Forecasting the returns on UK investment trusts: a comparison

The well known fact that investment trusts (closed-end mutual funds in the USA) trade at a discount means that the return to an investor depends not only on the change in net asset value (NAV), but also on changes in the discount over the holding period. Using daily data, this paper models the relationship between UK investment trust prices and NAV's using cointegration methodology then shows that the forecasts based on the, error correction mechanism (ECM) compare poorly with those from vector autoregressions. And then incorporates a number of modifications to the ECM in an attempt to improve the forecasts. In particular, modelling volatility persistance and allow for asymmetric resonses in the ECM.     

A comparative performance of conventional and Islamic unit trusts: Market timing and persistence evidence

It is expected that the returns and resistance of Islamic mutual funds will be different from conventional mutual funds as the former have limited choices for portfolio diversification. This article analyses the performance of conventional and Islamic unit trusts for the period February 1995 to July 2012 in the Malaysian market, one of the most developed Islamic mutual fund markets. The performance analysis is based on four parameters: (i) risk-adjusted returns of unit trusts; (ii) market timing abilities; (iii) selection performance; and (iv) persistence. The results of this study suggest that the returns of both conventional and Islamic unit trusts have outperformed the market throughout the sample period. The results for market timing and selectivity are mostly the same for both categories of funds. However, Islamic unit trusts seem to have better resistance to market downturn than conventional unit trusts. The results of this research can be used by investors to identify funds or create portfolios that are more suitable for a recessionary scenario and for fund managers to better manage their portfolio performance during times when markets are likely to fall. The findings in this article are highly relevant for policymakers, investors and fund managers to determine policy matters, deciding on investment and marketing strategy for Islamic mutual funds.     

Investment style positioning of UK unit trusts

We investigate the investment style positioning of UK equity unit trusts (mutual funds) over the 24-year period from 1987 to 2010 and assess if fund manager claims to follow a particular style strategy are evidenced in practice. Generally, UK unit trusts do not, in fact, consistently track declared styles but subject their funds to style switching or rotation. Nor do funds switch to become simple index trackers, as has widely been reported, but exhibit a mix of behaviour that we refer to as ‘market-momentum styling’. Our contribution is to offer a coherent, end-to-end picture of the evolution of investment styles over an economic cycle. In so doing we evidence that fund style positioning is subject to rotation and becomes subordinated to past portfolio performance or style momentum. Even this result is conditional as we go on to demonstrate that style investment is very likely to be driven by broader economic conditions, thereby creating market-momentum styling by default. This is arguably not a style at all and calls into question the intent behind fund ‘strategies’.     

Convertible debt and investment timing

In this paper we provide an investment-based explanation for the popularity of convertible debt. Specifically, we demonstrate the ability of convertible debt to alleviate and potentially totally eliminate the underinvestment problem of Myers (1977). A conversion feature induces shareholders to accelerate investment. This effect arises from the incentive of equity holders to accelerate the issuance of new equity, used to finance investment, since by investing early shareholders dilute the value of convertible debt holders by reducing their proportional claims to the firm's cash flows. Since the underinvestment effect and the accelerated investment effect work in opposite directions, convertible debt allows to mitigate or completely eliminate the debt overhang problem. In addition, we show that by choosing the right combination of straight debt and convertible debt, shareholders can, for a wide range of overall debt levels, commit to the investment strategy of an all-equity firm.     

The performance of U.K. investment trusts as internationally diversified portfolios over the period 1968 to 1977

This paper considered the share price performance of a sample of U.K. closed end funds as internationally diversified portfolios over the ten year period 1968 to 1977. Using a performance criterion which does not place restrictions on the form of the distribution functions being compared (i.e., second degree stochastic dominance criterion), U.K. funds are compared to the domestic (U.K.) market index as well as against artificially constructed benchmark portfolios which reflect the historical spread of foreign asset holdings of the funds being examined. The question addressed is whether U.K. investors could have out performed internationally diversified U.K. closed end funds by investing directly into foreign capital markets. The performance results, in sterling terms, indicate that U.K. international funds, were clearly inferior to their assigned benchmark portfolio, with the latter mirroring the historical geographical asset spread of the particular fund being examined.     

Empirical analysis of the average asset correlation for real estate investment trusts

The credit risk capital requirements within the current Basel II Accord are based on the asymptotic single risk factor (ASRF) approach. The asset correlation parameter, defined as an obligor's sensitivity to the ASRF, is a key driver within this approach, and its average values for different types of obligors are to be set by regulators. Specifically, for commercial real estate (CRE) lending, the average asset correlations are to be determined using formulas for either income-producing real estate or high-volatility commercial real estate. In this paper, the value of this parameter was empirically examined using portfolios of U.S. publicly-traded real estate investment trusts (REITs) as a proxy for CRE lending more generally. CRE lending as a whole was found to have the same calibrated average asset correlation as corporate lending, providing support for the recent U.S. regulatory decision to treat these two lending categories similarly for regulatory capital purposes. However, the calibrated values for CRE categories, such as multi-family residential or office lending, varied in important ways. The comparison of calibrated and regulatory values of the average asset correlations for these categories suggests that the current regulatory formulas generate parameter values that may be too high in most cases.     

Market timing,investment, and risk management

The 2008 financial crisis exemplifies significant uncertainties in corporate financing conditions. We develop a unified dynamic q-theoretic framework where firms have both a precautionary-savings motive and a market-timing motive for external financing and payout decisions, induced by stochastic financing conditions. The model predicts (1) cuts in investment and payouts in bad times and equity issues in good times even without immediate financing needs; (2) a positive correlation between equity issuance and stock repurchase waves. We show quantitatively that real effects of financing shocks may be substantially smoothed out as a result of firms' adjustments in anticipation of future financial crises.     

Abnormal investment and firm performance

We find a negative relation between abnormal investment and future stock performance. Such a negative relation is mainly driven by under-investment, not over-investment. Our results are robust to various estimation methods and investment models. Both delayed market reaction and agency issues may lead to the apparently anomalous return predictability of under-investment. First, market investors may not react promptly to the fundamental information contained in under-investment about a firm’s future profitability, asset growth, and financial distress probability. Second, the negative relation between under-investment and future stock returns is more pronounced for firms with lower investor monitoring and higher agency costs.     

Performance differences in property-type diversified versus specialized real estate investment trusts (REITs)

Evidence from the corporate finance literature indicates that diversified firms trade at a discount to otherwise comparable specialized firms. However, very little research has addressed whether a similar diversification discount might exist in equity REITs that diversify across property types relative to those specializing in one property type. Using a sample of 75 equity REITs, the existence of a property-type diversification discount is tested using standard Jensen's Alpha, Treynor Index, and Sharpe Ratio performance ranking methodologies over four commonly employed market proxies. Several variations of these standard tests are also utilized as robustness checks.     

The effects of costly exploration on optimal investment timing

This paper investigates a principal–agent model in which an owner (principal) optimizes a contract with a manager (agent) who has been delegated to undertake an investment project. In the model, we explore the effects of costly exploration by which the manager learns the real value of development cost. We show that high exploration cost can lead to a pooling policy not contingent on project type. Further, and more notably, we show that, in the presence of asymmetric information, higher exploration cost leads to wealth transfer from owner to manager and can ultimately improve social welfare.     

Credit risk assessment in real estate investment trusts: A perspective on blockholding and lending networks

This study assesses the credit risk of Japan's real estate investment trusts (J-REITs) in two related markets during the fiscal years 2008–2017. The first J-REIT market involves blockholders, while the second is a lending market of institutions, i.e., banks and insurers. J-REITs are corporation type of closed-end funds listed on the stock exchange and thus, has corporate credit risk. Consequently, a J-REIT's financial variables and its sponsor have a substantial effect on the J-REIT's credit risk. A sponsor's probability of default is a leading indicator of the J-REIT's default and double default probability acts as a coincident indicator of default. Network analysis indicates that some network centralities are proxies for funding liquidity via blockholding and lending networks. Rather than increases in other centralities, an increase in the degree of lending to a J-REIT explains a decrease in the issued J-REIT's credit risk.     

The impacts of share pledging on firm investment timing and valuation

This paper applies a model in the real options framework to analyze the impacts of controlling shareholder’s share pledging on corporate investment timing and valuation. We find that the optimal investment timing shows an inverted U-shape with the pledge ratio, indicating that share pledging exacerbates firms’ over-investment and worsens firms’ under-investment. Furthermore, share pledging hurts firms’ option value unless active measures are taken to control the pledging risks. The maintenance requirement can keep controlling shareholder from irrational early investments and protect investors from severe wealth losses. In addition, our work can provide testable empirical implications.     

Agency cost of debt overhang with optimal investment timing and size

The concept of debt overhang (that is, an equity‐maximizing levered firm will under‐invest relative to a firm‐value‐maximizing firm) is well established in the literature. A number of papers have demonstrated it as delayed investment (when investment size is specified) or smaller investment (when investment time is specified). However, there is no work on the underinvestment effect when the firm chooses both size and timing of investment, as it usually does in real life. This is what our paper focuses on. When the firm has the flexibility to choose both size and time, the effect is complicated by the fact that delayed investment results in larger investment, which suggests that the underinvestment problem might be mitigated. We find, however, that the effect depends on how underinvestment is measured. When measured by the expected present value of investment, flexibility can mitigate or exacerbate the underinvestment problem, depending on the cost of installing capacity. But when measured by the agency cost, flexibility always exacerbates the underinvestment problem. It is shown numerically that, at the optimal leverage ratio, the agency cost with plausible parameter values can be economically significant. Thus, with the flexibility of choosing both time and size of investment, the debt overhang problem can be of significant practical relevance in corporate investment decisions.     

Decomposing industry leverage: The special cases of real estate investment trusts and technology & hardware companies

Different industries exhibit significantly different leverage; companies in the real estate investment trust (REIT) and technology/hardware sectors are extreme examples. In the United States, the leverage ratio is twice as high for REITs (50%) as compared to non-real-estate firms (around 25%), and the technology/hardware sector has the lowest ratio (around 17%). We theoretically and empirically analyze their differences. By decomposing the difference into three channels, we find that the industry-specific channel explains around 67% for REITs and 68% for technology/hardware firms; the value-based channel is mostly responsible for the remaining portion. Taking the nonlinear influences of extreme values into account, the relevance of the industry-specific channel is considerably reduced.     

Fund manager conviction and investment performance

This paper examines the role conviction plays in asset management and its relationship with investment returns. We measure the strength of fund manager conviction through a fund's Active Share, i.e., the extent to which an investment portfolio differs from its benchmark index. First, we show fund manager conviction increases following both superior and, surprisingly, inferior past performance, and more so among solo-managed than team-managed funds. Second, and more importantly, we find an inverse-U relationship between conviction and subsequent performance. High levels of conviction proxied by high Active Share are associated with lower future returns and greater fund risk. Our study also illustrates an asymmetric investor reaction to fund manager conviction in the form of higher (lower) fund inflows rewarding good performance by high (low) conviction managers, but no pronounced penalties for poor performance, ceteris paribus.     

Price‐cap regulation and the scale and timing of investment

This article shows how scale economies affect regulated firms’ investment behavior and welfare‐maximizing regulation of price and quantity. Regulated firms invest in smaller, more frequent, increments than social planners, with greater investment distortions the greater the economies of scale. Regulators cap prices at lower levels than planners when economies of scale are moderate, and at higher levels when they are substantial. When quantity is also regulated, the average cost of building capacity increases but the price cap decreases. Immediately after firms make their initial investment, regulators want to transfer surplus from customers to shareholders by raising the price cap to induce additional investment.     

Venture capital reputation and investment performance

I propose a new measure of venture capital (VC) firm reputation and analyze its performance implications on private companies. Controlling for portfolio company quality and other VC-specific factors including experience, connectedness, syndication, industry competition, exit conditions, and investment environment, I find companies backed by more reputable VCs by initial public offering (IPO) capitalization share (based on cumulative market capitalization of IPOs backed by the VC), are more likely to exit successfully, access public markets faster, and have higher asset productivity at IPOs. Further tests suggest VCs’ IPO Capitalization share effectively captures both VC screening and monitoring expertise. My findings have financial implications for limited partners and entrepreneurs regarding their VC-sorting activities.     

Cash flow,investment, and investment opportunities: New tests using UK panel data

The interpretation of the correlation between cash flow and investment is controversial. Some argue that it is caused by financial constraints, others by the correlation between cash flow and investment opportunities that are not properly measured by Tobin’s Q. This paper uses UK firms’ contracted capital expenditure to capture information about opportunities available only to insiders and thus not included in Q. When this variable is added to investment regressions, the explanatory power of cash flow falls for large firms, but remains unchanged for small firms. This suggests that the significance of cash flow stems from its role in capturing the effects of credit frictions.     

Corporate financing decisions, managerial market timing, and real investment

Both market timing and investment-based theories of corporate financing predict under-performance after firms raise capital, but only market timing predicts that the composition of financing (equity compared with debt) should also forecast returns. In cross-sectional tests, we find that the amount of net financing is more important than its composition in explaining future stock returns. In the time series, investment-based factor models explain abnormal stock performance following a variety of corporate financing events that previous studies link to market timing. At the aggregate level, the amount of new financing is also more important for future market returns than its composition. Overall, our joint tests reveal that measures of real investment are correlated with future returns and measures of managerial market timing are not.