Income hedging and portfolio decisions

We examine whether the decision to participate in the stock market and other related portfolio decisions are influenced by income hedging motives. Economic theory predicts that the market participation propensity should increase as the correlation between income growth and stock market returns decreases. Surprisingly, empirical studies find limited support for the income hedging motive. Using a rich, unique Dutch data set and the National Longitudinal Survey of the Youth (NLSY) from the United States, we show that when the income-return correlation is low, individuals exhibit a greater propensity to participate in the market and allocate a larger proportion of their wealth to risky assets. Even when the income risk is high, individuals exhibit a higher propensity to participate in the market when the hedging potential is high. These findings suggest that income hedging is an important determinant of stock market participation and asset allocation decisions.     

Active portfolio management with benchmarking: A frontier based on alpha

Active portfolio management often involves the objective of selecting a portfolio with minimum tracking error variance (TEV) for some expected gain in return over a benchmark. However, Roll (1992) shows that such portfolios are generally suboptimal because they do not belong to the mean-variance frontier and are thus overly risky. Our paper proposes an appealing method to lessen this suboptimality that involves the objective of selecting a portfolio from the set of portfolios that have minimum TEV for various levels of ex-ante alpha, which we refer to as the alpha-TEV frontier. Since practitioners commonly use ex-post alpha to assess the performance of managers, the use of this frontier aligns the objectives of managers with how their performance is evaluated. Furthermore, sensible choices of ex-ante alpha lead to the selection of portfolios that are less risky (in variance terms) than the portfolios that active managers would otherwise select.     

Access to information and international portfolio allocation

We examine whether foreign equity holdings of portfolio investors depend on the level of information accessibility between the investors’ home and host countries. Using a comprehensive data set, alternative measures of information accessibility and robust analytical techniques, we show that differences in access to cross-country information significantly influence investors’ portfolio allocation decisions. Furthermore, the results suggest that for a given level of access to information, investors prefer to invest more in countries with a higher quality of legal/macro-institutions. Finally, the findings also confirm that the implications of information accessibility are more pronounced when markets are turbulent.     

Trend-following trading strategies in commodity futures: A re-examination

This paper examines the performance of trend-following trading strategies in commodity futures markets using a monthly dataset spanning 48 years and 28 markets. We find that all parameterizations of the dual moving average crossover and channel strategies that we implement yield positive mean excess returns net of transactions costs in at least 22 of the 28 markets. When we pool our results across markets, we show that all of the trading rules earn hugely significant positive returns that prevail over most subperiods of the data as well. These results are robust with respect to the set of commodities the trading rules are implemented with, distributional assumptions, data-mining adjustments and transactions costs, and help resolve divergent evidence in the extant literature regarding the performance of momentum and pure trend-following strategies that is otherwise difficult to explain.     

Global equity fund performance, portfolio concentration, and the fundamental law of active management

This paper investigates the relation between portfolio concentration and the performance of global equity funds. Concentrated funds with higher levels of tracking error display better performance than their more broadly diversified counterparts. We show that the observed relation between portfolio concentration and performance is mostly driven by the breadth of the underlying fund strategies; not just by fund managers’ willingness to take big bets. Our results indicate that when investors strive to select the best-performing funds, they should not only consider fund managers’ tracking-error levels. More important is that they take into account the extent to which fund managers carefully allocate their risk budget across multiple investment strategies and have concentrated holdings in multiple market segments simultaneously.     

Real option analysis of a technology portfolio

This article contributes to methodology of real options analysis of investments in capital intensive process industries, where relatively homogenous outputs are produced using commonly known production technologies. In addition to capacity expansion, the method can be used for analysis of mergers and acquisitions. Valuation of the real option is based on bid price; i.e., the maximum price the firm is willing to pay. To find such a price, stochastic optimization with an expected utility criterion is used to determine investments in product specific technologies as well as in publicly traded financial instruments (the competing investments). To operationalize the valuation principle, we develop a double binary tree employing Kalman filter for scenario generation. For exponential utility, valuation is carried out by dynamic programming. We extend known methods to allow interdependence of the mill cash flow and return on competing financial investments. For forest industries, we provide an illustration, where the underlying price process in our Kalman filter application is a vector error correction model.     

Size matters: Optimal calibration of shrinkage estimators for portfolio selection

We carry out a comprehensive investigation of shrinkage estimators for asset allocation, and we find that size matters—the shrinkage intensity plays a significant role in the performance of the resulting estimated optimal portfolios. We study both portfolios computed from shrinkage estimators of the moments of asset returns (shrinkage moments), as well as shrinkage portfolios obtained by shrinking the portfolio weights directly. We make several contributions in this field. First, we propose two novel calibration criteria for the vector of means and the inverse covariance matrix. Second, for the covariance matrix we propose a novel calibration criterion that takes the condition number optimally into account. Third, for shrinkage portfolios we study two novel calibration criteria. Fourth, we propose a simple multivariate smoothed bootstrap approach to construct the optimal shrinkage intensity. Finally, we carry out an extensive out-of-sample analysis with simulated and empirical datasets, and we characterize the performance of the different shrinkage estimators for portfolio selection.     

Efficiency in the international insurance industry: A cross-country comparison

The purpose of this paper is to provide new empirical evidence on frontier efficiency measurement in the international insurance industry, a topic of great interest in the academic literature during the last several years. A broad efficiency comparison of 6462 insurers from 36 countries is conducted. Different methodologies, countries, organizational forms, and company sizes are compared, considering life and non-life insurers. We find a steady technical and cost efficiency growth in international insurance markets from 2002 to 2006, with large differences across countries. Denmark and Japan have the highest average efficiency, whereas the Philippines is the least efficient. Regarding organizational form, the results are not consistent with the expense preference hypothesis, which claims that mutuals should be less efficient than stocks due to higher agency costs. Only minor variations are found when comparing different frontier efficiency methodologies (data envelopment analysis, stochastic frontier analysis).     

Dynamic hedge fund portfolio construction: A semi-parametric approach

In this article, we evaluate alternative optimization frameworks for constructing portfolios of hedge funds. We compare the standard mean–variance optimization model with models based on CVaR, CDaR and Omega, for both conservative and aggressive hedge fund investment strategies. In order to implement the CVaR, CDaR and Omega optimization models, we propose a semi-parametric methodology, which is based on extreme value theory, copula and Monte Carlo simulation. We compare the semi-parametric approach with the standard, non-parametric approach, used to compute CVaR, CDaR and Omega, and the benchmark parametric approach, based on both static and dynamic mean–variance optimization. We report two main findings. The first is that the CVaR, CDaR and Omega models offer a significant improvement in terms of risk-adjusted portfolio performance over the parametric mean–variance model. The second is that semi-parametric estimation of the CVaR, CDaR and Omega models offers a very substantial improvement over non-parametric estimation. Our results are robust to the choice of target return, risk limit and estimation sample size.     

Long-horizon event studies and event firm portfolio weights: Evidence from U.K. rights issues re-visited

Empirical results, in long-horizon event studies, are sensitive to whether equal- or value-weighting schemes are used to form event firm portfolios. In this paper we propose, as a first step, an evaluation of the economic value to investing in an equal-weighted and a value-weighted event firm portfolio prior to the event study. Using tests for mean-variance spanning we find in our data a significant improvement in an investor's investment opportunity set to investing in an equal-weighted portfolio. We then re-visit the long-run post-offer performance for rights issuers in the U.K. where we find, as in other studies, differences in both the magnitude and statistical significance of abnormal performance for value-weighted and equal-weighted event firm portfolios. We then use the results from our first step to provide an economic rationale for interpreting our results. A general conclusion we draw is that it may be useful to first ascertain, in long-horizon event studies, the economic value of portfolio weighting schemes as this can then provide some guidance to the use of a specific portfolio weighting scheme and thereby to interpretation of often conflicting results.     

Health status and portfolio choice: Causality or heterogeneity?

This paper explores the role of unobserved individual characteristics in the health-assets and health-portfolio correlations. We apply various econometrics models to a unique longitudinal dataset with rich information that allows for the exploitation of four different health indices. Our findings show strong cross-sectional correlations between health and both financial and non-financial assets, but these correlations seem to be mainly driven by heterogeneity as the correlations largely disappear in the fixed-effects model. Adverse health shocks, however, are found to motivate a safer portfolio choice even after individual fixed-effects are controlled for – a result consistent with the prediction made by the background risk theory. Our findings suggest that health shocks shift investment from risky assets toward other financial assets, but keep the total financial assets unchanged.     

Price trends and patterns in technical analysis: A theoretical and empirical examination

While many technical trading rules are based upon patterns in asset prices, we lack convincing explanations of how and why these patterns arise, and why trading rules based on technical analysis are profitable. This paper provides a model that explains the success of certain trading rules that are based on patterns in past prices. We point to the importance of confirmation bias, which has been shown to play a key role in other types of decision making. Traders who acquire information and trade on the basis of that information tend to bias their interpretation of subsequent information in the direction of their original view. This produces autocorrelations and patterns of price movement that can predict future prices, such as the “head-and-shoulders” and “double-top” patterns. The model also predicts that sequential price jumps for a particular stock will be positively autocorrelated. We test this prediction and find that jumps exhibit statistically and economically significant positive autocorrelations.     

Country-specific equity market characteristics and foreign equity portfolio allocation

Do country-specific equity market characteristics explain variations in foreign equity portfolio allocation? We study this question using comprehensive foreign equity portfolio holdings data and different measures of country-specific equity market factors for 36 host countries. Employing panel data econometric estimations, our investigation shows that foreign investors prefer to invest more in larger and highly visible developed markets which are more liquid, exhibit a higher degree of market efficiency and have lower trading costs. The findings imply that by improving the preconditions necessary for well-functioning capital markets, policymakers should be able to attract higher levels of foreign equity portfolio investments.     

Noise, equity prices, and hedging: A new approach

The existence of noise trading in equity markets has possible economic implications for arbitrage, and asset pricing. In terms of pricing, noise trading can lead to excess volatility which has been shown to influence the value of options and futures. Furthermore, option research shows that modeling volatility leads to improved hedging performance. To this end, we derive a general hedging model for equity index futures in the presence of noise trading. Our analysis shows how the level and dynamics of noise trading should influence a hedger's behavior. Finally, we empirically test our model using the NASDAQ-100 index futures and FTSE 100 index futures over the period of January 1998 to May 2003.     

Combining equilibrium,resampling, and analyst’s views in portfolio optimization

This paper proposes the use of a portfolio optimization methodology which combines features of equilibrium models and investor’s views as in Black and Litterman (1992), and also deals with estimation risk as in Michaud (1998). In this way, our combined methodology is able to meet the needs of practitioners for stable and diversified portfolio allocations, while it is theoretically grounded on an equilibrium framework. We empirically test the methodology using a comprehensive sample of developed countries fixed income and equity indices, as well as sub-samples stratified by geographical region, time period, asset class and risk level. In general, our proposed combined methodology generates very competitive portfolios when compared to other methodologies, considering three evaluation dimensions: financial efficiency, diversification, and allocation stability. By generating financially efficient, stable, and diversified portfolio allocations, our methodology is suitable for long-term investors such as Central Banks and Sovereign Wealth Funds.     

Cross-section of option returns and volatility

We study the cross-section of stock option returns by sorting stocks on the difference between historical realized volatility and at-the-money implied volatility. We find that a zero-cost trading strategy that is long (short) in the portfolio with a large positive (negative) difference between these two volatility measures produces an economically and statistically significant average monthly return. The results are robust to different market conditions, to stock risks-characteristics, to various industry groupings, to option liquidity characteristics, and are not explained by usual risk factor models.     

The determinants of household risky asset holdings: Australian evidence on background risk and other factors

We study the portfolio allocation decisions of Australian households using the relatively new Household, Income and Labour Dynamics in Australia (HILDA) Survey. We focus on household allocations to risky financial assets. Our empirical analysis considers a range of hypothesised determinants of these allocations. We find background risk factors posed by labor income uncertainty and health risk are important. Credit constraints and observed risk preferences play the expected role. A positive age gradient is identified for risky asset holdings and home-ownership is associated with greater risky asset holdings. A unifying theme for many of our empirical findings is the important role played by financial awareness and knowledge in determining risky asset holdings. Many non-stockholding households appear to lack the experience and financial literacy that might enable them to benefit from direct investment in stocks.     

Restricting consumer credit access: Household survey evidence on effects around the Oregon rate cap

Many policymakers and some theories hold that restricting access to expensive credit helps consumers by preventing overborrowing. I examine some effects of restricting access, using household panel survey data on payday loan users collected around the introduction of binding restrictions on payday loan terms in Oregon. Borrowing fell in Oregon relative to Washington, with former payday borrowers shifting partially into plausibly inferior substitutes: bank overdrafts and late bill payment. Additional evidence suggests that restricting access caused deterioration in the overall financial condition of Oregon households. Overall the results are consistent with restricted access harming, not helping, consumers on average.     

Asset allocation and age effects in retirement savings choices

We examine the asset allocation decisions of members of three large Australian retirement savings funds. Superannuation Guarantee legislation in 1992 made Australian employees compulsory investors by requiring employers to contribute a fixed proportion of earnings to a superannuation fund on behalf of employees. A majority of these employees can choose an investment strategy for these contributions. We examine how actual investment strategy and asset allocation choices of members change with age in view of the conventional wisdom that individuals allocate less to risky assets as they age and investments theory which provides conflicting advice on the issue.