Showing papers in "The Journal of Index Investing in 2014"
TL;DR: Smart beta strategies as discussed by the authors are better diversified and systematically buy low and sell high by periodically rebalancing to non-price-related target weights, and they profit from mean reversion in the value premium by effectively implementing a dollar cost averaging program.
Abstract: The active shares of traditional value style indexes are dominated by industry bets. They also capture less than the entire value premium; because they weight constituents on the basis of capitalization, they tend to hold large positions in overpriced stocks and small positions in underpriced (i.e., value) stocks. Smart beta strategies, in comparison, are better diversified, and they systematically buy low and sell high by periodically rebalancing to non-price-related target weights. In addition to exploiting mean reversion in prices, smart beta strategies profit from mean reversion in the value premium by effectively implementing a dollar cost averaging program.
16 citations
TL;DR: The authors summarizes the trade-offs between the use of futures and ETFs for fully funded investors and provides empirical evidence that ETFs are now, in many instances, a lower cost alternative to fully funded futures.
Abstract: The widespread adoption of exchange traded funds (ETFs) as institutional instruments, tighter trading spreads, and lower fees mean these investment vehicles are increasingly seen by investors as a viable alternative to futures-based exposure. At the same time, the costs of maintaining a given exposure using futures contracts have increased, driven by regulation which has increased capital requirements and which restricts proprietary trading activities. This article 1) summarizes the trade-offs between the use of futures and ETFs for fully funded investors; 2) provides empirical evidence that ETFs are now, in many instances, a lower cost alternative to fully funded futures; and 3) analyses the fundamental drivers of roll mispricing, providing evidence that higher costs for futures reflects longer-run, systematic factors such as regulation that are unlikely to reverse soon.
13 citations
TL;DR: In this article, the tracking ability of physical and synthetic exchange traded funds (ETFs) is examined by using three different measures of tracking error, and the authors examine ten pairs of ETFs, which on aggregate track different asset classes (equities, bonds, commodities, and foreign exchange rates), are sponsored by several investment companies and are listed on various stock exchanges.
Abstract: The purpose of this study is to examine the tracking ability of physical (in-kind) and synthetic (swap-based) exchange traded funds (ETFs). By using three different measures of tracking error, I examine ten pairs of ETFs, which on aggregate track different asset classes (equities, bonds, commodities, and foreign exchange rates), are sponsored by several investment companies and are listed on various stock exchanges. For consistency though, each pair under review tracks the same underlying index/asset, trades on the same stock exchange and is denominated in the same currency.
11 citations
TL;DR: In this paper, the authors consider smart beta indexing, which is an alternative to capitalization-weighted (CW) indexing and examine the tradeoff relationships that smart beta investors have to puzzle out among diversification, volatility, liquidity, and tracking error.
Abstract: In this article, the authors consider smart beta indexing, which is an alternative to capitalization-weighted (CW) indexing. In particular, the authors focus on risk-based (RB) indexing, the aim of which is to capture the equity risk premium more effectively. To achieve this, portfolios are built that are more diversified and less volatile than CW portfolios. However, RB portfolios are less liquid than CW portfolios by construction. Moreover, they also present two risks in terms of passive management: tracking difference risk and tracking error risk. This article examines the trade-off relationships that smart beta investors have to puzzle out among diversification, volatility, liquidity, and tracking error. The authors also define the return components of smart beta indexes.
11 citations
TL;DR: In this paper, the first analysis of the dynamics of precious metal ETFs and interrelationships between the price of physical precious metals and their associated ETFs is presented, which can be used to hedge gold and silver prices during periods of market volatility.
Abstract: Precious metals have been popular since the global financial crisis. This has been reflected in both a rise in the price of physical metals, as well as in the use of precious metal exchange traded funds (ETFs). This article offers the first analysis of the dynamics of precious metal ETFs and interrelationships between the price of physical precious metals and their associated ETFs. Traders will be able to use our results to help trade or hedge gold and silver prices during periods of market volatility.
10 citations
TL;DR: In this paper, the authors investigate the role of country and sector effects in low-volatility investing in global equities and find that the benefit of the lowvolatility anomaly can be earned through country-and sector selection in lieu of individual stock selection.
Abstract: Low-risk stocks have historically outperformed high-risk stocks, delivering better long-term returns with less volatility This counterintuitive effect has persisted since 1926, violating one of the basic tenets of finance theory We investigate the role of country and sector effects in low-volatility investing in global equities and find that the benefit of the low-volatility anomaly can be earned through country and sector selection in lieu of individual stock selection We find that low-volatility investing has a pronounced “anti-bubble” behavior that is driven by country and sector positioning Additionally, we see that employing a country–sector selection approach mitigates many of the implementation pitfalls associated with the minimum-volatility stock selection portfolio We conclude that country and sector selection is a more practical approach than individual stock selection for capturing the benefits of low-volatility investing in global equities
10 citations
TL;DR: In this paper, the authors examined the range of implementation decisions for a target volatility equity strategy as well as the drivers of strategy performance and concluded that target volatility has provided superior risk-adjusted return and limited downside risk compared with a U.S. equity benchmark.
Abstract: A target volatility equity strategy has provided superior risk-adjusted return and limited downside risk compared with a U.S. equity benchmark. We examine the range of implementation decisions for such a strategy as well as the drivers of strategy performance.
10 citations
TL;DR: In this article, the authors discuss why this combination has been of interest and summarize the key considerations for investing in such a strategy, which results in a portfolio with lower-than average valuation and return volatility, and higher-than-average quality (measured by metrics like profitability, earnings variability, and leverage).
Abstract: The latest wave in advanced beta, also known as smart beta, factor investing, and risk premia investing, among other names, has focused on combining multiple factors in one portfolio. One of the more widely discussed combinations has been Value, Low Volatility, and Quality, which results in a portfolio with lower-than-average valuation and return volatility, and higher-than-average quality (measured by metrics like profitability, earnings variability, and leverage). In this article, the authors discuss why this combination has been of interest and summarize the key considerations for investing in such a strategy. The intuition behind the three factors as well as the empirical evidence has provided support for the combination. Moreover, the three-factor portfolio attempts to take advantage of potential diversification benefits over time, which dampens the well-known challenge of cyclicality in advanced beta strategies, a key hurdle in implementation.
8 citations
TL;DR: In this paper, the authors take some of the mystery out of mutual fund revenue sharing, but without saying that investors have transparent disclosure, and it appears that most in the world of regulation and practice of revenue sharing lack clarity, consistency, proper redress, and investor transparency.
Abstract: The objective of this study is to take some of the mystery out of mutual fund revenue sharing, but without saying that investors have transparent disclosure. Topics begin with the transition from directed brokerage to revenue sharing. The discussions that follow include directed brokerage and revenue sharing, replacing 12b-1 fees, defensive 12b-1 fees, distribution with a difference, revenue sharing nuances, types of revenue sharing, revenue sharing summary, disclosure issues, revenue sharing and 401(k) plans, pension plan subtransfer agency fees, Schwab revenue sharing, SEC versus Edward D. Jones, and Morgan Stanley distribution fees. It appears that most in the world of regulation and practice of revenue sharing lack clarity, consistency, proper redress, and investor transparency, such as the so-called direct distribution of revenue sharing payments from mutual fund adviser profits.
7 citations
TL;DR: In this paper, changes in stock price volatility of banks and other financials resulting from the inception of the firstever, leveraged, inverse and traditional, purely financial exchange-traded funds (ETFs) are investigated.
Abstract: Changes in stock price volatility of banks and other financials resulting from the inception of the first-ever, leveraged, inverse and traditional, purely financial exchange-traded funds (ETFs) are investigated. Financials have become much more accessible to investors through these creative and increasingly popular ETF securities. Results from using a constant-variance, first-order, Markov regime-switching model show a significant increase in the volatility of banks and other financials following the introduction of XLF, the traditional ETF representing the Financial Select Sector SPDR, and the leveraged (long and inverse) ETFs, UYG and SKF, benchmarked to the Dow Jones U.S. Financials Index. Volatility emanating from the inception of the leveraged ETFs was several orders of magnitude greater than that of the traditional ETF. Banking and large-cap financials were most prominently affected by the XLF. All sectors and size categories of financial firms were significantly impacted by UYG and SKF, the leveraged ETFs.
6 citations
TL;DR: This paper found that active funds are more volatile than their passive counterparts and do not provide an absolute return advantage, and that active ETFs are generally not good substitutes for existing passively managed funds.
Abstract: Actively managed ETFs are a relatively recent introduction to the investing landscape, and understanding their performance against passive funds is becoming increasingly important. Consistent with preliminary studies, I find that active funds are more volatile than their passive counterparts and do not provide an absolute return advantage. Thus, active ETFs are generally not good substitutes for existing passively managed funds. However, in contrast to prior studies, I find that performance metrics based on relative risk (e.g., Information and Treynor ratios) suggest that active funds may be good additions to existing portfolios for their diversification benefits. I also find that these relative benefits are primarily concentrated in the funds with the highest average daily trading volume.
TL;DR: This paper argued that many of the so-called financial innovations turn out to be little more than old snake oil repackaged into new bottles, which obfuscate their true nature and tempt investors to forget the golden rule of investing: No asset (or strategy) is so good that you should invest irrespective of the price paid.
Abstract: Modern day investment management seems to closely resemble ancient alchemy. The latter promised to turn lead into gold, whereas the former keeps promising to turn low returns into high returns. However, many of the so-called financial innovations turn out to be little more than old snake oil repackaged into new bottles. They obfuscate their true nature and tempt investors to forget the golden rule of investing: No asset (or strategy) is so good that you should invest irrespective of the price paid.
TL;DR: In this paper, the authors study a universe of hedge fund managers with a focus on the North American markets with the objective of shedding some light on how much alpha they deliver, as a group, and when that alpha is present.
Abstract: Hedge fund managers have long touted their ability to add alpha, particularly in times of market stress. As the rapid growth of the exchange-traded products (ETPs) landscape has given rise to more liquid alternative betas, investors have started to take a closer look at the alpha hedge funds provide. We study a universe of long/short equity funds (with a focus on the North American markets) with the objective of shedding some light on how much alpha they deliver, as a group, as well as when that alpha is present. We find evidence that long/short equity managers, collectively, tend to underperform a liquid dynamic portfolio of ETPs designed to clone these managers’ collective performance. This underperformance tends to occur during periods of market stress, suggesting that hedge fund managers’ value-added, as a group, lies in their ability to make the right factor bets over longer time horizons relative to shorter time horizons.
TL;DR: In this paper, the authors examined whether R2, as a measure of flexibility or active management, can explain ETF alphas, and whether it also can predict ETF performance, and they found that 1-R2 positively affects ETF performance.
Abstract: The stated objective of exchange-traded funds (ETFs) is to hit their benchmarks. However, previous research identifies potential difficulties that arise for ETF managers attempting to exactly replicate the returns of the target benchmark and suggests that the flexibility associated with passive investment management can add value for investors. In this article, I expand the results of Amihud and Goyenko [2012] and examine whether R2, as a measure of flexibility or active management, can explain ETF alphas, and whether it also can predict ETF performance. Examining 88 ETFs from 2000–2012, I find that 1 – R2 positively affects ETF performance. I also find that 1 – R2 is a significant predictor of ETF alphas and that the R2-based investment strategy in ETFs earns a significant positive risk-adjusted excess return.
TL;DR: In the two decades since the launch of the widely followed Chicago Board Options Exchange (CBOE) Volatility Index (VIX), dozens of new volatility indexes have been introduced as discussed by the authors.
Abstract: In the two decades since the 1993 launch of the widely followed Chicago Board Options Exchange (CBOE) Volatility Index (VIX), dozens of new volatility indexes have been introduced. This article provides an overview of 30 volatility-related indexes; 25 of the indexes are indicators that gauge investor sentiment regarding expected volatility of traded instruments such as commodities, interest rates, currencies, or worldwide stock indexes, and 5 indexes are designed to serve as benchmarks for investable performance of strategies that use VIX futures or options. Volatility indexes are used as market signals in asset allocation programs. Over the past 14 years, many investors have struggled to cope with multiple bear markets for stocks, higher correlations among many investments, and lower risk-adjusted returns for their portfolios. Investors now use long-volatility strategies with the goal of diversifying their portfolios and short-volatility strategies with the goal of enhancing risk-adjusted returns. Increased interest in volatility indexes is reflected by the fact that average daily volume for VIX options rose from 23,491 contracts in 2006 to 442,959 in 2012.
TL;DR: In this paper, the authors investigate the differences in risk and return in the most well-known U.S. small-cap indexes and find significant differences in returns, both absolute and risk-adjusted, and in factor exposures.
Abstract: We investigate the differences in risk and return in the most well-known U.S. small-cap indexes and find significant differences in returns, both absolute and risk-adjusted, and in factor exposures. The Russell 2000 underperforms the S&P 600, MSCI 1750, and the CRSP U.S. Small in the period 2001–2102. All of the indexes studied had positive market, size, and value exposure. We do, however, find differences in exposure to profitability and momentum factors. The Russell 2000 has positive momentum exposure whereas the other indexes do not have significant momentum. This difference is likely due to the annual versus quarterly reconstitution of the Russell. Also, the S&P 600 Index has significant positive exposure to profitability whereas the other indexes have significant negative exposure. This difference is likely attributed to the profitability screens employed by S&P in determining index constituents.
TL;DR: The authors empirically analyze the properties of target risk strategies compared with pure index investments and study them in the context of popular alternative strategies such as minimum-variance and equally weighted portfolios.
Abstract: We empirically analyze the properties of target risk strategies compared with pure index investments. We also study them in the context of popular alternative strategies such as minimum-variance and equally weighted portfolios. We document a strong (out)performance. For our sample period of about 20 years, capitalization-weighted index returns can be systematically achieved at a lower variance. However, there is a trade-off between leveraging that potentially creates higher returns and the volatility loss due to leverage that leads to an optimal risk level.
TL;DR: The most recent changes were made because of terminal events; not replacing these companies would have left the Dow with fewer than 30 companies as mentioned in this paper, which may potentially have biased the Dow.
Abstract: Since 1997, the Dow Jones Industrial Average (DJIA) Index has replaced companies in the index on six occasions. Overall, 16 companies have been dropped from the index. The first four replacements involved dropping and then replacing companies that still existed. These four discretionary substitutions may potentially have biased the Dow. The most recent changes were made because of terminal events; not replacing these companies would have left the Dow with fewer than 30 companies.
TL;DR: This paper found that hedging currency risk would have led to a higher Sharpe ratio by decreasing risk while maintaining return at a similar level, and this result was consistent for multiple investor domiciles including the United States, Great Britain, Germany, Japan, and Australia.
Abstract: We found that it is important to address currency risk to take full advantage of the benefits of minimum-volatility investing. In our back test that extended back to 1979, we found that hedging currency risk would have led to a higher Sharpe ratio by decreasing risk while maintaining return at a similar level. In the absence of hedging, a minimum-volatility portfolio’s currency risk creates a home bias and other distortions. Separating equity selection from currency risk builds a portfolio that is low risk from a local-currency perspective. This local-currency portfolio historically delivered higher risk-adjusted returns, which we attribute to better stock selection. We found this result to be consistent for multiple investor domiciles including the United States, Great Britain, Germany, Japan, and Australia. As a bonus, the hedged portfolio’s return was also less correlated with the global equity market, making it a better portfolio diversifier. To our knowledge, despite extensive research published on low-volatility investing, currency-related issues have not yet been reported on.
TL;DR: In this article, the authors provide a detailed discussion on these breakthroughs and highlight the major criteria that the China A-shares market has to meet in order to be eligible for a possible inclusion.
Abstract: The China A-shares market has expanded tremendously and experienced several key changes in the last two decades. Recent revisions of the Qualified Foreign Institutional Investor (QFII) and Renminbi Qualified Foreign Institutional Investor (RQFII) programs, together with the introduction of the Shanghai-Hong Kong Stock Connect program, are manifestations of the effort of Chinese authorities to open the Chinese domestic capital market to international investors. These developments have led index providers to consider the inclusion of China A-shares in their global benchmarks. This article provides a detailed discussion on these breakthroughs and highlights the major criteria that the China A-shares market has to meet in order to be eligible for a possible inclusion. This article also provides a roadmap on how to determine the China A-shares allocation in a global benchmark in order to represent the true opportunity set for international investors.
TL;DR: The authors analyzes why the S&P 500 Index is not a self-financed or a tradable portfolio and why it cannot be replaced with a mimicking portfolio, such as the SPDR, when applying the standard arbitrage pricing theory.
Abstract: This article analyzes why the S&P 500 Index is not a self-financed or a tradable portfolio and why it cannot be replaced with a mimicking portfolio, such as the SPDR, when applying the standard arbitrage pricing theory. In particular, we show that the nonlinear and extreme risk dynamics of the mimicking portfolio are very different from that of the S&P 500 Index. The tracking errors on the S&P 500 Index can explain the violations of the spot-futures parity and the put-call parity by the index and its derivatives, which are encountered in practice. These properties also imply that the standard pricing methods that assume the underlying asset is tradable cannot be used to evaluate derivatives written on the S&P 500 Index.
TL;DR: In this paper, a less frequent rebalancing cycle may be more appropriate for investors looking for leveraged or inverse exposure for holding periods greater than one day, moving away from a straight market-capitalization-based weighting methodology may offer opportunities to enhance the return profile thereby enabling an investor to better achieve her long-run investment objectives.
Abstract: Investment products that seek to provide leveraged and inverse exposure to the equity markets have enjoyed great success in attracting assets. The largest and most popular exchange traded funds (ETFs) that provide these exposures rebalance their positions each day in an attempt to provide a precise multiple of the market return for the subsequent day. However, the daily rebalancing process can be detrimental to returns over holding periods longer than one day. For investors looking for leveraged or inverse exposure for holding periods greater than one day, a less frequent rebalancing cycle may be more appropriate. Further, moving away from a straight market-capitalization-based weighting methodology may offer opportunities to enhance the return profile thereby enabling an investor to better achieve her long-run investment objectives.
TL;DR: In a continually evolving investment universe, strategies that “begin at the beginning” with smart beta may offer the potential for better outcomes than traditional active and passive approaches as discussed by the authors.
Abstract: In a continually evolving investment universe, strategies that “begin at the beginning” with smart beta—such as GDP-weighted index strategies for bond investments and fundamental indexing strategies for equity investments—may offer the potential for better outcomes than traditional active and passive approaches. And investors can build upon the inherent benefits of smart beta by incorporating actively managed bond strategies within a smart beta solution, whether in a global bond portfolio informed by forward-looking fundamental views or in an absolute-return-oriented bond portfolio as a return generator in an index-plus approach. In either case, smart beta and active bond management can form a compelling combination.
TL;DR: In this paper, the authors demonstrate how to implement a minimum variance portfolio using country/sector exchange-traded funds (ETFs) and show that a minimum-variance methodology based on allocations to country and sector ETFs may allow for the capture of a significant portion of the lowvol risk premia on developed markets as well as emerging markets.
Abstract: Risk-reduction strategies have gained attention in recent times. Among these, low-volatility strategies have enjoyed significant inflows, making them one of the most sought-after smart beta strategies. The so-called low-vol anomaly (empirical outperformance of low-volatility equities versus their higher-volatility peers) has been well documented over the past 10 years in academia as well as among market participants. This article demonstrates how to implement a minimum variance portfolio using country/sector exchange-traded funds (ETFs). The analysis shows that a minimum-variance methodology based on allocations to country and sector ETFs may allow for the capture of a significant portion of the low-vol risk premia on developed markets as well as emerging markets.
TL;DR: A review of the relevant academic literature shows that most of these new ETFs find their roots in traditional ETFs as discussed by the authors. But in terms of risk-adjusted performance, investors in smart beta ETFs have on average not been appropriately compensated for the risks they have taken in comparison to investors who put their money into more traditional, cap-weighted ETFs.
Abstract: A new category of exchange-traded funds, which can arguably be referred to as “smart beta ETFs,” has lately issued a meaningful challenge to traditional, market-value-oriented ETFs. Although the concept seems new, a review of the relevant academic literature shows that most of these new ETFs find their roots in traditional ETFs. After having divided smart beta ETFs into three distinct categories, a thorough review shows that their share of the overall ETF market is rapidly expanding. In particular, factor and fundamental smart beta ETFs have established themselves as the dominant duo relative to low-volatility ETFs. But in terms of risk-adjusted performance, this study shows that investors in smart beta ETFs have, on average, not been appropriately compensated for the risks they have taken in comparison to investors who put their money into more traditional, cap-weighted ETFs.
TL;DR: A nonferrous base-metals index representative of the physical and futures market of the constituent metals (aluminium, copper, zinc, lead, tin, and nickel) is constructed using principal component analysis.
Abstract: A nonferrous base-metals index representative of the physical and futures market of the constituent metals (aluminium, copper, zinc, lead, tin, and nickel) is constructed using principal component analysis. The unique mathematical core to construction aims to capture maximum covariation in the metals basket and avoid subjectivity in weight assignment. The constructed index is evaluated to gauge usefulness to stakeholders. The index fares well on investment parameters, allows near-perfect hedge-to-price risk, and works as an information variable by acting as a lead indicator to industrial production. Notably, the period of analysis follows the economic turmoil of 2008–2009, enhancing the relevance of this study.
TL;DR: This article conducted an international survey to establish common denominators in the CTA and managed futures industry and found that CTA may be generalized in trading popular key global markets in a risk-weighted momentum portfolio managed to a target volatility and applying a 2/20 fee structure.
Abstract: How do commodity trading advisors (CTAs) generate returns? Which markets do they trade? How do they allocate risk, manage money, and what fees do they charge? We conducted an international survey to establish common denominators in the CTA and managed futures industry. This article presents the results and conclusions from the survey. The survey finds that the CTA and managed futures industry may be generalized in trading popular key global markets in a risk-weighted momentum portfolio managed to a target volatility and applying a 2/20 fee structure.
TL;DR: In this paper, the covariance patterns of the returns on the commodity and equity markets were analyzed from 1970M1 to 2013M7, and it was shown that returns on commodity and stock markets co-vary weakly in the opposite direction (r = -0.12) in the 1970s, move together in the same (weakly positive) direction in the 1980s, then journey in the slightly opposite direction, and run together in a weakly positive (r < 0.19) direction again in the 2000s.
Abstract: This study is designed to dissect the covariance patterns of the returns on the commodity and equity markets. Analyzing monthly return data from 1970M1 to 2013M7, we obtain results showing that returns on the commodity and equity markets co-vary weakly in the opposite direction (r = -0.12) in the 1970s, move together in the same (weakly positive) direction (r = 0.18) in the 1980s, then journey in the slightly opposite (r = -0.08) direction again in the 1980s, and run together in the weakly positive (r = 0.19) direction again in the 2000s. Then comes a surprise: In the past 3½ years (from 2010 to 2013M7), there is a significantly positive surge (r = 0.793) in the covariance between the returns on the commodity and equity markets. The OLS estimates show that return on the stock market can significantly (r 2 = 0.63) explain the return variability of the commodity market in the 2010s, as compared to other periods.
TL;DR: In this article, the authors discuss the dark side of smart beta strategies and how they might fit into portfolios, given the current investment landscape, and propose an alternative investment strategy for smart beta.
Abstract: “Smart beta” is a term that has prompted much discussion and debate. Recent commentary has run the gamut, from calling smart beta “a better mousetrap” to alluding to its “dark side.” It is important for investors and advisors alike to fully understand investment strategies deemed “smart” how they might fit into portfolios, given the current investment landscape.
TL;DR: In this article, the authors place active risk from active fund management in the same framework of uncertainty that asset allocators utilize for other portfolio decisions, and propose a balanced implementation approach.
Abstract: The proliferation of liquid, transparent, and inexpensive index-based implementation means that nearly all types of investors, individual and institutional, face a persistent portfolio implementation question regarding the allocation between active managers and index-based strategies. Placing active risk from active fund management in the same framework of uncertainty that asset allocators utilize for other portfolio decisions brings to the active versus passive debate a surprising and enlightening answer that does not match typical discourse on the matter. Instead of a binary, “all or none” answer, reasonable (and even optimistic or pessimistic) expectations for active management imply a balanced implementation approach. Only extreme assumptions (e.g., very positive or negative levels of active return, very short or long time horizons) indicate a binary choice.