Bruce A. Costa

Risk-adjusted returns of socially responsible mutual funds: how do they stack up?

This article establishes index suitability on a risk-adjusted basis for socially responsible investment (SRI) mutual funds that specify small-to-mid- or large-capitalization indexes as their performance benchmarks. Using a four-factor model, the authors calculate factor loadings for SRI mutual funds and their specified benchmark index and measure deviations with respect to the risk factors in the model using the authors’ F-test methodology. The results indicate that SRI mutual fund managers may not be selecting benchmark indexes that are true reflections of the risk characteristics associated with the funds’ investment activities, thus overstating or understating risk-adjusted performance. By considering alternative approaches to abnormal performance measurement, researchers can significantly change their conclusions regarding the economic contribution of SRI mutual fund managers. By applying similar methodologies, market participants may be able to more accurately assess risk-adjusted SRI fund manager performance and SRI-fund-specific risk characteristics relative to the benchmark index selected by the manager or other appropriate benchmark indexes. As a result, sustainable investors and funds managers will be more likely to accurately assess risk-adjusted performance relative to an appropriate benchmark.

Out of the money or striking it rich? Evidence on the risk-adjusted return performance of options-based equity funds versus the S&P 500 and other benchmark alternatives

This article examines the risk–return characteristics of 29 options-based equity funds, their self-specified S&P 500 total return benchmark index, and a suite of alternative options-based strategy indexes in the United States from 2010 to 2015. Using a multifactor risk-adjustment model, the authors attempt to establish whether fund managers are choosing suitable benchmark indexes in terms of their funds’ investment style/strategy and risk profile. Our findings indicate that options-based fund managers are unable to outperform both before and after adjusting for risk and after consideration of management/transaction costs. They also show that the S&P 500 total return index may not be the most appropriate benchmark for options-based funds. For instance, options-based fund managers appear to be selecting broad-based equity benchmark indexes that do not adequately reflect the risk–return characteristics associated with the funds’ investment strategy/options trading activities, thus understating their risk-adjusted performance. By considering alternative approaches to abnormal performance measurement, fund managers, investors, market regulators, and academics can significantly change the conclusions they draw regarding the economic contribution of options-based fund managers. Furthermore, market participants can more accurately assess risk-adjusted options-based performance and fund-specific risk characteristics relative to the benchmark index chosen by the manager or to alternative benchmark indexes.

Loan prepayment and default analyses of a US regional community development financial institution

Community development financial institutions (CDFIs) are instrumental lending organizations responsible for a large part of regional new venture creation. CDFIs provide financial services, loans, training, and technical assistance services to individual entrepreneurs and small businesses that are often turned away by conventional financial lending institutions. In most cases borrower and/or loan specific characteristics are outside of generally acceptable ranges. Loan prepayment risk and repayment risk are two financial hazards that CDFI managers must effectively control. We examine historical runoff rates (prepayment risk) and default rates (repayment risk) of the loan portfolio of a mid-sized regional CDFI. Specifically, we examine how loan prepayment risk is influenced by loan term at origination. We find that longer-term loans are paid back relatively more quickly. We also gather data from repaid and defaulted loans and identify borrower and loan specific characteristics that significantly influence default rates. These include measures such as borrower FICO score, household income, prior bankruptcy, the collateral coverage ratio, and whether the loan is gap or joint bank-partnered financing.

European Indexes and the Four-Factor Model

Using a four-factor model and newly available European risk factors, we generate alphas and factor loadings for a set of European stock market indexes. Indexes are essentially unmanaged portfolios, therefore their alphas should be insignificant. Since unmanaged indexes do not follow any particular momentum strategy, factor loadings for the momentum factor should also be insignificant. Earlier academic research shows that many U.S. indexes have significant alphas and factor loadings. In this study we report significant alphas and many significant factor loadings on the momentum factor for European indexes. We also find that the four-factor model with European data has lower explanatory power, and the factor loadings for European indexes differ dramatically from the factor loadings for U.S. indexes. Our findings indicate that a European fund’s alpha and risk factor loadings must be systematically adjusted relative to its benchmark index.