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Academic Research - October 23, 2012

IPE EDHEC-Risk Research Insights: EDHEC-Princeton Special

The inaugural EDHEC-PRINCETON Institutional Money Management Conference was held on April 27, 2012, at the Princeton Club in New York. In the face of a number of key changes of paradigms that are currently affecting the investment industry, this one-day conference was intended to provide a selected number of invited investment professionals with the latest academic insights related to new frontiers in institutional money management. The format of the conference was designed to facilitate the exchanges of views between academics and practitioners; it involved presentations by members of the faculty of Princeton University and EDHEC-Risk Institute, followed by a discussion with the audience.

In the present supplement, we feature three articles drawn from the research that was presented at this conference.

The first article, “A Generalised Approach to Portfolio Optimisation: Improving Performance by Constraining Portfolio Norms,” contributes to the literature on optimal portfolio construction in the presence of estimation error. More specifically, it provides a general framework for determining portfolios with superior out-of-sample performance in the presence of estimation error.

The second contribution, “Advantages of Long-Short Commodity Funds for Long-Term Investors,” by Professor John M. Mulvey of the Department of Operations Research and Financial Engineering, Bendheim Center for Finance at Princeton University, discusses advantages of long-short commodity funds as meaningful diversifiers within a portfolio of traditional assets.

The managed futures category of hedge funds performed particularly well during the 2008–09 crash periods. Similar results have been seen in previous crash periods, including the Asian currency crisis of 1997–98, and the Russian debt debacle and LTCM in 1998–99.

Positive performance during crashes can be attributed to:

  1. the ready ability to go long or short;
  2. deep liquidity allowing for dynamic asset allocation; and
  3. opportunity to take advantage of volatility via rebalancing gains and regime changes.

Each element provides a small advantage. When combined, a portfolio of commodity tactics can substantially improve overall investment performance, especially when traditional assets are doing poorly. The advantages of long-short commodity funds are described with attention to short positions during sharp downturns.

The third piece, “Portfolio Allocation Decisions in the Presence of Regimes in Asset Returns,” provides evidence that the pervasive presence of regimes in financial returns series has important implications for portfolio allocation decisions, both in the short run and in the long run. An important result is that the share invested in equities does not always increase with the investment horizon, contrary to what is usually assumed in life-cycle funds.

This supplement also features articles on the benefits of volatility derivatives in equity portfolio management, drawn from research supported by Eurex; the results of a call for practitioners’ reactions to the application of asset-liability management in sovereign wealth funds, from a research chair at EDHEC-Risk Institute supported by Deutsche Bank; the reactions of corporate finance departments and institutional investors to research that was carried out as part of the Rothschild & Cie research chair on “The Case for Inflation-Linked Corporate Bonds: Issuers’ and Investors’ Perspectives”; and a piece on “How to Assess Hedge Fund Performance in a Robust Manner,” drawn from the Newedge research chair on “Advanced Modelling for Alternative Investments.”

In “European regulation of the commodity derivatives markets – be wary of placebos,” we defend the efficiency of modern commodity futures markets. We also report the results of our recent European and North American index surveys and, finally, in “Risk Managed Investing in Non-Cap-Weighted Equity Indices,” discuss issues surrounding the relative risk of alternative weighting schemes and potential ways to address them by applying basic risk management principles (diversification and hedging) to design portfolios of alternative weighted strategies.

The full supplement can be found below. We thank our friends at IPE for their continuing support. Our mutual aim with this supplement is to provide academic insights that genuinely contribute to improving institutional investment practices.