Is the Market Portfolio a Dynamic Factor? Evidence from Individual Stock Returns

This paper uses a factor model to test whether the market portfolio is a dynamic factor in the sense that individual stock returns contain a premium linked to the conditional risk of the market portfolio. The market conditional risk is based on a decomposition of the market variance into a time-varying trend component and a transitory component. The evidence shows that the conditional market premium is rising when the permanent trend rises relative to the conditional variance. The evidence for individual stock returns supports the notion that the market portfolio is a dynamic factor. Individual stock return autocorrelations are fully explained by the time variation in the market premium. The risk premia attributed to static factors are statistically insignificant.     

Do hedge funds' exposures to risk factors predict their future returns?

This paper investigates hedge funds' exposures to various financial and macroeconomic risk factors through alternative measures of factor betas and examines their performance in predicting the cross-sectional variation in hedge fund returns. Both parametric and non-parametric tests indicate a significantly positive (negative) link between default premium beta (inflation beta) and future hedge fund returns. The results are robust across different subsample periods and states of the economy, and after controlling for market, size, book-to-market, and momentum factors as well as the trend-following factors in stocks, short-term interest rates, currencies, bonds, and commodities. The paper also provides macro-level and micro-level explanations of our findings.     

Economic forces and seasonality in secirity returns

This article finds strong seasonal behavior in the innovations for three Canadian macroeconomic variables (industrial production, unexpected inflation and GDP). An APT model is estimated as a restricted nonlinear multivariate regression system using seven macroeconomic variables, various residual market factor (RMF) proxies, and the returns on fifty size related portfolios of equities that traded on the Toronto Stock Exchange (TSE). As in Chen, Roll and Ross (1986), five macrofactors (lagged industrial production, lagged GDP, term structure, unexpected inflation, and risk premium) have significantly priced risk premia. The risk premia are insignificant for RMF based on two value weighted indices, and marginally significant (0.10 level) for the RMF based on an equally weighted index, which is somewhat consistent with McElroy and Burmeister (1988) and Brown and Otsuki (1989). The significance of the RMF risk premium appears not to be robust to whether portfolios or individual securities are used in the estimations. The significance of the estimated risk premia for the macrofactors also appear not to be robust to the number of portfolios (equations) used in the estimations. Unlike the risk premia estimates for the RMF, those for the other macrofactors are generally unaffected by the inclusion of a January dummy. This implies that the January seasonal remains a market phenomenon that requires further study.     

Consumption growth predictability and asset prices

We derive and test a consumption-based intertemporal asset pricing model in which an asset earns a risk premium if it performs poorly when expected future consumption growth deteriorates. The predictability of consumption growth combined with the recursive preference delivers news about future consumption growth an additional risk factor, in addition to news about current consumption growth. We model the consumption growth dynamics using a vector autoregressive (VAR) structure with a set of instrumental variables commonly used for forecasting future economic growth. Our VAR estimation provides strong empirical support for future consumption growth predictability. The cross-sectional test shows that the model explains reasonably well the dispersion in average excess returns of 25 portfolios sorted on size and book-to-market, as well as 25 portfolios sorted on size and long-term return reversal. Growth stocks and long-term winners underperform value stocks and long-term losers, respectively, because growth stocks and long-term winners hedge adverse changes in the future consumption growth opportunities.     

Convertible Bond Arbitrage: Risk and Return

Abstract:  This paper specifies a simulated convertible bond arbitrage portfolio to characterise the risks in convertible bond arbitrage. For comparison the risk profile of convertible bond arbitrage hedge fund indices at both monthly and daily frequencies is also examined. Results indicate that convertible bond arbitrage is positively related to default and term structure risk factors. These risk factors are augmented with the simulated convertible bond arbitrage portfolio, mimicking a passive investment in convertible bond arbitrage, to assess the risk and return of individual hedge funds. We provide estimates of the performance of two hedge fund indices (an equally weighted and value weighted index) and a sample of convertible bond arbitrage hedge funds using a factor model methodology. Lagged and contemporaneous observations of the risk factors are specified, controlling for illiquidity in the securities held by funds. Our results cover two time periods. Initially we find evidence of abnormal risk adjusted returns in the individual hedge fund data and the equally weighted hedge fund index and no evidence of abnormal risk adjusted returns in the value weighted hedge fund index. When we examine performance during the credit crisis of 2007 and 2008 we find evidence of negative abnormal returns amongst individual hedge funds and the hedge fund indices.     

The value, size, and momentum spread during distressed economic periods

We study the behavior of market risk, value, small cap, and momentum premia under different macro economic scenarios. If these factors are risk factors, then these factors offer high returns to investors at times when the gain (marginal utility) of additional consumption is low (good economic times) and low returns at times when the gain (marginal utility) of additional consumption is high (bad economics times). Our results show that market risk and small cap premia behave more like risk factors while value premium does not. In fact, our results show that a portfolio with a long position in value and a short position in growth is a hedge in the down market and recessionary periods. Our results also show that a momentum premium exists under different economically distressed scenarios we studied.     

Climate change news sensitivity and mutual fund performance

In the presence of rising concern about climate change that potentially affects risk and return of investors' portfolio companies, active investors might have dispersed climate change risk exposures. We compute mutual fund covariance with market-wide climate change news index and find that high (positive) climate news beta funds outperform low (negative) climate news beta funds by 0.24% per month on a risk-adjusted basis. High climate news beta funds tilt their holdings toward stocks with high potential to hedge against climate change news risk. In the cross section, such stocks yield higher excess returns, which are driven by greater pricing pressure and superior financial performance over our sample period.     

Idiosyncratic Volatility Covariance and Expected Stock Returns

Given that the idiosyncratic volatility (IDVOL) of individual stocks co‐varies, we develop a model to determine how aggregate idiosyncratic volatility (AIV) may affect the volatility of a portfolio with a finite number of stocks. In portfolio and cross‐sectional tests, we find that stocks whose returns are more correlated with AIV innovations have lower returns than those that are less correlated with AIV innovations. These results are robust to controlling for the stock's own IDVOL and market volatility. We conclude that risk‐averse investors pay a premium for stocks that pay well when AIV is high, consistent with our model.     

Asset Allocation and the Liquidity Premium for Illiquid Annuities

Academics and practitioners alike have developed numerous techniques for benchmarking investment returns to properly adjust seemingly high numbers for excessive levels of risk. The same, however, cannot be said for liquidity, or the lack thereof. This article develops a model for analyzing the ex ante liquidity premium demanded by the holder of an illiquid annuity. The annuity is an insurance product that is akin to a pension savings account with both an accumulation and decumulation phase. We compute the yield (spread) needed to compensate for the utility welfare loss, which is induced by the inability to rebalance and maintain an optimal portfolio when holding an annuity. Our analysis goes beyond the current literature, by focusing on the interaction between time horizon (both deterministic and stochastic), risk aversion, and preexisting portfolio holdings. More specifically, we derive a negative relationship between a greater level of individual risk aversion and the demanded liquidity premium. We also confirm that, ceteris paribus, the required liquidity premium is an increasing function of the holding period restriction, the subjective return from the market, and is quite sensitive to the individual's endowed (preexisting) portfolio.     

Trading Volume: Implications of an Intertemporal Capital Asset Pricing Model

We derive an intertemporal asset pricing model and explore its implications for trading volume and asset returns. We show that investors trade in only two portfolios: the market portfolio, and a hedging portfolio that is used to hedge the risk of changing market conditions. We empirically identify the hedging portfolio using weekly volume and returns data for U.S. stocks, and then test two of its properties implied by the theory: Its return should be an additional risk factor in explaining the cross section of asset returns, and should also be the best predictor of future market returns.     

SMB — Arousal,disproportionate reactions and the size-premium

This paper examines SMB (small minus big), the mimicking portfolio in Fama and French's [Fama, E., French, K., 1993. Common risk factors in the returns on stocks and bonds, Journal of Financial Economics 33, 3–56] three-factor asset pricing model. We do not examine whether SMB is a factor in explaining the cross-section of returns. This paper's focus is why S is greater than B. After controlling for market-pervasive effects, we argue that the small-firm premium is driven by both investors' emotional arousal (proxied by the turnover ratio) and their disproportionate reactions to arousing stimuli.     

Downside risk aversion,fixed-income exposure,and the value premium puzzle

The value premium is relatively small for investors with a material fixed-income exposure, such as insurance companies and pension funds, especially when they are downside-risk-averse. Value stocks are less attractive to these investors because they offer a relatively poor hedge against poor bond returns. This result arises for plausible, medium-term evaluation horizons of around one year. Our findings cast doubt on the practical relevance of the value premium for these investors and reiterate the importance of the choice of the relevant test portfolio, risk measure and investment horizon in empirical tests of market portfolio efficiency.     

MACROECONOMIC VARIABLES AND SEASONAL MEAN REVERSION IN STOCK RETURNS

In this paper I investigate whether seasonal mean reversion in stock portfolio returns is related to common macroeconomic risk factors. I decompose excess returns into explained and unexplained returns using a multifactor pricing model. The explained excess returns exhibit January mean reversion; the unexplained excess returns do not. The mean reversion can be attributed to the components of return related to unexpected inflation, bond default premium, and market risk. The results do not depend on the time-series properties of the portfolio betas. Bond default premia and excess market returns are mean reverting in January.     

Uncertainty,Time‐Varying Fear,and Asset Prices

I construct an equilibrium model that captures salient properties of index option prices, equity returns, variance, and the risk‐free rate. A representative investor makes consumption and portfolio choice decisions that are robust to his uncertainty about the true economic model. He pays a large premium for index options because they hedge important model misspecification concerns, particularly concerning jump shocks to cash flow growth and volatility. A calibration shows that empirically consistent fundamentals and reasonable model uncertainty explain option prices and the variance premium. Time variation in uncertainty generates variance premium fluctuations, helping explain their power to predict stock returns.     

Trapped in diversification – another look at the risk of fund of hedge funds

Recent literature implies that despite being more diversified, fund of hedge funds (FOFs) are exposed to tail risk. We propose an explanation for this phenomenon; tail risk is a systematic risk factor for hedge funds, which by construction, explains the higher portion of the returns in the diversified portfolios. Our study suggests that not only an additional tail risk factor improves the explanatory power of the factor model, the relative importance of tail risk factor increases with the number of underlying hedge funds in an FOF portfolio. Furthermore, we demonstrate that FOFs with a short history, higher management fees, leverage and requiring shorter lockup periods are more sensitive to tail risk.     

Not only skill but also scale: Evidence from the hedge funds industry

This paper empirically tests a two-levels model of decreasing returns to scale using a sample of hedge funds. The two-levels model assumes that a fund's gross alpha is a decreasing function of both the fund scale and the style scale measured by the aggregate size of peers in the hedge fund style. We find that a fund-level model underestimates the impact of diseconomies of scale on the gross alpha by 55 basis points. The results indicate that managers should consider the constraints imposed by the style scale when optimizing their portfolio sizes. We also provide evidence that hedge funds did not invest at their optimal amount and confirm that skill and the ability to resist decreasing returns to scale are two important components of selecting hedge fund performers.     

Accrual quality,skill, and the cross-section of mutual fund returns

We use returns of actively managed mutual funds to document the link between accrual quality (AQ) and systematic (priced) risk. Despite compelling theoretical arguments, prior research finds no evidence that poor AQ commands a risk premium in the cross-section of realized stock returns. We argue that the previously obtained premium estimates are biased downward because, for a large portion of poor AQ stocks, higher expected returns are offset by the news of deteriorating fundamentals. We suggest that skilled mutual fund managers should be able to either avoid investing in stocks with deteriorating fundamentals or assign them lower portfolio weights. As a consequence, returns on their portfolios should better reflect the expected AQ risk premium. Our empirical evidence is consistent with these predictions.     

Optimal allocation to hedge funds: an empirical analysis

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 et al (2002b Working Paper USC) for optimal investment strategies in the presence of uncertain abnormal returns to a database of hedge funds. We find that the presence of the 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 investor risk-free asset holdings.     

Corporate social responsibility as a common risk factor

This article challenges factor models widely used to explain stock returns. For European firms involved in corporate social responsibility (CSR) actions, we find a risk premium associated with extra-financial ratings priced by the market (that is, environmental, social, and governance [ESG] ratings). This premium is calculated as the excess return of low-rated firms compared to high-rated firms. To describe rated firms' returns, we propose a parsimonious two-factor model that includes both the market factor and this premium. Unlike the CAPM, three-, or five-factor models, our model is validated by the Gibbons, Ross and Shanken (1989) test. Our results lead to many managerial implications related to portfolio management, asset pricing, and corporate financial and investing decisions.     

Tracking down distress risk

This paper shows that exposure to aggregate distress risk is the underlying source of the premiums for the Fama-French size (SMB) and value (HML) factors. Using a unique data set of aggregate business failures of both private and public firms from 1926 to 1997, I build portfolios that track news about future firm failures. These tracking portfolios optimally hedge aggregate distress risk and earn a Capital Asset Pricing Model (CAPM) alpha of approximately −4% a year. Both HML and SMB predict changes in future failure rates. Small stocks have lower returns than large stocks and value stocks have lower returns than growth stocks when the market expects an increase in future failure rates. Finally, a two-factor model with the market and the tracking portfolio for aggregate distress as factors does as well as the Fama-French three-factor model in pricing the 25 size and book-to-market sorted portfolios.