Jenke ter Horst

Evaluating Style Analysis

In this paper we evaluate applications of (return based) style analysis. The portfolio and positivity constraints imposed by style analysis are useful in constructing mimicking portfolios without short positions. Such mimicking portfolios can be used e.g. to construct efficient portfolios of mutual funds with desired factor loadings if the factor loadings in the underlying factor model are positively weighted portfolios. Under these conditions style analysis may also be used to determine a benchmark portfolio for performance measurement. Attribution of the returns on portfolios of which the actual composition is unobserved to specific asset classes on the basis of return based style analysis is attractive if moreover there are no additional cross exposures between the asset classes and if fund managers hold securities that on average have a beta of one relative to their own asset class. If such restrictions are not met, and in particular if the factor loadings do not generate a positively weighted portfolio, the restrictions inherent in return based style analysis distort the outcomes of standard regression approaches rather than that the analysis is improved. The size of the distortions is illustrated by considering empirical results on style analysis of US mutual funds.

The Rise and Demise of the Convertible Arbitrage Strategy

This article analyzes convertible arbitrage, one of the most successful hedge fund strategies. The aim of the strategy is to exploit underpricing of convertible bonds by taking a long position in a convertible and a short position in the underlying asset. The authors find that convertible bonds are underpriced at the issuance dates; at the same time, short sales of underlying equity increase significantly. Both effects are stronger and more persistent for equity-like convertibles than for debtlike convertibles. Furthermore, short-sale pressures negatively affect stock returns around the announcement and issuance dates of convertibles. All these factors have likely contributed to the shift toward issuing more debtlike convertibles in recent years, which, in turn, has substantially lowered the returns from convertible arbitrage. This article analyzes convertible arbitrage, one of the most successful hedge fund strategies of the last two decades. The aim of the strategy is to exploit the underpricing of convertible bonds by taking a long position in a convertible and a short position in the underlying asset. Convertible arbitrage trades currently represent more than half of the secondary market trades in convertible securities, with hedge funds as the most important player in that market. Moreover, 70–75 percent of primary convertible bond issues are bought by hedge funds. The Convertible Arbitrage Index, which is tracked by Credit Suisse/Tremont, shows that annual returns on convertible arbitrage were, for the most part, above 15 percent in the 1990s and up to 2001. In recent years, however, convertible arbitrage performance has deteriorated. The popular press has proposed various explanations for this decline, including stable equity markets, rising interest rates, withdrawals from funds, increased competition in the hedge fund industry, and lower volatilities in the main capital markets. We demonstrate that the structure of the convertible bond (debt- or equity-like) is an important additional explanation to be considered because the structure affects (1) the degree of underpricing, (2) the “hedging” position in the underlying stock, and (3) the excess returns on the issuer’s equity. We used a sample of convertible bonds in the Canadian market issued between 1998 and 2007. We used the delta measure to make a distinction between debtlike and equity-like convertible bond issues. Using a valuation model, we found the equity-like issues (Δ ≥ 0.50) to be about 27 percent underpriced and the debtlike issues (Δ < 0.50) to be about 7 percent underpriced at the issuance date. Although the underpricing declines somewhat immediately after the issuance, it persists over a long period. Using information on aggregated biweekly short positions on the Toronto Stock Exchange, we examined changes in short positions (interest) around the issuance dates of convertible bonds. We observed a significant increase in the short positions (short interest) of the underlying stocks after the announcement. In the 40 trading days following the announcement, the increases in relative short positions for equity-like issuers are about 15 percentage points higher than those for debtlike issuers. These increased aggregated short positions remain stable for a longer period after the issuance of the convertible. Finally, we show that increases in the short positions negatively affect the excess stock returns of the issuers, particularly during the period between the announcement and the issuance of the convertible. The additional downward pressure exerted on excess returns by the increase in short interest has consequences for both shareholders and debtholders of the issuing company. Clearly, it negatively affects shareholders by destroying shareholder value. Moreover, it also affects debtholders because a lower value of a company’s collateral (proxied by the market value) generally leads to an increase in the credit spread and thus a lower value of current (outstanding) debt claims. To cap these losses in shareholder value, issuers apparently switched to issuing fewer underpriced debtlike convertible bonds, packaged the convertible bond issues together with share repurchases (called a “Happy Meal”), and/or moved out of the convertible bond market altogether. We believe that this shift provides an additional explanation for the lower returns on the convertible arbitrage strategy in recent years.

An Empirical Analysis of the Pricing of Bank Issued Options versus Options Exchange Options

Since 1998, large investment banks have become active as issuers of options, generally referred to as call warrants or bank-issued options. This has led to an interesting situation in the Netherlands, where simultaneously call warrants are traded on the stock exchange, and long-term call options are traded on the options exchange. Both entitle their holders to buy shares of common stock. We start with a direct comparison between call warrants and call options, written on the same stock and with the same exercise price, but where the call option has a longer time to maturity. In 13 out of 16 cases we find that the call warrants are priced higher, which is a clear violation of basic option pricing rules. In the second part of the analysis we use option pricing models to compare the pricing of call warrants and call options. If implied standard deviations from options are used to price the call warrants, we find that the call warrants are strongly overpriced during the first five trading days. The average overpricing is between 25 and 30%. Only a small part of the overpricing can be explained by rational arguments such as transaction costs. We suggest that the overvaluation can be explained by a combination of an active financial marketing by the banks and the framing effect.

Socially Responsible Investments: Methodology, Risk Exposure and Performance

This paper surveys the literature on socially responsible investments (SRI). Over the past decade, SRI has experienced an explosive growth around the world. Particular to the SRI funds is that both financial goals and social objectives are pursued. While corporate social responsibility (CSR) - defined as good corporate governance, sound environmental standards, and good management towards stakeholder relations - may create value for shareholders, participating in other social and ethical issues is likely to destroy shareholder value. Furthermore, the risk-adjusted returns of SRI funds in the US and UK are not significantly different from those of conventional funds, whereas SRI funds in Continental Europe and Asia-Pacific strongly underperform benchmark portfolios. Finally, the volatility of money-flows is lower in SRI funds than of conventional funds, and SRI investors’ decisions to invest in an SRI fund are less affected by management fees than the decisions by conventional fund investors.

The Price of Ethics: Evidence from Socially Responsible Mutual Funds

This paper estimates the price of ethics by studying the risk-return relation in socially responsible investment (SRI) funds. Consistent with investors paying a price for ethics, SRI funds in many European and Asia-Pacific countries strongly underperform domestic benchmark portfolios by about 5% per annum, although UK and US SRI funds do not significantly underperform their benchmarks. The underperformance of SRI funds does not seem to be driven by the loadings on an ethical risk factor. SRI funds do not suffer a cost of reduced selectivity nor do SRI funds managers time the market. There is mixed evidence of a smart money effect: SRI investors are unable to identify the funds that will outperform in the future, whereas they show some fund-selection ability in identifying ethical funds that will perform poorly. The screening activities of SRI funds have a significant impact on funds’ riskadjusted returns and loadings on risk factors: corporate governance and social screens generate better risk-adjusted returns whereas other screens (e.g. environmental ones) yield significantly lower returns.

Estimating Short-Run Persistence in Mutual Fund Performance

This paper analyzes the properties of a number of estimators that can be used to estimate short-run persistence in mutual fund returns. When data for different funds are pooled, it is advisable to correct for cross-sectional differences in expected returns. However, these adjustments may induce biases in the estimated persistence coefficients and thus lead to spurious persistence. Theoretical derivations, combined with a Monte Carlo study, show that these biases cannot be neglected for the samples that are typically used in applied work. We also estimate the short-run persistence in two samples of U.S. open-end mutual funds using quarterly returns for 19871994. An important conclusion is that the results are quite sensitive to the estimation method that is employed.

Stakeholder Relations and Stock Returns: On Errors in Expectations and Learning

A significant number of institutional investors publicly state the belief that corporate stakeholder relations are associated with firm value in a manner that the financial market fails to understand. We investigate whether stakeholder information predicted risk-adjusted returns due to errors in investors’ expectations and ultimately ceased to do so as attention for such information increased. We build a stakeholder-relations index (SI) for a wide range of U.S. firms over the period 1992-2009 and provide evidence that the SI explained errors in investors’ expectations about firms’ future earnings. The SI was positively associated with long-term risk-adjusted returns, earnings announcement returns, and errors in analysts’ earnings forecasts over the period 1992-2004. However, as attention for stakeholder issues became more widespread, subsequently, these relationships diminished considerably. The results are consistent with the idea that increased investor attention for stakeholder issues eventually eliminates mispricing.