post-1963 value premium by employing a model that captures the time-varying total risk of the value-minus-growth portfolios. The results show that the conditional variance model incorporating time-varying idiosyncratic risk can fully capture the post-1963 value premium. The conclusion is robust to the criterion used to sort stocks into value and growth portfolios, to the inclusion of the size premium into the conditional asset pricing model, and to the country under review (US and UK). This paper therefore adds to the debate on the possible role of idiosyncratic risk in explaining equity returns. A revisited version of this paper was published in the November/December 2009 issue of the Journal of Business Finance and Accounting. More...

04/05/07

Alternative Investments

Shedding Light on Alternative Beta: A Volatility and Fixed Income Asset Class Comparison

David Kuenzi Volatility is an alternative beta—a risk premium captured by hedge fund managers and investment bank proprietary traders—that is today moving closer to the mainstream and should be thought of as a veritable asset class. For many investors, it is difficult to derive intuition as to why volatility should deserve an ongoing allocation within a larger portfolio. If volatility is an asset class, then to what accepted asset class can it be compared? More...

27/04/07

Asset Pricing

Approximating Independent Loss Distributions with an Adjusted Binomial Distribution

Dominic O'Kane The author describes an approximation methodology for constructing independent loss distributions based on adjusting the binomial distribution. This method can handle both homogeneous and heterogeneous loss portfolios. He finds that this simple algorithm provides an excellent fit to the exact distribution for a broad range of correlations and portfolio credit quality. More...

26/04/07

Best Execution

EDHEC's response to the CESR's public consultation on Best Execution under MiFID

In response to the CESR's public consultation on best execution under MiFID, EDHEC strongly defend the idea that the analysis of the total net proceeds of financial transactions represent the most important factor for assessing execution quality. But this analysis also represents the most significant conceptual and technical challenge the industry will face in order to consistently monitor execution quality, and therefore allow best execution to become a tangible and measurable objective for investment firms. More...

17/04/07

Alternative Investments

Momentum Strategies in Commodity Futures Markets

Joëlle Miffre, Georgios Rallis The article looks at the performance of 56 momentum and contrarian strategies in commodity futures markets. The authors build on the research of Erb and Harvey (2006) who focus on one momentum strategy. While contrarian strategies do not work, 13 momentum strategies are found to be profitable in commodity futures markets over horizons that range from 1 to 12 months. A revisited version of this paper was published in the June 2007 issue of the Journal of Banking and Finance. More...

04/04/07

Alternative Investments

The Impact of Non-Normality Risks and Tactical Trading on Hedge Fund Alphas

Harry M. Kat, Joëlle Miffre This paper highlights the importance of non-normality risks and tactical asset allocation in assessing hedge fund performance. As such, it underlines the inaccuracies of previous papers on hedge fund performance that ignored higher moments in the distribution of hedge fund returns and assumed constant asset allocation. Correcting for these shortcomings, the authors find that failure to account for non-normality risks and tactical asset allocation on average leads to an overstatement of performance by 1.54% and to incorrect statistical inference on the performance of 1 out of 4 funds. On average, non-normality risks and conditional asset allocation explain 23.1% of the abnormal performance of hedge funds as commonly perceived. A revisited version of this paper was published in the Spring 2008 issue of the Journal of Alternative Investments. More...

04/04/07

Best Execution

MiFID: the (in)famous European Directive?

In this study, EDHEC-Risk Institute, while recognising that the directive allows the conditions in which investment companies can operate on the regulated markets or over-the-counter to be harmonised, warns of the eventual adverse effects relating to the obligation of transparency for systematic "internalisers" and the obligation of "best execution". The authors find, in the case of the obligation imposed on systematic “internalisers” to maintain a public spread of prices, that it is prejudicial for this restriction to be removed for the least liquid securities. This provision will lead, in a certain number of cases, (small-caps on markets that are centrally organised at present), to a deterioration in the pre-trade transparency that is currently provided to investors. More...

02/04/07

Alternative Investments

Measure for Measure

Hilary Till In a previous paper, Life at Sharpe's End, the author touched upon the difficulty of using standard measures to evaluate a number of hedge fund strategies. In this article, after reviewing these difficulties, she discusses the state-of-the-art methodology in this area. More...

30/03/07

Alternative Investments

Life at Sharpe’s End

Hilary Till For futures programs, the meaning of rate-of-return numbers can be somewhat ambiguous, given that one does not need to set aside capital in the amount of a program’s funding level. Instead, an investor can fractionally fund an account using “notional funding.” More...

30/03/07

Alternative Investments

Conditional Risk Premia and Correlations in Commodity Futures Markets

James Chong, Joëlle Miffre In this paper, the authors study the conditional risk premia of commodity futures and the way their returns vary over time with those of traditional asset classes (S&P500 stocks and US T-bonds). They draw the following two conclusions. First, that historically investors earned significant risk premia on 19 of the 21 commodity futures markets studied. Second, that the conditional correlations between equity and commodity futures returns fell over time. More...

30/03/07

Performance Measurement

Momentum Profits and Time-Varying Unsystematic Risk

Xiafei Li, Joëlle Miffre and Chris Brooks This article considers whether the widely documented momentum profits are a compensation for time-varying unsystematic risk as described by the family of autoregressive conditionally heteroscedastic models. The motivation for estimating a GJR-GARCH(1,1)-M model stems from the fact that, since losers have a higher probability than winners to disclose bad news, one cannot assume a symmetric response of volatility to good and bad news. A revisited version of this paper was published in the April 2008 issue of the Journal of Banking & Finance. More...

30/03/07

Performance

Performance Measurement for Traditional Investment

This paper presents the state of the art of performance measurement in the area of traditional investment, from a simple evaluation of portfolio return to the more sophisticated techniques including risk in its various acceptations. It also describes models that take a step away from modern portfolio theory and allow a consideration of cases beyond mean-variance theory. More...

30/03/07

Wealth Management

Asset-Liability Management Decisions in Private Banking

Working from the observation that the contribution of asset-liability management techniques developed for institutional investors is not yet familiar within private banking, a new study from the EDHEC Risk and Asset Management Research Centre, entitled “Asset-Liability Management Decisions in Private Banking” shows the expected benefits of a transposition of that kind. According to the authors of the study, Noël Amenc, Lionel Martellini and Volker Ziemann, asset-liability management represents a genuine means of adding value to private banking that has not been sufficiently explored to date. Within the framework of private financial management offerings, personal wealth managers tend to confine their clients to mandates that are only differentiated through their level of volatility, without the client’s personal wealth constraints and objectives being genuinely taken into account in order to determine the overall strategic asset allocation. In that sense, private wealth management is not sufficiently different from the management of a diversified or profiled mutual fund. More...

19/03/07

Alternative Investments

Hedge Fund Performance: A Vintage Year for Hedge Funds?

Véronique Le Sourd In a report entitled “Hedge Fund Performance: A Vintage Year for Hedge Funds?”, Véronique Le Sourd, Senior Research Engineer with the EDHEC Risk and Asset Management Research Centre provides a comprehensive account of the performance of each hedge fund strategy included in the EDHEC Alternative Indexes. The author reveals that funds of hedge funds, which are often taken to give an aggregate view of the industry’s performance, yielded a solid return of 11.25% in 2006. More...

19/03/07

Performance

Mean-Variance-Skewness Portfolio Performance Gauging: A General Shortage Function and Dual Approach

Walter Briec, Kristiaan Kersten, Octave Jokung This paper proposes a nonparametric efficiency measurement approach for the static portfolio selection problem in mean-variance-skewness space. A shortage function is defined that looks for possible increases in return and skewness and decreases in variance. Global optimality is guaranteed for the resulting optimal portfolios. We also establish a link to a proper indirect mean-variance-skewness utility function. For computational reasons, the optimal portfolios resulting from this dual approach are only locally optimal. This framework makes it possible to differentiate between portfolio efficiency and allocative efficiency, and a convexity efficiency component related to the difference between the primal, non-convex approach and the dual, convex approach. Furthermore, in principle, information can be retrieved about the revealed risk aversion and prudence of investors. An empirical section on a small sample of assets serves as an illustration. A revisited version of this paper was published in the January 2007 issue of Management Science. More...

23/02/07

Performance Measurement

Momentum Profits and Non-Normality Risks

Ana-Maria Fuertes, Joëlle Miffre and Wooi-Hou Tan This paper examines the role of non-normality risks in explaining the momentum puzzle of equity returns. It shows that momentum returns are not normally distributed. About 70 basis points of the annual momentum profits can be attributed to systematic skewness risk. This finding is pervasive across nine strategies and is reinforced when time dependencies in abnormal returns and risks are explicitly modeled. The analysis also reveals that the market and skewness risks of momentum portfolios evolve over the business cycle in a manner that is consistent with market timing and risk aversion. A revisited version of this paper was published in the June 2009 issue of Applied Financial Economics. More...

05/02/07

Institutional Investment

EDHEC study identifies grave incoherencies in CEIOPS' Consultation Paper 20 on Solvency II

A new EDHEC position paper entitled "CP20: Significant improvements in the Solvency II framework but grave incoherencies remain", by Philippe Foulquier, Director of the EDHEC Financial Analysis and Accounting Research Centre, and Samuel Sender, Research Associate with the EDHEC Risk and Asset Management Research Centre, contains EDHEC's answer to CP20, a consultation process initiated by CEIOPS (Committee of European Insurance and Occupational Pensions Supervisors) on the "Advice to the European Commission in the Framework of the Solvency II Project on Pillar I Issues". More...

26/01/07

Performance Measurement

A Comparison of Alternative Approaches for Determining the Downside Risk of Hedge Fund Strategies

Daniel Giamouridis and Ioanna Ntoula This paper compares a number of different approaches for determining the Value at Risk (VaR) and Expected Shortfall (ES) of hedge fund investment strategies. The authors compute VaR and ES through completely model-free methods, as well as through mean/variance and distribution model-based methods. Among the models considered certain specifications can technically address autocorrelation, asymmetry, fat tails, and time-varying variances which are typical characteristics of hedge fund returns. They find that conditional mean/variance models coupled with appropriate distributional assumptions improve their ability to predict VaR, 1% VaR in particular. They also find that the goodness of ES prediction models is primarily influenced by the distribution model rather than the mean/variance specification. A revisited version of this paper was published in the March 2009 issue of the Journal of Futures Markets. More...

25/01/07

Alternative Investments

Quantification of Hedge Fund Default Risk

In a working paper entitled ‘Quantification of Hedge Fund Default Risk’, which led to the publication of a full article in the Fall issue of the Journal of Alternative Investments, Jean-René Giraud and Stéphane Daul of the EDHEC Risk and Asset Management Research Centre, together with co-author Corentin Christory, examined numerous cases of hedge fund default in order to find the common factors behind fund failures. The objective of the paper was to provide an initial framework for quantifying the non-financial extreme risk of hedge funds with the aim of factoring it into the portfolio construction phase. The paper examines the statistical properties of hedge fund failures and attempts to identify essential risk factors that can tentatively explain why certain funds are more likely to default on their investors and creditors than others. A revisited version of this paper was published in the Fall 2006 issue of the Journal of Alternative Investments. More...

24/01/07

Alternative Investments

Hedge Fund Indices for the Purpose of UCITS: EDHEC Answers the CESR Issues Paper

In a reply to the CESR Issues Paper on the eligibility of hedge fund indices for the purpose of UCITS, the EDHEC Risk and Asset Management Research Centre argues that hedge fund indices should not be required to offer more controls and more transparency than existing financial indices such as stock market indices. Likewise, their construction should not be subjected to detailed rules for choosing constituents and implementing rebalancing and weighting mechanisms. More...

23/01/07

Exchange-Traded Funds

EDHEC European ETF Survey 2006

In a new survey, The EDHEC European ETF Survey 2006, the EDHEC Risk and Asset Management Research Centre has carried out an in-depth study on the use of ETFs (Exchange-Traded Funds) by European investors. The results of the survey show that following rapid growth, ETFs are being widely used by European institutional investors, private bankers and asset managers. The increasing popularity of ETFs is reflected in the responses of survey participants. More than half of the respondents are current or planned users of ETFs in equity investments (61%), and this is the case for more than a quarter of respondents (26%) for bond investments.

More remarkably, among those that use Equity ETFs, 92% were satisfied, which indicates an extremely high level of satisfaction. With 45% of responses, the most distinct reason for satisfaction was the reliability of the tracking error. 23% were satisfied with the good performance of ETFs, while 21% were pleased with the level of liquidity, and only 4% cited the reduced expenses of ETFs. Interestingly, half of the respondents who were not satisfied with Equity ETFs pointed to the poor level of liquidity of ETFs. More...

18/01/07

Transaction Cost Analysis

EDHEC Risk Advisory survey highlights lack of consensus on best execution

A new report from EDHEC Risk Advisory, Transaction Cost Analysis in Europe: Current and Best Practices, which was commissioned by HSBC Investment Bank, reviews the conditions in which buy-side firms (traditional and alternative) are currently monitoring transaction costs and investigates the various issues related to transaction cost analysis in the context of the Markets in Financial Instruments Directive due to be enforced in November 2007. This directive contains an important provision related to Best Execution. More...

16/01/07

Institutional Investment

The Impact of IFRS and Solvency II on Asset-Liability Management and Asset Management in Insurance Companies

A new study jointly produced by the EDHEC Risk and Asset Management Research Centre and the EDHEC Financial Analysis and Accounting Research Centre entitled ‘The Impact of IFRS and Solvency II on Asset-Liability Management and Asset Management in Insurance Companies’ reveals the contradictions inherent in the current Solvency II and IFRS provisions for insurance companies. The report shows notably that the numerous provisions proposed by the IFRS are at odds with the good risk management practices put forward by Solvency II. While IFRS and Solvency II should lead to a genuine evolution in the management of insurance companies, by empowering them with respect to their risks (identification, measurement and management), one is forced to observe today that the standards implemented often oppose their initial objectives: the adoption of modern asset management and ALM techniques with a view to reducing the exposure to risks is considerably penalised by the IFRS treatment by leading to additional purely accounting volatility, without any connection to the economic reality. More...

11/12/06

Performance Measurement

The Challenge of Hedge Fund Performance Measurement: a Toolbox rather than a Pandora’s Box

Walter Géhin This paper, which is being written to provide an overview of the multitude of publications we have seen on hedge fund performance, is the result of a reading and analysis of about 200 studies on this subject. The issue of performance measurement in the hedge fund industry has led to literature that is both abundant and controversial. The explanation of this complexity lies in the particular features of alternative funds. More...

17/11/06

Institutional Investment

Solvency II: EDHEC regrets modelling approach chosen by CEIOPS in QIS 2

In a new position paper by Philippe Foulquier, director of the EDHEC Financial Analysis and Accounting Research Centre, and Samuel Sender, research associate with the EDHEC Risk and Asset Management Research Centre, entitled ‘QIS 2: Modelling that is at odds with the prudential objectives of Solvency II’, EDHEC regrets the approach chosen by the CEIOPS (Committee of European Insurance and Occupational Pensions Supervisors) for the European Commission as proposed in the QIS 2 (Quantitative Impact Study 2), which does not favour optimal management of the risks of European insurance companies. In light of the changing face of risks and how they are perceived, the existing prudential rules are totally inadequate and the European Commission has established a vast project to overhaul the methods used for calculating the solvency of insurance companies. More...

15/11/06

Indices

Assessing the Quality of Stock Market Indices: Requirements for Asset Allocation and Performance Measurement

At a presentation to the members of the Af2i (French association of institutional investors) in Paris on September 12th, Noël Amenc, Director of the EDHEC Risk and Asset Management Research Centre, warned his institutional audience about the dangers of relying solely on stock market indices as a benchmark for their investment management performance. More...

18/10/06

Transaction Cost Analysis

Cash Equity Transaction Cost Analysis: State of the art … and beyond

Jean-René Giraud, Catherine d’Hondt MiFID is the second step in the harmonization of the European capital markets industry and intends to adapt the first Investment Services Directive (ISD 1 issued in 1993) to the realities of the current market structures. After having clarified the nature of the new regulation, this paper first describes the role of Transaction Cost Analysis in the fulfilment of the best execution obligation as well as the limits of existing frameworks. Then, the paper presents a new methodology that makes it possible to measure the quality of execution as part of peer group review and identify whether the broker, trader or algorithm has implemented the execution too aggressively or too slowly. This approach relies on a couple of indicators allowing an easy comparison of a large universe of trades and providing insightful information not only about the final performance (EBEX absolute indicator) but also about the possible justification of the performance (EBEX direction). In order to illustrate both the framework and the level of interpretation made possible, the results of a preliminary study conducted on 2737 orders on Euronext blue chips over a 4-month sample period are reported. A revisited version of this paper was published in the November 2006 issue of the Journal of Asset Management. More...

06/10/06

Alternative Investments

EDHEC comments on the lessons to be drawn from the Amaranth debacle

In a little over a week, Amaranth Advisors, a respected, diversified multi-strategy hedge fund, lost 65% of its $9.2 billion assets. In a paper entitled ‘EDHEC Comments on the Amaranth Case: Early Lessons from the Debacle’, noted commodities expert Hilary Till, Research Associate with the EDHEC Risk and Asset Management Research Centre and Principal of Premia Capital Management, LLC, examines how Amaranth could have suffered such massive losses and draws lessons from this debacle for investors, funds of fund & energy fund risk managers, multi-strategy hedge fund managers, policy makers, and the alternative investment industry as a whole. More...

02/10/06

Commodity Futures

Structural Sources of Return and Risk in Commodity Futures Investments

Hilary Till By now it has become well-known that commodities have had superior performance over the past four and a half years; commodity investing has become a sign of sophistication. Because commodity index investing has grown from an obscure, niche strategy to a more widely accepted investment, there has been a need to better understand the drivers of historical commodity returns and risks. An investor would presumably then be in a better position to make informed judgments on the future prospects of a commodity investment. More...

25/09/06

UCITS Eligibility

EDHEC replies to the CESR recommendations on the eligibility of hedge fund indices for UCITS investments

In a document entitled ‘A Reply to the CESR Recommendations on the Eligibility of Hedge Fund Indices for Investments of UCITS’, Noël Amenc and Felix Goltz of the EDHEC Risk and Asset Management Research Centre have urged the CESR to reconsider their position on suspending the eligibility of hedge fund indices. More...

21/09/06

Institutional Investment

Improving investment performance for pension plans

John M Mulvey, Koray D. Simsek, Zhuojuan Zhang Over the past half-decade, pension plans in the US have seen their ample surpluses turn into massive deficits. Many pension trusts in early 2006 possess funding ratios below 75 per cent. This paper suggests that multi-period investment models can increase performance for long-term investors including pension plans, family offices and university endowments. The framework improves the investor's understanding of risks and rewards in a temporal setting. Contribution and saving strategies can be integrated with asset allocation decisions to enhance the sponsoring company's shareholder value via the pension trust. Applying an overlay strategy further improves performance. Advantages are illustrated via several examples, including the slow-growing telecommunication sector and the under-funded pension plan of a car company. This paper was published in the July 2006 issue of the Journal of Asset Management. More...

04/09/06

Alternative Investments

How to Include Hedge Funds in a Risk Allocation Framework

Hilary Till. This article, which was originally written as a two-part series, discusses the innovative ways in which academics and practitioners are enhancing asset allocation methodologies in order to incorporate hedge funds. It begins by discussing the current practice in asset allocation work and goes on to describe the unique problems that occur when this methodology is applied to hedge funds. It also discusses a number of leading edge solutions to these problems. Included are anecdotes from anonymous hedge fund managers and traders, which illustrate some of the academic points made in the article. A revisited version of this paper was published in the GARP Risk Review, the Journal of the Global Association of Risk Professionals, September/October and November/December 2002 issues. More...

04/08/06

Commodities

The Risks of Commodity Investing

Hilary Till and Joseph Eagleeye. This article covers investment in commodities through futures contracts. It notes the unique sources of risk and return for such investments and also discusses the factors that one should take into consideration before deciding upon how much of a portfolio should be in commodities. We will see how an investment in commodities can be used as either a diversifier for a traditional portfolio or as a source of returns, depending on the market environment. Finally, it is argued that some of the considerations that apply to equity investing are also relevant for commodity investing. More...

04/08/06

Alternative Investments

Measuring Risk-Adjusted Returns in Alternative Investments

Hilary Till. Academic criticism of classic Capital Asset Pricing Model (CAPM) performance measures is not new. Until recently it was fine to use the Sharpe ratio as a way of summarizing the attractiveness of an investment. Only now have the shortcomings of using traditional performance measures to evaluate all manner of strategies become relevant to investors. This article touches on the problems with using traditional performance evaluation methods and summarize the state-of-the-art in alternative performance evaluation techniques. A revisited version of this paper was published in Quantitative Finance, (2002) 2:4 pp.237-238. More...

02/08/06

Alternative Investments

A Review of the Differences between Traditional Investment Programs and Absolute-Return Strategies

Hilary Till and Joseph Eagleeye. Given the ongoing stock market downdraft since March 2000, U.S. mutual fund inflows have dramatically slowed down while hedge fund investing has exploded. Some have argued that there is an accelerating convergence between the hedge fund industry and traditional institutional fund management. This article will argue the opposite: that in a very fundamental way, these two investment industries are still quite distinct. A revisited version of this paper was published in Quantitative Finance, (2003) 3:3 pp. C42-C48. More...

02/08/06

Alternative Investments

The Risk Considerations Unique to Hedge Funds

Hilary Till. A distinguishing feature in evaluating the risk of hedge fund strategies is the relative paucity of data, as noted by Feldman et al (2002). This creates great discomfort in attempting to apply statistical techniques to sparse datasets. This article will discuss five further approaches that academics and practitioners have proposed since this summer for addressing the risk considerations that are unique to hedge funds. A revisited version of this paper was published in Quantitative Finance, (2002) 2:6 pp. 409-411. More...

02/08/06

Commodities

Commodities at the Cross-Roads: Where to Now?

Hilary Till. While it is useful to review the past performance of commodities, investors are most concerned about what to expect going forward. And unfortunately, one cannot look in the rear-view mirror to see what is coming up ahead. In this article, the author reviews the drivers of commodity returns along with some observations on what the future may hold. More...

27/07/06

Alternative Investments

Determinants of Funds of Hedge Funds’ Performance

Noël Amenc and Mathieu Vaissié. Despite institutional investors’ growing interest in funds of hedge funds, little attention has been paid so far to their added value and/or the sources of their added value. This is all the more striking in that funds of funds are far from transparent and are, with their double-fee structure, relatively costly investment vehicles. The objective in this paper is to fill that gap and find out whether funds of funds add value through strategic allocation and active management. A revisited version of this paper was published in the Winter 2006 issue of the Journal of Investing. More...

27/07/06

Alternative Investments

EDHEC disagrees with the ECB

An article in the June 2006 edition of the European Central Bank’s Financial Stability Review (FSR) claims that hedge fund activities pose considerable risk to the financial system. We disagree with this conclusion, which is based on mere speculation. We outline the fallacies in the reasoning of the FSR article and makes some propositions on how to assess the welfare impacts of hedge funds. In particular, we argue that it would be worthwhile for financial regulators to work towards obtaining data on hedge fund leverage and counterparty credit risk. Such data would allow a reliable assessment of the question of systemic risk. In addition, we argue that besides evaluating potential systemic risk, it should be recognised that hedge funds play an important role as “providers of liquidity and diversification.” More...

27/07/06

Operational Performance

Hidden Liquidity in a Pure Order-Driven Market

Rudy De Winne, Catherine D’Hondt This letter focuses on hidden orders and shows how they contribute to liquidity. Based on a rebuilt order book from Euronext data, the part of liquidity which is not disclosed to market participants is described and its determinants are analyzed. A revisited version of this paper was published in the July 2006 issue of Finance Letters. More...

07/07/06

Asset Allocation

Derivatives Strategies for Bond Portfolios

Felix Goltz, Lionel Martellini, Volker Ziemann. In this paper, the authors examine how standard exchange-traded fixed-income derivatives (futures and options on futures contracts) can be included in a sound risk and asset management process so as to improve risk and return performance characteristics of managed portfolios. The results show that the non-linear character of the returns on protective option strategies offers appealing risk reduction properties in the pure asset management context. Consequently, such strategies should optimally receive a significant allocation, especially when investors are concerned with minimising extreme risks. A revisited version of this paper was published in the June 2006 issue of the Journal of Fixed Income. More...

21/06/06

Indexes & Benchmarking

Hedge Fund Strategy Benchmarks: Tricks of the Light or Lighthouses?

Walter Géhin, Mathieu Vaissié The construction of an appropriate benchmark is one of the major challenges of the performance measurement process. Without quality benchmarks, it is not possible to differentiate between returns due to the investment style of the manager and returns due to the talent of the manager, which in turn makes it difficult to measure relative returns. This paper examines the issue of hedge fund strategy benchmarks in the light of improvements in hedge fund index construction methodologies and management principles, and with the launch of new series of investable hedge fund indices. The paper notably tries to answer the following question: Can investors in the alternative arena measure the relative returns of hedge funds? A revisited version of this paper was published in the May-June 2005 issue of the Journal of Indexes. More...

01/06/06

Indices

Country-Specific ETFs: An Efficient Approach to Global Asset Allocation

Joëlle Miffre The article shows that country-specific exchange-traded funds (ETFs) enhance global asset allocation strategies. Because ETFs can be sold short even on a downtick, global strategies that diversify risk across country-specific ETFs generate efficiency gains that cannot be achieved by simply investing in a global index open- or closed-end fund. Besides, the benefits of international diversification can be achieved with country-specific ETFs at low cost, with low tracking error and in a tax-efficient way. For all these reasons, country-specific ETFs may be considered serious competitors to traditional country open and closed-end funds. A revisited version of this paper was published in the March 2007 issue of the Journal of Asset Management. More...

31/05/06

Alternative Investments

Equity Hedge Fund ABS Models: Choosing the Volatility Factor

David E. Kuenzi, Xu Shi. The use of asset-based style analysis (ABS) in the context of hedge fund investments continues to take hold within the industry. Many of the factors used in performing this analysis are straightforward and well-accepted—particularly in the area of equity hedge funds, where a long market index factor, a small-minus-large factor, and a value-minus growth factor seem to be well-accepted components of an equity hedge fund ABS model. Little attention, however, has been given to understanding the most relevant volatility factors and the relative merits of various instruments in this context. More...

19/05/06

Wealth Management

Absolute returns in wealth management: implementing risk controlled strategies

Francois-Serge Lhabitant, Denis Mirlesse, Michel Chardon The first few years of the 2000s have been characterized by a magnified and explicit return to the investment approach that is now widely known as ‘absolute return.’ In this article, we discuss the practical steps to implement an absolute return strategy in equity markets, by first unbundling alpha from beta in the portfolio, then optimising the beta component by choosing the most efficient index tracking method, and finally applying the most appropriate dynamic risk budgeting technique to the indexation. This paper was published in the April 2006 issue of the Journal of Financial Transformation. More...

04/05/06

Alternative Investments

The Fund of Hedge Fund Reporting Puzzle: Reconciling Investors’ Expectations and Fund Managers’ Constraints

Noël Amenc, Philippe Malaise, Mathieu Vaissié The development of alternative investment has not yet been accompanied by a genuine consideration of the specific characteristics of the risks and returns of hedge funds with regard to the provision of information to investors. This inadequacy came to light in a study published by EDHEC in 2003, a study that showed that a very large majority of European hedge fund managers were satisfied with a reporting method designed for investment in traditional asset classes. This method proposes a mean variance-structure that is inappropriate for the risk and return profiles of alternative investment and does not inform investors of extreme risk and risk factors affecting the different returns of the hedge fund strategies in which the funds of funds are invested. To address this issue, in 2004, EDHEC launched, an international consultation process for the implementation of a new framework for funds of hedge funds reporting. A revisited version of this paper was published in the Journal of Risk Finance, 1st Quarter 2006. More...

06/04/06

Alternative Investments

Absolute Returns in Commodity (Natural Resource) Futures Investments

Hilary Till, Jodie Gunzberg. In this article, the authors introduce readers to commodity (natural resource) futures programs. They begin the article by describing the present investment landscape as one where return compression in a number of popular hedge fund strategies has led absolute-return investors to investigate other promising return sources. This includes the highly volatile natural-resource markets, which Lammey (2004) describes as a "paradise for speculators." More...

04/04/06

Risk

Risk Measurement of Investments in the Satellite Ring of a Core-Satellite Portfolio: Traditional versus Alternative Approaches

Hilary Till. This paper provides a risk framework for fiduciaries considering using a core-satellite approach to investing. While the article mainly covers the additional risk measurement techniques, which are needed when investing in hedge funds, its recommendations are also relevant for other investments that have default, devaluation, and/or liquidity risks associated with them. While the article’s focus is on quantitative techniques, the author notes that a fiduciary must also understand the economic basis for each investment’s returns. More...

31/03/06

Risk

Portfolio Risk Measurement in Commodity Futures Investments

Hilary Till. Commodity futures investing has only recently entered the mainstream. As recently as 2001, there was only $10 billion invested in commodity indexes whereas during the fall of 2005 this figure had increased to over $70 billion, according to Rodger (2005). Once an institution has obtained its core commodity exposure through a commodity index investment, the next logical step is to include active commodity managers for further value-added. More...

30/03/06

Commodities

Challenges in Commodities Risk Management

Hilary Till, Joseph Eagleeye. The recent outperformance of commodities versus equities has caused a positive re-evaluation of commodities by both retail and institutional investors. While the commodity markets provide a manager with ample opportunities for creating portfolios of diverse strategies, there are a number of challenges in doing so. In this article, the authors provide two examples of those challenges: (1) the correlations amongst commodities vary seasonally due to meaningful weather events, and (2) the entrée of China as a dominant force in the commodity markets has created new correlation footprints. The main implication of these observations is that risk management in the commodity markets is a very dynamic process. More...

30/03/06

Alternative Investments

On the Role of Hedge Funds in Institutional Portfolios

Hilary Till. Hedge funds do not easily fit into the current way institutions go about investing. In this article, the author reviews both academic and practitioner research from the standpoint of a hypothetical institutional investor who is looking into whether hedge funds make sense for their portfolio. A revisited version of this paper was published in the Spring 2004 issue of The Journal of Alternative Investments. More...

30/03/06

Commodities

Commodities – Active Strategies for Enhanced Return

Hilary Till, Joseph Eagleeye. In this article, the authors note how a set of active commodity strategies could potentially add value to an investor’s commodity allocation. But they also emphasize the due care that must be taken in risk management and implementation discipline, given the “violence of the fluctuations which normally affect the prices of many … commodities,” as Keynes (1934) put it. A revisited version of this paper was published in the Fall 2005 issue of The Journal of Wealth Management. More...

30/03/06

Asset Allocation

Dynamic Portfolio Choice with Parameter Uncertainty and the Economic Value of Analysts’ Recommendations

Jakša Cvitanic, Ali Lazrak, Lionel Martellini, Fernando Zapatero. In this paper, the authors derive a closed-form solution for the optimal portfolio of a non-myopic utility maximizer who has incomplete information about the “alphas”, or abnormal returns of risky securities. They show that the hedging component induced by learning about the expected return can be a substantial part of our demand. A revisited version of this paper was published in the Winter 2006 issue of the Review of Financial Studies. More...

23/03/06

Alternative Investments

Survey of Recent Hedge Fund Articles

Hilary Till, Jodie Gunzberg. In this article, the authors provide the busy reader with a survey of articles that were written over the past four years on hedge funds. Specifically, they review the economic basis for hedge fund returns and then discuss some of the logical consequences of these observations. Next, they summarize the general statistical properties of hedge fund strategies. They then examine what the appropriate performance measurement and risk management techniques are for these investments. And lastly, they briefly cover ways that investors can consider incorporating hedge funds within their overall portfolios. A revisited version of this paper was published in the Winter 2005 issue of the Journal of Wealth Management. More...

21/03/06

Commodities

Separating the Wheat from the Chaff: Backwardation as the Long-Term Driver of Commodity Futures Performance; Evidence from Soy, Corn and Wheat Futures from 1950 to 2004

Barry Feldman, Hilary Till. In this paper, the authors examine the role of backwardation in the performance of passive long positions in soybeans, corn and wheat futures over the period of 1950 to 2004. They find that over this period, backwardation has been highly predictive of the return of a passive long futures position when measured over long investment horizons. The share of return variance explained by backwardation rises from 24% at a one-year horizon to 64% using five-year time periods. A revisited version of this paper was published in the Winter 2006 issue of the Journal of Alternative Investments. More...

16/03/06

Asset-Liability Management

Managing Pension Assets: from Surplus Optimization to Liability-Driven Investment

Lionel Martellini. In this paper, the author considers an intertemporal portfolio problem in the presence of liability constraints. Using the value of the liability portfolio as a natural numeraire, he finds that the solution to this problem involves a three fund separation theorem that provides formal justification to some recent so-called liability-driven investment solutions offered by several investment banks and asset management firms, which are based on investment in two underlying building blocks (in addition to the risk-free asset), the standard optimal growth portfolio and a liability hedging portfolio. More...

09/03/06

Alternative Investments

EDHEC European Alternative Diversification Practices Survey

The results of the EDHEC European Alternative Diversification Practices Survey, which enabled EDHEC to produce a detailed assessment of current institutional practices in Europe, were presented to a distinguished group of institutional investors at the EDHEC Institutional Investor Summit in London on February 14th. The study generated responses from 151 European institutional investors representing, at 30/09/2005, a total volume of over one trillion euros of assets under management. The survey shows that 51% of European institutional investors are already exposed to hedge fund strategies. These represent, on average, 7% of their global assets. More...

20/02/06

Alternative Investments

Comparative Analysis of Hedge Fund Returns

Daniel Capocci Hedge funds have an absolute return performance objective stated independently of the global market conditions. Nevertheless they have been compared to classical bond and equity indices by academics since the late 90s. Independently of their absolute or relative performance it is of particular importance to determine if some hedge funds consistently outperform their peers. This is exactly the objective of this study: Do some hedge funds consistently and significantly outperform others? Do some individual funds or some strategies continuously create alpha in comparison to others? More...

03/02/06

Alternative Investments

EDHEC disagrees with most of the conclusions of the FER statement on hedge funds

Following its meeting in Sonoma, California on July 10-11, 2005, the Financial Economists Roundtable (FER), an international group of senior financial economists, issued a statement in which it warned about the risks involved in investing in hedge funds. The EDHEC Risk and Asset Management Research Centre, which has carried out a multi-faceted research programme on hedge funds over the past three years, has published a paper by Noël Amenc, PhD, and Mathieu Vaissié in response to the FER statement in which it comments on the FER’s recommendations. More...

18/01/06

Alternative Investments

Hedge Fund Returns: An Overview of Return-Based and Asset-Based Style Factors

Walter Géhin The goal of modelling is to find one or more factors that offer the best explanatory power for a given variable. Applied to hedge fund returns, it allows their sources to be better understood. In the search for significant factors, two approaches can be employed, namely return-based style factors (RBS factors) and asset-based-style factors (ABS factors). More...

10/01/06

Institutional Investment

Modernizing the Defined-Benefit Pension System

John M. Mulvey, Frank J. Fabozzi, William R. Pauling, Koray D. Simsek, Zhuojuan Zhang The defined–benefit pension system may not survive into the future absent changes in the current regulatory environment. A risk–based and anticipatory approach to evaluating pension trusts is proposed as a way to diminish the probability that large and insolvent companies will transfer their pension trusts to the Pension Benefit Guaranty Corporation. Because current difficulties are concentrated in a few industries, there will be severe problems in the future if the healthiest companies reduce their exposure to defined–benefit pensions. This paper was published in the Winter 2005 issue of the Journal of Portfolio Management. More...

04/01/06

Alternative Investments

Investing in Hedge Funds: Adding Value through Active Style Allocation Decisions

Lionel Martellini, Mathieu Vaissié, Volker Ziemann One of the by-products of the bull market of the 90’s has been the consolidation of hedge funds as an important segment of financial markets. It was recently announced that the value of the hedge fund industry worldwide had passed the $1 trillion mark for the first time, with approximately 7,000 hedge funds in the world, around 1,000 of which were launched in 2003. One of the key reasons behind the success of hedge funds in institutional money management is that such alternative investment strategies seem to provide diversification benefits with respect to other existing investment possibilities. In an attempt to fully capitalize on such beta benefits in a top-down approach, investors or (funds of hedge funds) managers must be able to rely on robust techniques for optimization of portfolios including hedge funds. More...

19/12/05

Operational Risk

Mitigating Hedge Funds’ Operational Risks: Benefits and limitations of managed account platforms

Jean-René Giraud Operational risk is by far the most complex and intriguing issue investors are dealing with when allocating capital to hedge funds. Due to sophisticated trading strategies, potentially high levels of portfolio turnover, investment in illiquid or difficult to price instruments and a moderately regulated environment, hedge funds tend to exhibit high levels of extreme risks related to non-financial events (fraud and misappropriation, misrepresentation, model risk, infrastructure risk, etc.). More...

06/12/05

Asset-Liability Management

Hedge Funds from the Institutional Investor’s Perspective

Noël Amenc, Lionel Martellini, Felix Goltz As a consequence of entering a more mature stage, the hedge fund industry has extended its investor base to institutional investors, who are now faced with a large number of product offerings including not only single hedge funds, but also funds of funds and, more recently, investable indexes. Although the existing literature seems to concur on the interest of hedge funds as valuable investment alternatives, there still remain a large a large number of institutional investors who wonder whether they should invest in hedge funds, and more importantly, how they should do it. In order to address these questions, this paper looks at the risk factors in hedge fund strategies and attempts to assess the diversification benefits investors can expect from allocating part of their wealth to hedge funds. More...

18/11/05

Asset-Liability Management

The Benefits of Hedge Funds in Asset Liability Management

Lionel Martellini, Volker Ziemann Institutional investors in general and pension funds in particular have been dramatically affected by negative stock market returns at the beginning of the millennium. In the context of a cumulative asset/liability deficit that was estimated at more than £55 billion in 2003 for the companies in the FTSE 100, institutional investors are seeking new asset classes or forms of investment management that would allow them to broaden their traditional choice of asset allocation. An alternative investment offering has been introduced in the past several years, allowing investors to optimise the risk/return combination of their portfolio. A revisited version of this study was published in the June 2006 issue of The IFCAI Journal of Financial Risk Management. More...

05/10/05

Alternative Investments

Neutrality of Market Neutral Funds

Daniel Capocci Using an original database of 634 market neutral hedge funds, this study formally analyses the market neutrality of market neutral funds which are particular in the hedge fund universe since the only objective of these funds is to provide positive returns completely independent of the market conditions. We start by analysing this neutrality using various market neutral indices before focusing on individual fund returns. Finally, an analysis based on ex-post beta helps us explaining and confirming our previous results. We perform this analysis over the global January 1993- December 2002 period as well as on bull and bear market periods. A revisited version of this paper was published in the December 2006 issue of the Global Finance Journal. More...

16/08/05

Alternative Investments

EDHEC Capacity Effect Survey

In a major survey of 183 industry players, including institutional investors and hedge fund and fund of hedge fund managers, conducted from May 31st to July 8th 2005, the EDHEC Risk and Asset Management Research Centre has found that alternative investment professionals are upbeat about future prospects for the industry and do not see the so-called “capacity effect” as a major threat to future profitability. More...

10/08/05

Risk Management

Is there a gain to explicitly modelling extremes? A risk management analysis

Jean-Christophe Meyfredi When risk managers make decisions, they need them to be based upon reliable measures. Strong assumptions are often made to simplify the risk estimation process and there has to be a trade-off between ease of estimate and accuracy. In this paper, “Is there a gain to explicitly modelling extremes? A risk measurement analysis”, Jean-Christophe Meyfredi of the Edhec Risk and Asset Management Research Centre develops a copula-based approach in order to estimate the Value-at-Risk of portfolios containing financial assets. He proposes a survival copula, the Heavy Right Tail copula, which could solve many difficulties that risk managers currently have to face. More...

15/07/05

Structured Products

Structured Forms of Investment Strategies in Institutional Investors’ Portfolios

Lionel Martellini, Koray Simsek, Felix Goltz Institutional investors in general and pension funds in particular have been dramatically affected by recent market downturns. This seems to be surprising given that an increasingly thorough range of structured products has been developed over the past few years, which allows investors to tailor the risk-return profile of their portfolio in a more efficient way than simple linear exposure to traditional asset classes. The salient characteristic of structured products is the repackaging of strategies that involve long and short positions in derivatives and the underlying or a risk-free asset into an investment vehicle that is easily accessible by investors. More...

07/07/05

Asset Allocation

Static Mean-Variance Analysis with Uncertain Time Horizon

Lionel Martellini, Branko Uroševic In this paper, we generalize Markowitz analysis to the situations involving an uncertain exit time. Our approach preserves the form of the original problem in that an investor minimizes portfolio variance for a given level of the expected return. However, inputs are now given by the generalized expressions for mean and variance-covariance matrix involving moments of the random exit time in addition to the conditional moments of asset returns. While efficient frontiers in the generalized and the standard Markowitz case may coincide under certain conditions, we demonstrate, by means of an example, that in general that is not true. In particular, portfolios efficient in the standard Markowitz sense can be inefficient in the generalized sense and vice versa. As a result, an investor facing an uncertain time-horizon and investing as if her time of exit is certain would in general make sub-optimal portfolio allocation decisions. Numerical simulations show that a significant efficiency loss can be induced by an improper use of standard mean-variance analysis when time-horizon is uncertain. A revisited version of this paper was published in the June 2006 issue of Management Science. More...

01/07/05

Alternative Investments

The Right Place for Alternative Betas in Hedge Fund Performance: An Answer to the Capacity Effect Fantasy

Walter Géhin, Mathieu Vaissié Two studies, by Watson Wyatt and UBS (both from March 2005), give a pessimistic view of the hedge fund industry’s capacity to generate long-term returns, due to its increasing size. Unfortunately, these studies focus almost exclusively on alpha. In the present paper, we show the importance of considering not only the exposure to the market (the traditional beta), but also the other exposures (the alternative betas) to cover all the sources of hedge fund returns. To do so, we examine the real extent to which the variability and level of hedge fund returns are affected by (static) betas, dynamic betas (i.e. factor timing), and pure alpha (i.e. security selection). A revisited version of this study was published in the Summer 2006 issue of The Journal of Alternative Investments. More...

13/06/05

Fixed-Income Strategies

Exploiting Predictability in the Time-Varying Shape of the Term Structure of Interest Rates

Frank J. Fabozzi, Lionel Martellini, Philippe Priaulet This paper presents evidence of predictability in the time-varying shape of the U.S. term structure of interest rates using a robust recursive modelling approach based on a Bayesian mixture of multi-factor models. We find that variables such as default spread, equity volatility, short-term and forward rates, among others, can be used to predict changes in the slope of the yield curve, and also, albeit to a lesser extent, changes in the curvature of the yield curve. By using systematic trading strategies based on butterfly swaps, we also find that this evidence of predictability in the shape of the yield curve is economically significant in addition to being statistically significant. A revisited version of this paper was published in the June 2005 issue of the Journal of Fixed Income. More...

01/06/05

Derivatives

From Delivering to the Packaging of Alpha

Noël Amenc, Philippe Malaise, Lionel Martellini In this paper, "From Delivering to the Packaging of Alpha. Illustration from Active Bond Portfolio Management: Using Fixed-Income Derivatives to Design Hedge Fund Type Offerings that Better Fit Investors’ Needs", the authors emphasize the need for the hedge fund industry to adopt a consumer (investor)-driven approach, as opposed to the current producer (manager) perspective, and call for the emergence of new types of offering with characteristics better suited to the needs of institutional investors. Using active bond portfolio management as an example, they present evidence on the use of derivatives by managers for generating and delivering abnormal performance, and also for packaging such performance in a form that is consistent with the modern core-satellite approach to institutional portfolio management, for which they explore both a standard static version and also a dynamic extension allowing for dissymmetric control of active management risk. A revisited version of this paper was published in the Winter 2006 issue of the Journal of Portfolio Management. More...

23/05/05

Alternative Investments

Pricing Traditional versus Alternative Asset Management Services

François-Serge Lhabitant The delegation of asset management services is a source of potential agency problems between investors and their portfolio managers. Most of these problems can be avoided by using an adequate compensation theme. While the academic literature tends to be somewhat inconclusive as to whether or not, and to what degree optimal compensation should be linked to relative or absolute performance, industry practice seems to show a clear pattern: mutual funds charge an asset-based fee, while hedge funds charge both an asset-based fee and a performance fee. In this article, the author discusses the advantages and drawbacks of both types of fees. A revisited version of this paper was published in The Journal of Financial Transformation. More...

29/04/05

Asset-Liability Management

A Stochastic Network Approach for Integrating Pension and Corporate Financial Planning

John M. Mulvey, Bill Pauling, Koray D. Simsek This paper presents a multi-period stochastic network model for integrating corporate financial and pension planning. Pension planning in the United States has gained importance with the population aging and the growth of retirement accounts. In certain cases, the pension plan assets are several times larger than the value of the company itself (e.g. General Motors – Market cap: $19 billion, Pension plan assets: $67 billion, Estimated pension fund deficit: $25 billion – in December 31, 2002; see General Motors Corporation (2003)). More...

09/03/05

Alternative Investments

Edhec Funds of Hedge Funds Reporting Survey

In 2004, Edhec launched an international consultation process on the implementation of a new framework for Funds of Hedge Funds reporting. This consultation process was based on a series of recommendations proposed by Edhec with regard to the academic state-of-the-art on risk measurement in the alternative universe. The results of this consultation were presented to a panel of journalists on February 17th in London at a meeting hosted by FIMAT. A revisited version of this study was published in The Journal of Risk Finance, 1st Quarter 2006. More...

08/03/05

Alternative Investments

Evaluating a Trend-Following Commodity Index for Multi-Period Asset Allocation

John M. Mulvey, Shiv Siddhant N. Kaul, Koray D. Simsek The Mt. Lucas index provides a systematic approach for capturing a portion of the return of trend-following commodity traders. The authors analyze the Mt. Lucas Index across different historical periods, evaluating its performance within a multi-period asset allocation framework. Their results indicate that the index improves the overall return/risk characteristics of the multi-period asset allocation model. They show that the total return consists of: 1) T-Bill returns on marginable assets, 2) static returns from trendfollowing futures markets, and 3) rebalancing gains. The importance of the third element is emphasized. More...

02/02/05

Alternative Investments

Trend-following Hedge Funds and Multi-period Asset Allocation

Dries Darius, Aytac Ilhan, John Mulvey, Koray D. Simsek, Ronnie Sircar Selected hedge funds employ trend-following strategies in an attempt to achieve superior risk adjusted returns. The authors employ a lookback straddle approach for evaluating the return characteristics of a trend following strategy. The strategies can improve investor performance in the context of a multi-period dynamic portfolio model. The gains are achieved by taking advantage of the funds’ high level of volatility. More...

02/02/05

Asset-Liability Management

Rebalancing Strategies for Long-Term Investors

John M. Mulvey, Koray D. Simsek Leading pension plans employ asset and liability management systems for optimizing their strategic decisions. The multi-stage models link asset allocation decisions with payments to beneficiaries, changes to plan policies and related issues, in order to maximize the plan’s surplus within a given risk tolerance. Temporal aspects complicate the problem but give rise to special opportunities for dynamic investment strategies.Within these models, the portfolio must be re-revised in the face of transaction and market impact costs. The re-balancing problem is posed as a generalized network with side conditions. We develop a specialized algorithm for solving the resulting problem. A real-world pension example illustrates the concepts. More...

02/02/05

Performance

Rating the Ratings

EDHEC-Risk Institute recently released a research paper that is highly critical of the existing fund rating systems. Originating in 2002, when EuroPerformance, the leading French firm for the dissemination of mutual fund data, approached EDHEC-Risk Institute to consider the implementation of a value-added offering in the area of external analysis of the performance and risks of European investment funds, the Rating the Ratings document constitutes a detailed summary of the critical study and puts into perspective the responses given to the inadequacies of the existing ratings by the EuroPerformance/EDHEC-Risk Institute Style Ratings. The method followed to implement the design of these new ratings was to carry out a thorough study of the insufficiencies of the existing rating methods in order to correct them by relying on the state-of-the-art in portfolio risk and performance measurement in a business context. More...

01/12/04

Indexes

Hedge Fund Indices from an Academic Perspective: Reconciling Investability and Representativity

Lionel Martellini, Mathieu Vaissié, Felix Goltz Following a growing concern among investors about the quality of hedge fund index return data, and given the lack of capacity and transparency specific to that industry, this paper questions from an academic perspective whether it is feasible or not to design hedge fund benchmarks satisfying all defining properties for a good index. In particular, in an attempt to test whether achieving investability necessarily comes at the cost of representatitivity, as sometimes claimed by hedge fund index providers, we borrow from the asset pricing literature the concept of factor replicating portfolios and apply it to the benchmarking of hedge fund style returns. A revisited version of this paper was published in the March 2007 issue of European Financial Management. More...

09/11/04

Asset Pricing

Dynamic Asset Pricing Theory with Uncertain Time-Horizon

Christophette Blanchet-Scalliet, Nicole El Karoui, Lionel Martellini This paper addresses the problem of pricing and hedging a random cash-flow received at a random date in a general stochastic environment. We first argue that specific timing risk is induced by the presence of an uncertain time-horizon if and only if the random time under consideration is not a stopping time of the filtration generated by prices of traded assets. In that context, we provide an explicit characterization of the set of equivalent martingale measures, as well as a necessary and sufficient condition for a convenient separation between adjustment for market risk and timing risk. A revisited version of this paper was published in the October 2005 issue of the Journal of Economic Dynamics and Control. More...

08/11/04

Asset Allocation

Be Active with your Bond Trackers

Noël Amenc, Jean-René Giraud, Philippe Malaise, Lionel Martellini Newly launched fixed-income Exchange Traded Funds (ETFs) have specifically been designed to track bond market indices, and share many of the same benefits of equity ETFs, including in particular lower costs, transparency, buying and selling flexibility, all day tracking and trading. While it has often been argued that ETFs were natural investment vehicles for implementing passive indexing strategies, we show in this paper that the benefits of ETFs are actually much larger than traditionally reported, as these instruments can also be used to implement almost the full range of existing investment strategies. More...

04/11/04

Hedge Fund Indices

Hedge Fund Indices: Investable, Non-Investable and Strategy Benchmarks

Mathieu Vaissié, Walter Géhin In the mutual fund industry, which is based on a passive investment approach, and where respecting the tracking error is an inevitable notion, the use of indices is necessary in order to play on exposure to the market. In the hedge fund universe, where it is frequently said that performance is extracted from managers, reflecting active asset management, the implementation of hedge fund indices may be surprising, because the notion of index is commonly associated with the notion of passive management. However, picking the best performers in the hedge fund universe appears to be a very challenging task. More...

02/11/04

Asset Allocation

Using Index Options to Improve the Performance of Dynamic Asset Allocation Strategies

Noël Amenc, Philippe Malaise, Lionel Martellini, Daphné Sfeir It has long been argued that equity managers can use derivatives markets to help implement a systematic risk management process designed to enhance the performance of their portfolio (see for example Ineichen (2002) for a recent reference). These derivatives instruments can be used in the context of completeness portfolios that are designed not to interfere with the original portfolio composition, so that they can be used to generate what have been labeled portable beta benefits (Amenc et al. (2004)). Consider for example the case of long/short equity hedge fund managers. A revisited version of this paper was published in the Winter 2004 issue of Economic & Financial Computing. More...

22/10/04

Risk

History of the Risk Concept and Risk Modeling

Jean-Christophe Meyfredi What is risk? The answer is far from simple. The definition depends on the context and is highly subjective. A first attempt is to define risk as the possibility of something unexpected occurring. But what could the constituents of those expected and unexpected events be? Again there is no single answer. The field of finance is a symptomatic example where risk is multiform. It is usual to distinguish between market risk, credit risk, liquidity, operational and legal risks. More...

18/10/04

Alternative Investments

A Survey of the Literature on Hedge Fund Performance

Walter Géhin The issue of performance measurement in the hedge fund industry has led to literature that is both abundant and controversial. The explanation for this complexity lies in the particular features of alternative funds. Hedge funds invest in a heterogeneous range of financial assets and cover a wide range of strategies that have different risk and return profiles. Even though the current studies on hedge fund performance appear to be confusing, due to conflicting conclusions and criticism of the methods employed in previous papers, they contribute to an improvement in the knowledge of alternative funds, and leading approaches are confirmed. More...

13/10/04

Alternative Investments

In Search of Quality Benchmarks for Hedge Fund Strategies

Mathieu Vaissié Over the last few years, alternative investment strategies have dramatically gained in popularity. Initially reserved for High Net Worth Individuals (HNWI), they progressively drew the attention of individual and institutional investors, to reach approximately 1 trillion dollars in assets under management today. However, while HNWI were looking for absolute returns, private and institutional investors are more focused on capital preservation and/or risk-adjusted performance. More...

07/10/04

Business Analysis

Taking a Close Look at the European Fund of Hedge Funds Industry - Comparing and Contrasting Industry Best Practices and Academic Recommendations

Noël Amenc, Jean-René Giraud, Lionel Martellini, Mathieu Vaissié Over the last few years institutional investors’ traditional portfolios have failed to meet their objectives in terms of risk and performance. Investors have thus shown growing interest in new forms of diversification, especially in investment vehicles that offer better protection during extreme market conditions. A revisited version of this paper was published in the Winter 2004 issue of the Journal of Alternative Investments. More...

22/09/04

Asset Allocation

Revisiting Core-Satellite Investing - A Dynamic Model of Relative Risk Management

Noël Amenc, Philippe Malaise, Lionel Martellini Tracking error is not necessarily bad. Just like with good and bad cholesterol, there is “good” tracking error, which refers to out-performance of a portfolio with respect to the benchmark, and “bad” tracking error, which refers to underperformance with respect to the benchmark. By severely restricting the amounts invested in active strategies as a result of tight tracking error constraints, investors forgo an opportunity for significant out-performance, especially during market downturns. In this paper, the authors introduce a new methodology that allows investors to gain full access to good tracking error, while maintaining the level of bad tracking error below a given threshold. A revisited version of this paper was published in the Fall 2004 issue of The Journal of Portfolio Management. More...

22/09/04

Asset Allocation

The Benefits of Bond ETFs for Institutional Investors - The Natural Vehicle for a Core-Satellite Approach

Noël Amenc, Philippe Malaise, Lionel Martellini, Jean-René Giraud< Recent market difficulties have drawn attention to the risk management practices of institutional investors. Particularly significant was the fact that negative equity market returns were eroding plan assets at the same time as declining interest rates were increasing benefit obligations. These events have spotlighted the weakness of current funding standards for corporate defined benefit pension plans. They have also emphasized the weakness of investment practices. More...

03/09/04

Indexes

Evaluating Hedge Fund Investments: The Role of Pure Style Indices

Francois-Serge Lhabitant Over the past decade, the hedge fund industry has grown – big time. According to estimates, the number of hedge funds increased from 2,000 to 8,000, assets under management went from US $67 billion to US $800 billion, and inflows of money to hedge funds have never been greater. This growth was essentially driven by the attractive risk-adjusted performance achieved by hedge funds, their ability to protect capital in negative equity markets, and the shrinkage in proprietary trading activities, which coincided neatly with a welter of hedge fund launches. More...

27/04/04

Hedge Funds

Hedge Funds Investing: A Quantitative Look Inside the Black Box

François-Serge Lhabitant There is an increasing amount of evidence that shows the benefits of considering hedge funds as an asset class at the strategic asset allocation level. The investors’ greatest challenge remains the identification of desirable investment vehicles, since very little formal quantitative analysis of hedge funds has been done in the past. In this paper, we suggest an innovative approach to hedge fund investing, which is valid at the individual fund level as well as at the aggregate portfolio level (e.g. portfolio of hedge funds). This approach only relies on hedge funds historical returns. We provide several illustrations, including static and dynamic style analysis, benchmark construction, performance assessment, and value at risk calculations. A revisited version of this paper was published in the Journal of Financial Transformation, nº 1. More...

27/04/04

Hedge Funds

Finding the Sweet Spot of Hedge Fund Diversification

François-Serge Lhabitant, Michelle Learned De Piante Vicin Hedge funds are often thought of as being high-risk investments and many investors in the past have shied away from them for fear of making large losses. However, over the recent years, hedge funds have generally substantially outperformed equities, with much lower volatility. As a consequence, they are now in strong demand, particularly when one remembers that any risk associated with hedge fund investing diminishes in importance when the funds are repackaged into fund of funds products. A revisited version of this paper was published in the April 2004 issue of the Journal of Financial Transformation. More...

27/04/04

Asset Allocation

Portable Alpha and Portable Beta Strategies in the Euro Zone - Implementing Active Asset Allocation Decisions using Equity Index Options and Futures

Noël Amenc, Philippe Malaise, Lionel Martellini, Daphne Sfeir In this paper, we show how portfolio managers in the Euro-zone can benefit from using derivatives markets to actively manage their asset allocation decisions in a systematic manner. Using a robust econometric process based on a non-linear multi-factor thick and recursive modeling approach, we report statistically and economically significant evidence of predictability in Dow Jones EURO STOXX 50 excess return. These econometric forecasts can be turned into active portfolio decisions and implemented via Eurex index futures to generate active asset allocation portable alpha benefits. A revisited version of this paper was published in the Summer 2004 issue of The Journal of Portfolio Management. More...

08/01/04

Indexes

Indexing Hedge Fund Indexes

Noël Amenc, Lionel Martellini, Mathieu Vaissié As a response to the needs of investors, the Edhec Risk and Asset Management Research Centre proposes an original solution by constructing an “index of indexes”, the performance of which is posted on a dedicated web site (www.edhec-risk.com). The aim of the methodology used to construct this “index of indexes” is to construct a benchmark with degrees of representativity and stability that are significantly higher than those of the indexes available on the market. This methodology was first introduced in Amenc, Martellini (2002a). More...

08/01/04

Indexes

A Detailed Analysis of the Construction Methods and Management Principles of Hedge Fund Indices

Mathieu Vaissié The aim of this document is to provide a detailed presentation of the different hedge fund indices in order to highlight their strengths and weaknesses. To analyse the reasons for the heterogeneity of their performances, we will focus on the following five points: Transparency & Independence, Accuracy of the data and punctuality, Stability, Representativity, Purity. The first three points will allow us to provide details on the index construction methods. The following two points will allow us to understand the consequences of the heterogeneity of the construction methods in terms of representativity and purity. We will thus be able to reply to the following question: are all hedge funds created equal? More...

29/12/03

Risk

Towards the Integration of Extreme Values

Jean-Christophe Meyfredi In this paper we aim to show how risk managers can benefit from this integration of EVT (Extreme Value Theory) into their VaR calculation and how they could easily reduce the effects of some of the important drawbacks that VaR presents. More...

18/12/03

Risk

Improving the Market Model: The 4-State Model Alternative

Octave Jokung, Jean-Christophe Meyfredi The present paper conducts an empirical study by examining the Market Model and the three versions of the 4-State Model (translated, rotated and un-rotated) in a mean-beta framework. Using daily returns from the CAC 40 Index's assets, we find that the explanatory power of the 4- State Model is greater than the one of the Market Model and this effect is improved by rotation. A reduction in the non-systematic risk is also observed when switching from Market Model to 4- State Models. Surprisingly, the betas are more stable when using any version of the 4-State Model. This could have a strong impact on portfolio diversification and call widely held opinion into question. More...

18/12/03

Alternative Investments

Edhec European Alternative Multimanagement Practices Survey

Noël Amenc, Anne Delaunay, Jean-René Giraud, Felix Goltz, Lionel Martellini, Mathieu Vaissié On 11th December 2003 in Paris, Edhec presented the results of its survey on alternative multimanagement in Europe, the Edhec European Alternative Multimanagement Practices survey. This study, sponsored by FIMAT, is based both on a review of all the professional and academic research on alternative investment and a survey of the practices of European multimanagers, to which 61 firms (investors, advisors and funds of funds) replied, representing a total of 136 billion euros under management. The key findings of this study were published in the March 2004 issue of The Journal of Financial Transformation. More...

17/12/03

Alternative Investments

Challenges Arising from Alternative Investment Management

Noël Amenc, François Haas, Mathieu Vaissié Over the past few years the alternative investment industry has developed spectacularly, attracting so much investor interest that it appears at times to have taken on the proportions of a “fad”. This article sets out to chart the development of this phenomenon. We will start out by attempting to define the broad outlines and trends of this rapidly evolving industry. We will then try to show why this style of management requires specific risk analysis techniques and performance indicators. This will enable us to assess the impact of alternative investment management on financial market dynamics, and identify the conditions under which these management strategies might “usefully” contribute to the functioning of financial markets and become a lasting feature in the world of asset management. More...

05/12/03

Performance

How to Price Hedge Funds: From Two- to Four-Moment CAPM

Angelo Ranaldo, Laurent Favre In the last decade, the hedge fund industry grew impressively. Many studies show that hedge funds have a superior performance and that the introduction of hedge funds in a classical portfolio enhances the portfolio's performance. The attractive performance of hedge funds may be due to inadequate measurement techniques of the risk-return profile of hedge funds. The main aim of this paper is to investigate how to price hedge funds and, in particular, the validity of the traditional asset pricing models in measuring the risk-return trade-off in hedge fund investment. More...

04/11/03

Performance

The Generalized Treynor Ratio

Georges Hübner This paper presents a generalization of the Treynor ratio in a multi-index setup. The solution proposed in this paper is the simplest measure that keeps Treynor's original interpretation of the ratio of abnormal excess return (Jensen's alpha) to systematic risk exposure (the beta) and preserves the same key geometric and analytical properties as the original single index measure. More...

17/10/03

Performance

An Analysis of Hedge Fund Performance 1984-2000

Daniel Capocci, Georges Hübner Using one of the largest hedge fund databases ever used (2796 individual funds including 801 dissolved), this paper investigates hedge funds performance using various asset pricing models, and a new factor that takes into account the fact that some hedge funds invest in emerging bond markets. More...

17/10/03

Tactical Allocation

Evidence of Predictability in Bond Indices and Implications for Fixed-Income Tactical Style Allocation Decisions

Noël Amenc, Philippe Malaise, Lionel Martellini, Daphné Sfeir There is now a consensus in empirical finance that expected asset returns, and also variances and covariances, are, to some extent, predictable. The use of predetermined variables to predict asset returns has produced new insights into asset pricing models, and the literature on optimal portfolio selection has recognized that these insights can be exploited to improve on existing policies based upon unconditional estimates. While the performance of tactical style allocation models is well documented in equity markets, very little evidence is available on the performance of systematic dynamic allocation decisions among various bond indices. This paper investigates the predictability of fixed-income style portfolio returns using a robust recursive modeling approach based on multi-factor models for the return on bond indices. More...

17/10/03

Performance

The Benchmark's Benchmark: Measuring the Performance of a Manager's Long-Term Strategy

David E. Kuenzi When investment managers construct strategy benchmarks and manage their portfolios against them, they are making an implicit bet that some subset of the broader investment universe will produce better risk and return characteristics than a similar published index over the long term. Despite the long-term focus of this decision, it is nonetheless active in nature. Strategy benchmark performance should thus be evaluated as a source of manager value-added. More...

17/10/03

Derivatives

Grafting Information in Scenario Trees, Application to Option Prices

Michael Schyns, Yves Crama and Georges Hübner Many mathematical models used in management science do not impose any complex restrictions on the parameter values arising in a given problem. As a consequence, when the instances arise from a specific real-world application, the models under consideration are usually sufficiently robust to remain meaningful even if their numerical parameters are not estimated with very high accuracy or, alternatively, if small perturbations are applied to the parameter values. Things can be quite different, however, with models developed for financial applications. Indeed, in such applications, many models turn out to be utterly meaningless unless one can ensure that the data sets are realistic and internally consistent with the assumptions underlying the model. More...

17/10/03

Indexes

Desperately Seeking Pure Style Indices

Noël Amenc, Robert Faff, Lionel Martellini There is an urgent need for improved measurement and benchmarking of size and book-to-market (style) performance. Given the proliferation of choice, a potentially serious problem is that existing style indexes can provide a somewhat confusing picture of the return on these factors. More...

15/09/03

Performance

On the Valuation and Incentive Effects of Executive Cash Bonus Contracts

Lionel Martellini, Branko Urosevic Executive compensation packages are often valued in an inconsistent manner: while employee stock options (ESOs) are typically valued ex-ante, i.e., before uncertainties are resolved, cash bonuses are valued ex-post, i.e., by discounting the realized cash grants. Such a lack of consistency can, potentially, distort empirical results. A related, yet mostly overlooked, problem is that when ex-post valuation is used pay-performance measures can not be well defined. Consistent use of ex-ante valuation for all components of a compensation package would simultaneously resolve both of these problems and provide a natural framework for the analysis of agency problems. More...

01/09/03

Tactical Allocation

Tactical Style Allocation - A New Form of Market Neutral Strategy

Noël Amenc, Philippe Malaise, Lionel Martellini, Daphne Sfeir Even though there is little evidence of predictability in stock specific risk in the absence of private information, most equity market neutral managers still rely on stock picking as the preferred way to generate abnormal returns. In this paper, we document the benefits of a new form of market-neutral portfolio strategy that aims at deliver absolute return over the full business cycle through systematic equity style timing decisions. A revisited version of this paper was published in the Summer 2003 issue of the Journal of Alternative Investments. More...

15/07/03

Business Analysis

Edhec European Asset Management Practices Survey

Edhec has conducted a major survey into the practices of the leading 400 European asset management firms which generated responses from 60 companies. The survey is the first study conducted in Europe dealing with the application of the results of academic research within investment management companies. The survey results reveal that in spite of their extensive knowledge of the concepts involved in research into portfolio management and the progress made, the major European asset managers were either not implementing them or not adopting them rapidly as part of their investment management process. More...

12/06/03

Performance

An Integrated Framework for Style Analysis and Performance Measurement

Noël Amenc, Daphne Sfeir, Lionel Martellini In this paper, we propose an integrated framework for assessing the risk-adjusted performance of mutual fund managers. The methodology is designed so as to be consistent not only with modern portfolio theory but also with constraints imposed by practical implementation in a context where the presence of a variety of investment styles needs to be accounted for. A revisited version of this paper was published in the Summer 2003 issue of the Journal of Performance Measurement. More...

28/02/03

Indexes

EDHEC Alternative Indexes

Different hedge fund indexes available on the market are constructed from different data, according to diverse selection criteria and methods of construction, and they evolve at differing paces. As a result of this heterogeneity, investors cannot rely on competing hedge fund indexes to obtain a “true and fair” view of hedge fund performance. Investors are therefore at a loss when selecting benchmarks. As a response to the needs of investors, the Edhec Risk and Asset Management Research Center proposes an original solution by constructing an “index of indexes.” The aim of the methodology used to construct this “index of indexes” is to construct a benchmark with degrees of representativity and stability that are significantly higher than those of the indexes available on the market. More...

27/02/03

Performance

The Alpha and Omega of Hedge Fund Performance Measurement

Noël Amenc, Susan Curtis, Lionel Martellini That hedge funds start gaining wide acceptance while they still remain a somewhat mysterious asset class enhances the need for a better measurement their performance. This paper is an attempt to test the ability of hedge fund managers to generate superior performance. More...

18/02/03

Asset Allocation

Optimal Allocation to Hedge Funds: An Empirical Analysis

Jaksa Cvitanic, Ali Lazrak, Lionel Martellini and Fernando Zapatero What percentage of their portfolio should investors allocate to hedge funds? The only available answers to the above question are set in a static mean-variance framework, with no explicit accounting for uncertainty on the active manager’s ability to generate abnormal return, and usually generate unreasonably high allocations to hedge funds. In this paper, we apply the model introduced in Cvitanic, Lazrak, Martellini and Zapatero (2002) for optimal investment strategies in the presence of uncertain abnormal returns to a database of hedge funds. Wefind that the presence of model risk significantly decreases an investor’s optimal allocation to hedge funds. Another finding of this paper is that low beta hedge funds may serve as natural substitutes for a significant portion of an investor risk-free asset holdings. A revisited version of this paper was published in the February 2003 issue of Quantitative Finance. More...

23/01/03

Risk

Four-State Model v.s. Market Model : Part I

Octave Jokung, Jean-Christophe Meyfredi The present paper conducts an empirical study by examining the Market Model and the three versions of the 4-State Model (translated, rotated and un-rotated) in a mean-beta framework. Using daily returns from the CAC 40 Index’s assets, we find that the explanatory power of the 4-State Model is greater than the one of the Market Model and this effect is improved by rotation. A reduction in the non-systematic risk is also observed when switching from Market Model to 4-State Models. Surprisingly, the betas are more stable when using any version of the 4-State Model. More...

25/11/02

Asset Allocation

Noël Amenc, Lionel Martellini Two competing approaches are used in practice to build portfolios: bottom-up and topdown. The bottom-up approach is the older and the more traditional, and focuses on individual stock picking. The top-down approach gives more importance to the choice of different markets as opposed to individual security selection, and, as such emphasizes the importance of asset allocation. More...

20/11/02

Tactical Allocation

Tactical Asset Allocation

Lionel Martellini, Daphné Sfeir Tactical Asset Allocation (TAA) broadly refers to active strategies that seek to enhance portfolio performance by opportunistically shifting the asset mix in a portfolio in response to the changing patterns of return and risk. More...

20/11/02

Asset Allocation

Portfolio optimization and hedge fund style allocation decisions

Noël Amenc, Lionel Martellini This paper attempts to evaluate the out-of-sample performance of an improved estimator of the covariance structure of hedge fund index returns, focusing on its use for optimal portfolio selection. A revisited version of this paper was published in the Fall 2002 issue of the Journal of Alternative Investments. More...

13/11/02

Tactical Allocation

Evidence of Predictability in Hedge Fund Returns

Noël Amenc, Sina El Bied, Lionel Martellini While there has been a significant amount of research on the predictability of traditional asset classes, very little is known about the predictability of returns emanating from alternative vehicles such as hedge funds. This paper attempts to fill this gap by documenting evidence of predictability in hedge fund returns. A revisited version of this paper was published in the September/October 2003 issue of the Financial Analysts Journal. More...

13/11/02

Indexes

The Brave New World of Hedge Fund Indices

Noël Amenc, Lionel Martellini The fact that hedge funds have started to gain widespread acceptance while remaining a somewhat mysterious asset class enhances the need for better measurement and benchmarking of their performance. One serious problem is that existing hedge fund indices provide a somewhat confusing picture of the investment universe. In this paper, we first present detailed evidence of strong heterogeneity in the information conveyed by competing indices. We also attempt to provide remedies to the problem and suggest various methodologies designed to help build a “pure style index”, or “index of the indices” for a given style. More...

13/11/02

Alternative Investments

Benefits and Risks of Alternative Investment Strategies

Noël Amenc, Lionel Martellini, Mathieu Vaissié The growth of alternative investment has been considerable in recent years. For both institutional and private investors, it seems that alternative investment now constitutes a distinct class within their overall asset allocation. A revisited version of this paper was published in the July 2003 issue of the Journal of Asset Management. More...

04/11/02

Asset Allocation

Mean-modified Value-at-Risk Optimization with Hedge Funds

Laurent Favre, José-Antonio Galeano Based on the normal Value-at-Risk, we develop a new Value-at-Risk method called Modified Value-at-Risk. This Modified Value-at-Risk has the property to adjust the risk, measuring with the volatility only, with the skewness and the kurtosis of the distribution of returns. The Modified Value-at-Risk allows to measure first the risk of portfolio with assets non normally distributed like hedge funds or technology stocks and to compute optimal portfolio by minimizing the Modified Value-at-Risk at a given confidence level. A revisited version of this paper was published in the Autumn 2002 issue of the Journal of Alternative Investments. More...

17/10/02

Performance

Methodology applied for the Agefi Asset Management Awards

Noël Amenc, Lionel Martellini, Daphné Sfeir Fund performance measurement is an important issue both for professionals, for whom it is the justification of their remuneration, and for researchers, for whom the right evaluation of returns and risks constitutes the very core of modern portfolio theory. This twofold academic and professional issue underlies extensive research and numerous methods for evaluating the performance of funds. Indeed, the diversity of the resulting models and methods has consequences on fund performance rankings and the evaluation of fund performance. Identifying the best managers actually presupposes taking two areas into account - the risk and the management style. The modelling of those two areas is subject to substantial debate and theoretical and statistical options. More...

10/10/02

Asset Allocation

The difficulties of measuring the benefits of hedge funds

Laurent Favre, Andreas Signer In this paper, the use mean-variance approach for the determination of the benefits of allocations to hedge funds is critically evaluated. The advantages of investing in hedge funds are often explained and demonstrated with reference to a shift in the efficiency frontier of traditional portfolios. The added value of hedge funds is almost always indicated in a mean-standard deviation environment and should in our view be reconsidered. The estimated risk exposure can be quantified by the introduction of Value-at-risk analysis corrected according to higher moments of distribution. With this new risk measure, we are able to obtain a corrected value. A revisited version of this paper was published in the Summer 2002 issue of the Journal of Alternative Investments. More...

13/08/02

Risk

The Cross-Section of Expected Stock Returns at the Paris Stock Exchange

Eric Molay This study reconsiders the subject of describing the expected return of French stocks through different variables: the beta coefficient drawn from the CAPM, the market capitalisation and book-to-price ratio and the si and hi sensitivities to the SMB and HML return premiums taken from Fama and French's three-factor model. More...

20/03/02

Asset Allocation

An Analysis of Hedge Fund Performance Using Loess Fit Regression

Laurent Favre, José-Antonio Galeano In this article, we analyze the returns distribution of Hedge Funds strategies, the average returns obtained over the past ten years and their correlation with a traditional portfolio. The aim is to identify the characteristics of each Hedge Fund investment strategy in order to be able to construct an optimal Hedge Fund portfolio for a Swiss pension fund. We will show that the classical linear correlation and the classical linear regression cannot be applied for Hedge Funds. Moreover, we will show that only three strategies, Convertible Arbitrage, Market Neutral and CTA, give diversification during market downturns. The techniques used are non-linear regressions and local correlations. A revisited version of this paper was published in the Spring 2002 issue of the Journal of Alternative Investments. More...

17/03/02

Asset Allocation

It's Time for Asset Allocation

Noël Amenc, Lionel Martellini Despite repeated evidence that asset allocation accounts for a very large fraction of a portfolio return, the industry has never stopped favouring stock picking as the preferred form of active investment strategy. In this paper, we attempt to rehabilitate the importance of active asset allocation in the investment process. A revisited version of this paper was published in the December 2001 issue of the Journal of Financial Transformation. More...

13/11/01

Performance

Derivatives in portfolio management: Why beating the market is easy

François-Serge Lhabitant Under the efficient market hypothesis, overwriting calls or purchasing insurance should not improve risk-adjusted portfolio returns. A proper analysis should show that if options are traded at a fair cost, the risk-reward characteristics of an option position would fall on the efficient market line. In this paper we show that, due to several limitations of mean-variance analysis, this is not the case in practice. We quantify and identify the nature of the resulting biases for performance evaluation, and explain why alternative measures such as semi variance do not help in avoiding such biases. A revisited version of this paper was published in the Winter, 7(2) issue of Derivatives Quarterly. More...

01/11/00


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