Felix Goltz

Diversifying the Diversifiers and Tracking the Tracking Error:Outperforming Cap-Weighted Indices with Limited Risk of Underperformance

A number of quantitative or fundamental weighting schemes have been shown to produce robust outperformance with respect to standard cap-weighted equity indices over long time periods. Over periods ranging from a few months to a few years, however, such alternative weighting schemes can generate substantial downside risk relative to cap-weighted indices, which would be a source of concern for most investment managers or chief investment officers. In this article, the authors focus on two reasonable proxies for well-diversified, efficient frontier portfolios, namely, the maximum Sharpe ratio (MSR) portfolio and the global minimum volatility (GMV) portfolio. They address the question of how to use these building blocks to design an improved equity benchmark while satisfying target levels of average and extreme tracking error with respect to cap-weighted indices. The authors find that robust proxies for the GMV portfolio provide defensive exposure to equity that does well in adverse market conditions, while robust proxies for MSR portfolios provide greater access to the upside of equity markets. Because the relative performance of these two diversification approaches depends on market conditions, they expect a combination of both approaches to lead to a smoother conditional performance and higher probability of outperformance of the cap-weighted index, an intuition that is confirmed in empirical tests. Empirical analysis also suggests that “diversifying the diversifiers” still leads to high levels of relative downside risk, in particular when the performance of cap-weighted indices is unusually strong. In this context, the authors introduce an explicit relative risk control mechanism designed to reduce the consequences of severe short-term underperformance with respect to the cap-weighted index and confirm through out-of-sample empirical tests that “tracking the tracking error” would allow investors to achieve better access to outperformance per unit of extreme relative risk taken. Overall, the results reported in this article suggest that it is possible to achieve robust outperformance versus cap-weighted indices by diversifying model risk and by controlling relative risk compared to the cap-weighted indices.

Choose Your Betas: Benchmarking AlternativeEquity Index Strategies

This article clarifies that methodological choices can be made independently for two steps in the construction of alternative equity index strategies: the constituent selection and choice of a diversification-based weighting scheme. By flexibly combining the different possible choices for these steps, the authors create a large variety of strategies and test their performance and risk results. The results suggest that diversification approaches may be a superior alternative, or at least a very important complement, to pure stock selection approaches when it comes to reaching a risk–return objective. Moreover, even though some argue that the risk and performance of diversification-based weighting schemes are solely driven by factor tilts, the authors show how straightforward it is to correct such tilts through the selection of stocks with appropriate characteristics while maintaining the improvement in achieving a risk–return objective that is due to the respective diversification approaches.

Does Finance Theory Make the Case forCapitalization-Weighted Indexing?

Indexers often evoke financial theory to claim that cap-weighted stock market indices are good investment choices. This article analyzes the existing literature to see whether the recommendation of holding cap-weighted indices is indeed grounded in financial theory. Although the capital asset pricing model (CAPM) theory does lead to a recommendation to hold the market portfolio, the model’s practical relevance is limited by its unrealistic assumptions. If we relax those assumptions, theory does not predict that the market portfolio is efficient. In addition, the CAPM also fails in empirical tests, showing that it is not the true asset pricing model. Even if the CAPM were the true model, and the market portfolio was efficient, a stock market index is a very poor proxy for the market portfolio, because it includes only a fraction of the economy-wide wealth. Thus, from a theoretical perspective, cap-weighted stock market indices seem to have no particular appeal.

Smart Beta 2.0

Alternative equity indexes are likely to outperform traditional cap-weighted indexes over the long term, research results show that such smart beta strategies are exposed to several types of risk, including systematic risk (e.g., factor tilts), specific risk (related to the assumptions and inputs of a strategy), and relative risk (i.e., the risk of potentially severe underperformance) compared to cap-weighted indexes that can last for extended periods of time. Smart beta can play an important role in institutional investors’ allocations, but only at the price of implementing a genuine risk-management process. This article discusses a new approach to smart beta investing (Smart Beta 2.0) that not only deviates from the default solution of using market capitalization as the sole criterion for weighting and constituent selection, but also analyzes and manages the risks of such deviations.

Practitioner Portfolio Construction and Performance Measurement: Evidence from Europe

Responses to a survey of investment management practitioners in Europe show that most practitioners are aware of key academic concepts in portfolio construction. But they still resort to ad hoc heuristics when they construct portfolios. Consideration of risk–return matters is less common in performance evaluation than in portfolio construction. An economically significant firm-size effect plays a role in the use of sophisticated (versus unsophisticated) portfolio construction but not in performance measurement. We surveyed 229 investment management practitioners in Europe for information on their methods of constructing portfolios and measuring performance. Our purpose was to assess the impact of academic finance research on investment industry practices. The responses show that most practitioners are well aware of key academic concepts in portfolio construction and frequently consider risk–return trade-offs. They often resort to ad hoc heuristics, however, when they construct their portfolios. For example, investment managers are aware of the importance of extreme risks, but the instruments they use to measure them are inadequate. To deal with estimation risk, practitioners use arbitrary weight restrictions rather than portfolio construction methods that explicitly address estimation risk. Responses relating to measurement of ex post performance show that risk–return considerations are less common in this area than in portfolio construction. Extreme risks are hardly taken into account in performance measurement, and adjustments for risk are crude. In general, practitioners use both sophisticated and unsophisticated techniques. When we analyzed the response patterns to determine what drives the differences in sophistication, we found an economically significant firm-size effect for portfolio construction. That is, response patterns from large institutions are markedly different from those from small institutions; small firms tend to use less sophisticated tools than large firms use. For performance measurement, we found a firm-size effect, but it is less pronounced than it is for portfolio construction. In view of the current failure of the industry to adopt sophisticated measures, one is compelled to wonder why investors do not demand better risk assessment in portfolio construction and performance evaluation. Some would argue that greater financial literacy of investors is key in improving matters; others would call for external regulators to mandate the use of appropriate risk measures. Although the evidence reported in this article does not allow us to take a stance on that issue, we believe that ensuring a sufficient transfer of knowledge about portfolio and risk management concepts from research results to practice is a necessary condition for sound investment processes in the industry.

The Performance of Characteristics-Based Indices

This paper analyses a set of characteristics-based indices that, it has been argued, outperform market cap-weighted indices. We analyse the performance of an exhaustive list of these indices and show that i) the outperformance over value-weighted indices may be negative over long time periods, and ii) there is no significant outperformance over equal-weighted indices. An analysis of the style and sector exposures of characteristics-based indices reveals a significant value tilt. When this tilt is properly adjusted for, the abnormal returns of these indices decrease considerably. Moreover, it is straightforward to construct portfolios with higher Sharpe ratios than characteristics-based indices through factor or sector tilts.

Risk Control Through Dynamic Core-Satellite Portfolios of ETFs: Applications to Absolute Return Funds and Tactical Asset Allocation

Asset managers generally focus on diversification or returns prediction to create added value in portfolios of exchange-traded funds (ETFs). This article draws on dynamic risk-budgeting techniques to emphasize the importance of risk management when decisions to allocate to ETFs are made. Absolute return funds, in which the low-risk profiles of government-bond ETFs and conditional allocations to riskier equity ETFs can be combined to obtain portfolios that—beyond the natural diversification between stocks and bonds—provide upside potential while protecting investors from downside risk, are an initial application of ETFs to allocation decisions. A second application is risk control of tactical strategies. Dynamic risk budgeting is used to provide risk-controlled exposure—taking the manager’s forecasts as a given—to an asset class. This article shows that, even if the manager is an excellent forecaster, this approach yields intra-horizon and end-of-horizon risk-control benefits considerably greater than those of standard tactical asset allocation.

Towards Smart Equity Factor Indices: Harvesting Risk Premia without Taking Unrewarded Risks

This article argues that current smart-beta investment approaches provide only a partial answer to the main shortcomings of capitalization-weighted indices and develops a new approach to equity investing, which the authors refer to as smart-factor investing. The authors then provide an assessment of the benefits of simultaneously addressing the two main problems of cap-weighted indices—their undesirable factor exposures and their heavy concentration—by constructing factor indices that explicitly seek exposures to rewarded risk factors, while diversifying away unrewarded risks. The results suggest that such smart-factor indices lead to considerable improvements in risk-adjusted performance. For long-term U.S. data, smart-factor indices for a range of different factor tilts consistently outperform cap-weighted, factor-tilted indices. Compared with the broad cap-weighted index, smart-factor indices roughly double the risk-adjusted return (Sharpe ratio). Outperformance of such indices persists at levels ranging from 2.92% to 4.46% annually, even when assuming unrealistically high transaction costs. Moreover, by providing explicit tilts to consensual factors, such indices improve upon many current smart-beta offerings where, more often than not, factor tilts exist as unintended consequences of ad hoc methodologies.

Empirical Properties of Straddle Returns

An at-the-money (ATM) straddle, i.e., going long an ATM call and an ATM put with the same maturity, is generally thought of as a volatility trade. It is essentially delta-neutral, but a large price move in either direction or an increase in implied volatility will produce a profit. A delta-neutral straddle position also has zero beta, so under the CAPMit should earn the riskless rate. Research has shown, however, that straddles with stock index options tend to lose money, which may be attributed to a volatility risk premium: it is the cost of hedging against a rise in volatility. If buying straddles produces losses, writing straddles should yield excess profits. An important aspect of the trade is that the delta (and beta) of the position change when the underlying index moves away from its initial level, and rebalancing is necessary if one wishes to maintain neutrality. In this article, Goltz and Lai examine the performance of buying and holding one-month straddles on the DAX index, with and without rebalancing, and find negative returns on average. If investors are entering the trade as a volatility hedge, one might expect the return to vary with other measures on volatility risk and potential hedging demand. They find that a widening credit spread on corporate bonds relative to government bonds, greater stock market turnover, and higher actual volatility all are related to straddle returns. But in considering what position an investor with constant relative risk aversion would take in straddles as part of an optimal portfolio including the underlying stock index and the riskless asset, they show that for risk aversion over a broad range, the optimal position would be to short straddles. That is, the “risk premium” in the market is too big to be consistent with utility maximization by investors with a reasonable level of risk aversion. The effect is most important for daily rebalancing, but that requires bearing heavy transaction costs, to the point that the potential improvement in utility would be largely wiped out in trying to capture it in the market.

Hedge Fund Transparency: Where Do We Stand?

Unlike mutual funds, hedge funds are reluctant to provide detailed information on their investment portfolios. Since hedge funds may use niche investment strategies in narrow market segments, fund managers portend that thorough disclosure of their portfolio holdings—which are important to assessing future returns—would crowd out their trades, thus decreasing opportunities to generate outsized returns. However, incomplete disclosure can have some undesirable side effects. It might encourage hedge fund managers to take positions that are riskier than provided for by the manager’s mandate. Investors even risk fraudulent behavior, since the action of hedge fund management may be detected only when a fund has failed.This article presents the results of a comprehensive survey of hedge fund managers and investors on current hedge fund reporting practices. The authors find that the quality of hedge fund reporting is considered an important investment criterion. In analyzing the spectrum of opinions, the authors identify critical points of conflict between investors and managers.They find that investors are especially dissatisfied with the quality of information on liquidity and operational risk exposure. The survey also reveals that inappropriate performance measures are prevalent.