Ludwig B. Chincarini

Hedging Inflation Internationally

The objective of this paper is to explore and identify inflation as it is embedded in a broad range of asset classes beyond simply TIPS, oil, gold and real estate. The analysis is conducted primarily from the perspective of a United States investor however the results are validated across a range of countries that span the developed and emerging world including resource intense economies and those that have previously experienced hyperinflation. We find that an investor who is looking for a reasonable positive real return of 4.5% while minimizing the downside with respect to inflation will have an allocation that consists primarily of short-term bonds, longer-term bonds, some gold, some oil, and some emerging market equities. The weight of gold and oil together is less than 10% of the portfolio and is not always relevant for all countries. We also find that TIPS are only slightly effective for protecting against inflation conditional on an investor using a group of asset classes. The out-of-sample performance of the real return optimizations are quite promising, providing an emulative inflation protection strategy for international investors.

The Failure of Long-Term Capital Management

The recent collapse of the brilliant hedge fund, Long-Term Capital Management, has caused a lot of concern in the financial community. The quants are saddened by the limits of critical thinking and some of the non-quants are claiming that LTCM is just like the rest of them. This article describes the type of trading LTCM may have been doing and shows analytically what may have gone wrong in August, 1998. It formalizes much of the jitter in the papers in order to understand how a sophisticated system could fail, despite not having any major bets in any one market.

The Life Cycle of Beta

We document a robust pattern of beta declining over the age of a firm. We find that changes in systematic risk via firm characteristics and life-cycle stages are insufficient to explain this pattern. Moreover, standard proxies for the quantity and quality of information also explain this pattern only partially. To fully explain this pattern we rely on the increasingly important role of familiarity in financial decision making: familiarity is a determinant of beta and firm age is a proxy for the degree of familiarity that investors feel toward individual stocks. To illustrate the implication of our findings, we document that when we control for firm age there is support for the CAPM and the use of beta as input for the cost of equity capital calculation.

Crowded Spaces and Copycat Risk Management

In recent years, a new form of risk has been recognized. This risk is the risk of crowded spaces. That is, how the saturation of a particular trading strategy can lead to a mis-measurement of the future expected returns and risks of the trading strategy. The primary focus of this risk has to do with copycat trading, whereby traders or investors engage in a similar trading strategy. As too many dollars chase the same strategy, the opportunity fades away but leaves the remaining traders at greater risk exposure. This paper focuses on an entirely neglected source of crowding. The crowding explicitly from the risk management process. In particular, this paper focuses on equity portfolio managers that use similar risk models and examines the extent to which these similar risk models can mis-measure risk and lead to crowding of the investment space, even when the investment models are completely unrelated to one another. Our empirical analysis with real-world professional portfolio management data finds that the risk modeling process leads to crowding and mis-measured risk. Interestingly, we find a rise in crowding due to portfolio construction immediately before the quant crisis of 2007. We also show how a simple method of altering the eigenvalue structure can reduce the average crowding from portfolio management by 20%, and in some cases as high as 61%. We also find that crowding in the financial system would be lower if the distribution of risk model usage amongst portfolio managers was more diversified.

An Alternative Method to Construct Levered Indexes

Investment products that seek to provide leveraged and inverse exposure to the equity markets have enjoyed great success in attracting assets. The largest and most popular exchange traded funds (ETFs) that provide these exposures rebalance their positions each day in an attempt to provide a precise multiple of the market return for the subsequent day. However, the daily rebalancing process can be detrimental to returns over holding periods longer than one day. For investors looking for leveraged or inverse exposure for holding periods greater than one day, a less frequent rebalancing cycle may be more appropriate. Further, moving away from a straight market-capitalization-based weighting methodology may offer opportunities to enhance the return profile thereby enabling an investor to better achieve her long-run investment objectives.

Stephen A. Ross: Excellence Beyond Recognition

On March 3, 2017, Professor Stephen A. Ross died unexpectedly. Because of his major contributions to the field of financial economics, many expected that he would be awarded the most prestigious award in economics, the Sveriges Riksbank Prize in Economic Sciences, and were surprised that he had not received the award previously. In this article, the authors summarize the many contributions of Professor Ross and assess their originality, impact, and influence on the field of economics and finance.

Transaction costs and crowding

We use industry data to determine whether crowding of the investment space is caused by portfolio construction processes typical to the investment community. In particular, this paper examines the extent that transaction cost models cause crowding of the investment space, even when the investment models are completely unrelated to one another. We find that as transaction costs become more significant in the portfolio creation process as portfolios increase in size from

An Approach to Enhanced Indexing

500 million to

Managing a Student-Managed Fund: The University of San Francisco Experience

5 billion, crowding actually declines for long-only portfolios and mainly declines, but sometimes increases for market neutral portfolios. This research sheds more light on how crowding develops through actions by players within the financial system.

Transaction Cost and Crowding

Investment managers often manage a portfolio of stocks with respect to a benchmark. Their primary concern is selecting the best stocks to outperform their benchmark, while constraining their tracking error. The most common way of doing this is to use an optimization framework to maximize the information ratio of their portfolio. In this paper, we develop an unconventional approach to determining how a portfolio should be managed with respect to the benchmark. In particular, given some assumptions, we determine what percentage of the benchmark stocks would be optimal for the portfolio manager to select. The optimal portfolio depends on Fisher’s noncentral hypergeometric distribution and the Wallenius noncentral hypergeometric distribution. We find that the optimal selectivity of a benchmark universe varies from 50% to 80%, when managers have selection ability. The information ratio and the selectivity percentage can vary as the selection ability of the portfolio manager changes and as the underlying size of the universe changes. These results are provocative, given that many enhanced index portfolio managers select a low a percentage of the benchmark universe.