Portfolio optimization under a generalized hyperbolic skewed t distribution and exponential utility

In this paper, we show that if asset returns follow a generalized hyperbolic skewed t distribution, the investor has an exponential utility function and a riskless asset is available, the optimal portfolio weights can be found either in closed form or using a successive approximation scheme. We also derive lower bounds for the certainty equivalent return generated by the optimal portfolios. Finally, we present a study of the performance of mean–variance analysis and Taylor’s series expected utility expansion (up to the fourth moment) to compute optimal portfolios in this framework.     

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.     

Locked Up by a Lockup: Valuing Liquidity as a Real Option

Hedge funds often impose lockups and notice periods to limit the ability of investors to withdraw capital. We model the investor's decision to withdraw capital as a real option and treat lockups and notice periods as exercise restrictions. Our methodology incorporates time-varying probabilities of hedge fund failure and optimal early exercise. We estimate a two-year lockup with a three-month notice period costs approximately 1% of the initial investment for an investor with constant relative risk aversion utility and risk aversion of three. The cost of illiquidity can easily exceed 10% if the hedge fund manager can arbitrarily suspend withdrawals.     

Myopic loss aversion,reference point,and money illusion

We use the portfolio selection model presented in He and Zhou [Manage. Sci., 2011, 57, 315–331] and the NYSE equity and US treasury bond returns for the period 1926–1990 to revisit Benartzi and Thaler’s myopic loss aversion theory. Through an extensive empirical study, we find that in addition to the agent’s loss aversion and evaluation period, his reference point also has a significant effect on optimal asset allocation. We demonstrate that the agent’s optimal allocation to equities is consistent with market observation when he has reasonable values of degree of loss aversion, evaluation period and reference point. We also find that the optimal allocation to equities is sensitive to these parameters. We then examine the implications of money illusion for asset allocation. Finally, we extend the model to a dynamic setting.     

Continuous-time delegated portfolio management with homogeneous expectations: can an agency conflict be avoided?

In a continuous-time framework, the issue of how to delegate an investor’s portfolio decision to a portfolio manager is studied. First, we solve the first-best problem. For the second-best case, a specific quadratic contract is introduced resolving the agency conflict completely in the sense that the solutions to the first-best and second-best problems coincide. This contract can be implemented if the investor is able to observe the value of the growth optimal portfolio at her investment horizon. If the investment opportunity set is assumed to be constant, in equilibrium the value of the market portfolio is a sufficient statistic for the value of the growth optimal portfolio. Throughout the paper, we assume that the investor and the manager have homogeneous expectations about the investment opportunity set. This, however, does not necessarily mean that investor and manager are symmetrically informed about all prices.

A theory of outside equity: Financing multiple projects

In the financial economics literature debt contracts provide optimal solutions for addressing managerial moral hazard problems. We analyze a model with multiple projects where the manager obtains private information about their quality after the contract with investors is agreed. The likelihood of success of each project depends on both its quality and the level of effort exerted on it by the manager. We find distributions of the quality shock such that the optimal financial contract requires the investor to hold an equity claim. Our model addresses issues that are relevant for financial intermediation and corporate governance.     

The impacts of Net Stable Funding Ratio requirement on Banks’ choices of debt maturity

In this paper, we study the impacts of the Net Stable Funding Ratio (NSFR) requirement on banks’ choices of debt maturity and asset structures, with consequences for banks’ profitability and social welfare. We develop a model in which the manager of a bank determines both debt maturity structure (short-term vs. long-term debt) and asset composition (cash vs. risky assets). To address the incongruence of goals between the bank manager and the bank stakeholders, in our model we assume that the manager receives only a proportion of the bank’s profit in her pay schedule. We demonstrate that the optimal choices of the manager regarding debt maturity and asset structure lead to socially inefficient (second-best) outcomes because the manager internalizes only part of the social benefit. We then study the implications of the NSFR requirement on the manager’s choices and demonstrate that the NSFR requirement can enhance social welfare and reach an efficient (first-best) outcome, if a sufficiently low weight of short-term debt as available stable funding is required by regulation. Further, we find that under the same conditions the NSFR requirement reduces banks’ use of short-term financing and thus increases the probability of banks’ survival and profits from the ex ante point of view, while it decreases banks’ profits from the ex post point of view, since it reduces the threshold for banks’ survival. Our main results have some interesting empirical implications: under certain conditions, the NSFR requirement may reduce both bank failures and banks’ observed profits.     

Dynamic preferences for popular investment strategies in pension funds

In this paper, we characterize dynamic investment strategies that are consistent with the expected utility setting and more generally with the forward utility setting. Two popular dynamic strategies in the pension funds industry are used to illustrate our results: a constant proportion portfolio insurance (CPPI) strategy and a life-cycle strategy. For the CPPI strategy, we are able to infer preferences of the pension fund’s manager from her investment strategy, and to exhibit the specific expected utility maximization that makes this strategy optimal at any given time horizon. In the Black–Scholes market with deterministic parameters, we are able to show that traditional life-cycle funds are not optimal to any expected utility maximizers. We also prove that a CPPI strategy is optimal for a fund manager with HARA utility function, while an investor with a SAHARA utility function will choose a time-decreasing allocation to risky assets in the same spirit as the life-cycle funds strategy. Finally, we suggest how to modify these strategies if the financial market follows a more general diffusion process than in the Black–Scholes market.     

Investor Protection and Corporate Governance: Evidence from Worldwide CEO Turnover

Recent research asserts that an essential feature of good corporate governance is strong investor protection, where investor protection is defined as the extent of the laws that protect investors' rights and the strength of the legal institutions that facilitate law enforcement. The purpose of this study is to test this assertion by investigating whether these measures of investor protection are associated with an important role of good corporate governance: identifying and terminating poorly performing CEOs. Our tests indicate that strong law enforcement institutions significantly improve the association between CEO turnover and poor performance, whereas extensive investor protection laws do not. In addition, we find that in countries with strong law enforcement, CEO turnover is more likely to be associated with poor stock returns when stock prices are more informative. Finding that strong law enforcement institutions are associated with improved CEO turnover‐performance sensitivity is consistent with good corporate governance requiring law enforcement institutions capable of protecting shareholders' property rights (i.e., protecting shareholders from expropriation by insiders). Finding that investor  protection laws are not associated with improved CEO turnover‐performance sensitivity is open to several explanations. For example, investor protection laws may not be as important as strong law enforcement in fostering good governance, the set of laws we examine may not be the set that are most important in promoting good governance, or measurement error in our surrogate for extensive investor protection laws may reduce the power of our test of this variable.     

Islamic and conventional portfolios optimization under investor sentiment states: Bayesian vs Markowitz portfolio analysis

This paper investigates the portfolio optimization under investor’s sentiment states of Hidden Markov model and over a different time horizon during the period 2004–2016. To compare the efficient portfolios of the Islamic and the conventional stock indexes, we have employed two approaches: the Bayesian and Markowitz mean-variance. Our findings reveal that the Bayesian efficient frontier of Islamic and conventional stock portfolios is affected by the investor’s sentiment state and the time horizon. Our findings also indicate that the investor’s sentiment regimes change the Islamic and the conventional optimal diversified portfolios.Moreover, the results show that the potential diversification benefits seem to be more important when using the Bayesian approach than when applying the Markowitz approach. This finding is valid for the bearish, depressed, bullish and calm states in Islamic stock markets. However, the diversification of potential portfolios is significant only for the bullish and the bubble states in the conventional financial markets.The findings of the study provided additional evidence for investors to exploit googling investor sentiment states to evaluate the portfolio performance and make an optimal portfolio allocation.     

Leading indicator variables and managerial incentives in a dynamic agency setting

This paper studies, in a dynamic agency setting, how incentives and contractual efficiency are affected by leading indicators of firms’ future financial performance. In our two-period model, a leading indicator variable provides a noisy forecast of the uncertain return from the manager’s long-term effort, and both contracting parties cannot refrain from renegotiating contract terms based on updated information. We find that the leading indicator can reduce the manager’s long-term effort incentive, as it allows the firm owner to capture more of the resulting return through renegotiated wages (i.e., the manager is held up). By reducing the uncertainty about future aggregate cash flows, the leading indicator also exacerbates the “ratchet” effect and discourages the manager’s short-term effort. In equilibrium, as the leading indicator becomes more accurate in forecasting future cash flows, the first-period contract attaches higher explicit weights to both the forward-looking leading indicator and backward-looking cash flow, and yet the manager may find it optimal to reduce both the short- and long-term efforts. We further show that with a more accurate leading indicator variable, the explicit incentive on the lagging cash flow may increase more than that on the leading indicator, and the equilibrium firm profit may decrease and diverge from the manager’s equilibrium efforts.     

The dynamics of portfolio management contracts

We consider the multiperiod relationship between a client anda portfolio manager and the resulting problem of motivatinga manager of unknown ability to acquire valuable information.We explore the contractual form and the optimal retention policyof the client and find that the optimal initial set of contractsfeatures a smaller performance based fee component paid to themanager than in a first-best contract, and the contract choiceelicits only partial information about the manager. As a result,ex post performance measurement is critical to future recontracting.In general, managers are retained only if the returns on theirportfolio exceed the benchmark by an appropriate amount.     

The 4% strategy revisited: a pre-commitment mean-variance optimal approach to wealth management

In contrast to single-period mean-variance (MV) portfolio allocation, multi-period MV optimal portfolio allocation can be modified slightly to be effectively a down-side risk measure. With this in mind, we consider multi-period MV optimal portfolio allocation in the presence of periodic withdrawals. The investment portfolio can be allocated between a risk-free investment and a risky asset, the price of which is assumed to follow a jump diffusion process. We consider two wealth management applications: optimal de-accumulation rates for a defined contribution pension plan and sustainable withdrawal rates for an endowment. Several numerical illustrations are provided, with some interesting implications. In the pension de-accumulation context, Bengen (1994)’s [J. Financial Planning, 1994, 7, 171–180], historical analysis indicated that a retiree could safely withdraw 4% of her initial retirement savings annually (in real terms), provided that her portfolio maintained an even balance between diversified equities and U.S. Treasury bonds. Our analysis does support 4% as a sustainable withdrawal rate in the pension de-accumulation context (and a somewhat lower rate for an endowment), but only if the investor follows an MV optimal portfolio allocation, not a fixed proportion strategy. Compared with a constant proportion strategy, the MV optimal policy achieves the same expected wealth at the end of the investment horizon, while significantly reducing the standard deviation of wealth and the probability of shortfall. We also explore the effects of suppressing jumps so as to have a pure diffusion process, but assuming a correspondingly larger volatility for the latter process. Surprisingly, it turns out that the MV optimal strategy is more effective when there are large downward jumps compared to having a high volatility diffusion process. Finally, tests based on historical data demonstrate that the MV optimal policy is quite robust to uncertainty about parameter estimates.     

Investment Horizon and Repo in the Over‐the‐Counter Market

This paper presents a three‐period model featuring a short‐term investor in the over‐the‐counter bond market. A short‐term investor stores cash because of a need to pay cash at some future date. If a short‐term investor buys bonds, then a deadline for retrieving cash lowers the resale price of bonds for the investor through bilateral bargaining in the bond market. Ex‐ante, this hold‐up problem explains the use of a repo by a short‐term investor, the existence of a haircut, and the vulnerability of a repo market to counterparty risk. This result holds without any uncertainty about bond returns or asymmetric information.     

Taste,information, and asset prices: implications for the valuation of CSR

Firms often undertake activities that do not necessarily increase cash flows (e.g., costly investments in corporate social responsibility or CSR), and some investors value these non cash activities (i.e., they have a “taste” for these activities). We develop a model to capture this phenomenon and focus on the asset-pricing implications of differences in investors’ tastes for firms’ activities and outputs. Our model shows that, first, investor taste differences provide a basis for investor clientele effects that are endogenously determined by the shares demanded by different types of investors. Second, because the market must clear at one price, investors’ demands are influenced by all dimensions of firm output even if their preferences are only over some dimensions. Third, information releases cause trading volume, even when all investors have the same information. Fourth, investor taste provides a rationale for corporate spin-offs that help firms better target their shareholder bases. Finally, individual social responsibility can lead to corporate social responsibility when managers care about stock price because price reacts to investments in CSR activities.     

Risk aversion and the dynamics of optimal liquidation strategies in illiquid markets

We consider the infinite-horizon optimal portfolio liquidation problem for a von Neumann–Morgenstern investor in the liquidity model of Almgren (Appl. Math. Finance 10:1–18, 2003). Using a stochastic control approach, we characterize the value function and the optimal strategy as classical solutions of nonlinear parabolic partial differential equations. We furthermore analyze the sensitivities of the value function and the optimal strategy with respect to the various model parameters. In particular, we find that the optimal strategy is aggressive or passive in-the-money, respectively, if and only if the utility function displays increasing or decreasing risk aversion. Surprisingly, only few further monotonicity relations exist with respect to the other parameters. We point out in particular that the speed by which the remaining asset position is sold can be decreasing in the size of the position but increasing in the liquidity price impact.      

Small caps in international equity portfolios: the effects of variance risk

We show that predictable covariances between means and variances of stock returns may have a first order effect on portfolio composition. In an international asset menu that includes both European and North American small capitalization equity indices, we find that a three-state, heteroskedastic regime switching VAR model is required to provide a good fit to weekly return data and to accurately predict the dynamics in the joint density of returns. As a result of the non-linear dynamic features revealed by the data, small cap portfolios become riskier in bear markets, i.e., display negative co-skewness with other stock indices. Because of this property, a power utility investor ought to hold a well-diversified portfolio, despite the high risk premium and Sharpe ratios offered by small capitalization stocks. On the contrary, small caps command large optimal weights when the investor ignores variance risk, by incorrectly assuming joint normality of returns.      

All Guts,No Glory: Trading and Diversification among Online Investors

I explore cross‐sectional portfolio performance in a sample containing 324,736 transactions conducted by 16,831 Swedish investors at an Internet discount brokerage firm during the period May 1999 to March 2002. On average, investors hold undiversified portfolios, show a strong preference for risk, and trade aggressively. I measure performance using a panel data model, and explain the cross‐sectional variation using investors' turnover, portfolio size and degree of diversification. I find that turnover is harmful to performance due to fees, and is therefore more predominant among investors with small portfolios. I argue that the degree of diversification is a proxy for investor skill, and it has a separate and distinct positive effect on performance. Investors underperform the market by about 8.5% per year on average, of which half can be attributed to trading costs.     

Optimal internal control regulation: Standards,penalties, and leniency in enforcement

To protect investors, regulators increasingly rely on regulating firms’ internal controls over financial reporting, but they punish noncompliance only if an internal control weakness enabled accounting manipulation. In other words, enforcement is manipulation-contingent. We develop an economic model with a manager who sequentially chooses internal control quality and manipulative effort, and a welfare-maximizing regulator who determines an internal control standard, the penalty size for internal control weaknesses, and when to invoke such a penalty. Internal control regulation under manipulation-contingent enforcement not only provides incentives to invest in internal controls, but also improves manipulation deterrence when there are internal control weaknesses. The optimal regulation takes advantage of this additional deterrence effect by using a very strict internal control standard and an intermediate penalty that is only levied in the event of accounting manipulation. Overall, we rationalize why the commitment to lenient enforcement of internal control regulation is optimal.     

Presidential Address: Sustainable Finance and ESG Issues—Value versus Values

In this address, I discuss differences across investor and manager motivations for considering sustainable finance—value versus values motivations—and how these differences contribute to misunderstandings about environmental, social, and governance investment approaches. The finance research community has the ability and responsibility to help clear up these misunderstandings through additional research, which I suggest.