EDHEC Publications
Commodities as Lotteries: Skewness and the Returns of Commodity Futures
2015
This article studies the relation between skewness and subsequent returns in commodity futures markets. Systematically buying commodities with low skewness and shorting commodities with high skewness generates a significant excess return of 8% a year, which is not merely a compensation for the risks associated with backwardation and contango. Skewness is also found to explain the cross-section of commodity futures returns beyond exposures to the backwardation and contango risk factors previously identified.
Stock Market Dispersion, the Business Cycle and Expected Factor Returns
2015
This paper provides evidence using data from the G7 countries suggesting that return dispersion may serve as an economic state variable in that it reliably predicts time-variation in economic activity, market returns, the value and momentum premia and market volatility. A relatively high return dispersion predicts a deterioration in business conditions, a higher value premium, a smaller momentum premium and lower market returns. The evidence is robust to alternative specifications of return dispersion and is not driven by US data. Return dispersion conveys incremental information relative to...
Factor Investing: A Welfare-Improving New Investment Paradigm or Yet Another Marketing Fad?
2015
This paper examines the relative efficiency of standard forms of practical implementation of the factor investing paradigm based on commonly-used factors in the equity, fixed-income and commodity universes. Investment practice has recently witnessed the emergence of a new approach known as factor investing, which recommends that allocation decisions be expressed in terms of risk factors, as opposed to standard asset class decompositions. To answer the question of whether factor investing is truly a welfare-improving new investment paradigm or whether it is merely yet another marketing fad,...
Commodity Markets, Long-Run Predictability and Intertemporal Pricing
2015
This paper shows that backwardation versus contango factor-mimicking portfolios exhibit in-sample and out-of-sample predictive power for the first two moments of the distribution of long-run aggregate market returns and for the business cycle. It also demonstrates that a pricing model based on innovations to the backwardation versus contango risk factors explains relatively well a wide cross-section of equity portfolios. The cross-sectional “hedging” risk prices are economically consistent with the direction of long-run predictability of expected market returns and variances. Backwardation...
Commodity Risks and the Cross-Section of Equity Returns
2015
The article examines whether commodity risk is priced in the cross-section of global equity returns. We employ a long-only equally-weighted portfolio of commodity futures and a term structure portfolio that captures phases of backwardation and contango as mimicking portfolios for commodity risk. We find that equity-sorted portfolios with greater sensitivities to the excess returns of the backwardation and contango portfolio command higher average excess returns, suggesting that when measured appropriately, commodity risk is pervasive in stocks. Our conclusions are robust to the addition to...
Active Allocation To Smart Factor Indices
2015
This paper provides a formal empirical analysis of the benefits of strategic and tactical allocation to multiple equity smart factor indices in a context where relative risk with respect to the cap-weighted indices needs to be explicitly controlled for. The focus of this paper is to provide a quantitative assessment of the benefits expected from the three sources of added-value (which come from time-varying strategic, time-varying tactical or time-varying core-satellite allocation decisions) in the design of equity benchmarks with superior risk and return characteristics.
The Valuation of Privately-Held Infrastructure Equity Investments: Theoretical Framework and Data Collection Requirements
2015
This paper proposes a valuation framework for privately-held and very illiquid assets such as equity stakes in infrastructure projects. Such a framework is one of the key steps identified by EDHEC-Risk Institute as part of a roadmap to design long-term infrastructure investment benchmarks that can take into account the nature of such assets as well as the paucity of available data.
Investor Interest In And Requirements For Smart Beta ETFs
2015
Exchange-traded funds (ETFs) are perhaps one of the greatest financial innovations of recent years. Unlike conventional index funds, ETF units trade on stock exchanges at market-determined prices, thereby combining the advantages of mutual funds and common stocks. Most of them represent passive instruments designed to track the performance of a financial index as closely as possible. Recently, the standard practice of using a capitalisation-weighting scheme for the construction of indices has been the target of harsh criticism. Nowadays, growing demand for indices as investment vehicles has...
The EDHEC European ETF Survey 2014
2015
EDHEC Risk Institute conducted its 8th survey of European investment professionals about the usage and perceptions of ETFs at the end of 2014. The aim of this study is to analyse the usage of exchange-traded funds (ETFs) in investment management and to give a detailed account of the current perceptions and practices of European investors in ETFs.
Alternative Equity Beta Investing: A Survey
2015
Alternative equity beta investing has attracted increased attention within the industry recently. Though products in this segment currently represent only a fraction of overall assets, there has been tremendous growth recently in terms of both assets under management and new product development. In this context, EDHEC-Risk recently carried out a survey among a representative sample of investment professionals to identify their views and uses of alternative equity beta.
Accounting For Geographic Exposure In Performance And Risk Reporting For Equity Portfolios
2015
A standard practice in reporting geographic exposure of equity portfolios is to report breakdown of portfolio constituents by country or region, which are assigned to a stock based on its place of listing, incorporation or headquarters. However, the practice is questionable in the context of a globalised marketplace where a company's operations are usually not restricted to any single country (or region).
Introducing A Comprehensive Investment Framework For Goals-Based Wealth Management
2015
Any investment process should start with a thorough understanding of the investor problem. Individual investors do not need investment products with alleged superior performance; they need investment solutions that can help them meet their goals subject to prevailing dollar and risk budget constraints. This paper develops a general operational framework that can be used by financial advisors to allow individual investors to optimally allocate to categories of risks they face across all life stages and wealth segments so as to achieve personally meaningful financial goals.
Where Experience Matters: Asset Allocation and Asset Pricing with Opaque and Illiquid Assets
2015
Alternative assets, such as private equity, hedge funds, and real assets, are illiquid and opaque, and thus pose a challenge to traditional models of asset allocation. In this paper, we study asset allocation and asset pricing in a general-equilibrium model with liquid assets and an alternative risky asset, which is opaque and incurs transaction costs, and investors who differ in their experience in assessing the alternative asset. We find that the optimal asset-allocation strategyof the relatively inexperienced investors is to initially tilt their portfolio away from the alternative asset...
Crude Oil Futures Markets: Are the Benefits of "Roll Yield" Real?
2014
This paper examines whether roll yield is still a useful concept in evaluating crude oil futures markets. This is a timely question because of (a) scepticism on the benefits of roll yield; and (b) the dramatic drop in oil prices had led investors to question whether crude-oil-futures positions deserve a role in a diversified investment portfolio.
Equity Portfolios with Improved Liability-Hedging Benefits
2014
This paper extends the LDI paradigm by assessing whether LDI solutions can be enhanced by the design of performanceseeking equity benchmarks with improved liability-hedging properties. We confirm this intuition and show that improving hedging characteristics of the performance portfolio generates welfare gains unless this improvement comes at an exceedingly large opportunity cost in terms of performance — a result that we call the fund interaction theorem.
How Much Construction Risk do Sponsors Take in Project Finance?
2014
Using new data, this paper shows that construction risk in infrastructure project finance is well-managed and that project sponsors face very little construction risk compared to the well-documented, systematic and very large cost overruns found in traditional infrastructure project procurement. We know from the project management literature that construction risk is significant in public infrastructure projects delivered through traditional procurement methods. We also know that, when similar projects are procured using project financing, construction risk is passed on through date-certain,...
The Impact Of Risk Controls And Strategy-Specific Risk Diversification On Extreme Risk
2014
To overcome the deficiencies of cap-weighted indices, smart beta strategies have been proposed. They employ weighting schemes that deviate from cap-weighting, deal with the problem of concentration and allow for a flexible index construction process in which the index can be tilted to better rewarded factors. Along with the better risk-adjusted performance, however, investors in smart beta strategies are exposed to additional risks.The goal of this paper is to check empirically if controlling the exposure to some risks such as country, sector, tracking error, or sample risk does not increase...
Unlisted Infrastructure Debt Valuation & Performance Measurement: Theoretical Framework and Data Collection Requirements
2014
Building on advanced and robust credit risk modelling and private debt valuation techniques, this paper focuses on delivering those performance measures that are the most relevant to investors at the strategic asset allocation level, and to prudential regulators for the calibration of risk weights. It provides a implementable framework for the formation of risk and return expectations in illiquid infrastructure debt, and also defines the most parsimonious data input requirements. Hence, we can realistically expect to deliver these performance measures at a minimal data collection cost.
Superannuation V2.0: Towards The Next Generation Of Pension Funds In Australia
2014
This paper discusses potential improvements to the design of retirement products in the Superannuation system, including the impact of transparency and governance on the credibility of the pension investment solutions, the role of market structure and competition on the creation of adequate investment options, the role of asset allocation and risk management in the determination of optimal pension products including default options, and the matter of the horizon of lifecycle investment solutions in a country with rising longevity.
Dynamic Allocation Strategies for Absolute and Relative Loss Control
2014
The maximum drawdown control strategy dynamically allocates wealth between cash and a risky portfolio, keeping losses below a chosen pre-defined level. This paper introduces variations of the strategy, namely the excess drawdown and the relative drawdown control strategies. The excess drawdown control is a more flexible strategy that can cope with common (re)allocation restrictions such as lock-up periods, cash bans or liquidity constraints through an implementation with a hedging overlay. The relative drawdown control strategy is adapted to contexts in which investors seek to limit benchmark...
Risk Allocation, Factor Investing And Smart Beta: Reconciling Innovations In Equity Portfolio Construction
2014
This publication argues that current smart beta investment approaches only provide a partial answer to the main shortcomings of capitalisation-weighted (cap-weighted) indices, and develops a new approach to equity investing referred to as smart factor investing. It provides an assessment of the benefits of simultaneously addressing the two main shortcomings of cap-weighted indices, namely 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...
Should A Skeptical Portfolio Insurer Use An Optimal Or A Risk-Based Multiplier?
2014
Following recent evidence of out-of-sample stock market return predictability, the authors aim to evaluate whether the potential benefits suggested by asset allocation theory can actually be captured in the real world using expected return estimates from a predictive system. The question is addressed in the context of an investor maximising the long-term growth rate of wealth under a maximum drawdown constraint, and comparing the optimal strategy using the predictive system with a similar risk-based allocation strategy, independent of expected return estimates. More...
Tail Risk Of Smart Beta Portfolios: An Extreme Value Theory Approach
2014
This paper studies the in-sample extreme risk of smart beta portfolios using the GARCH-EVT model. To validate the in-sample approach, we back-tested the methodology on smart beta indices constructed from long-term US data spanning 40 years and found that the methodology is robust and reliable. The VaR- and CVaR-based tests for the case of 1% tail probability indicated that, with a couple of exceptions, the model is statistically acceptable for all portfolios for both the left and the right tail.
A Predictive System with Heteroscedastic Expected Returns and Economic Constraints
2014
We propose a variation of a predictive system that incorporates two (additional) economically motivated assumptions about the dynamics of expected returns, namely 1) their positivity, and 2) a time-varying volatility correlated with economic regimes. The implications of the modified system are consistent with well established empirical facts of stock returns, in particular, the simpler version of the modified system without predictors can explain the well documented countercyclicality of the dividend-price ratio’s predictive power.
Catastrophe Bonds: An Important New Financial Instrument
2014
This paper describes key features of catastrophe bonds or CAT bonds. CAT bonds are issued by a reinsurer for indemnification against tail risks of a major disaster such as a hurricane, earthquake, or pandemic. The money with which investors purchase CAT bonds is deposited in safe securities such as US Treasuries. The investor then receives interest on these securities plus premiums paid regularly by the issuer of the bond. If a “triggering event” (the covered catastrophe) occurs before maturity the bond may “default” in that investors may not be returned part or all of their principal, which...
Equal or Value Weighting? Implications for Asset-Pricing Tests
2014
Does the choice of weighting scheme used to form test portfolios influence inferences drawn from empirical tests of asset pricing? To answer this question we first show that, with monthly rebalancing, an equal-weighted portfolio outperforms a value-weighted portfolio in terms of total mean return, four-factor alpha, and Sharpe ratio. We then explain that this outperformance is partly because the equal-weighted portfolio has higher exposure to systematic risk factors; but, a considerable part (42%) of the outperformance comes from the difference in alphas, which is a consequence of the...
Global Style Portfolios Based on Country Indices
2014
Factor portfolios created by dynamically weighting country indices generated significant global market adjusted returns over the last 30 years. The comparison between stock and country based factor portfolios suggests that country based value, size and momentum factor portfolios implemented through index futures or country ETFs capture a large part of the return of stock based factor strategies. Given the complex issues and costs involved in implementing stock based factor strategies in practice, country based factor strategies offer a viable alternative.
Benchmarking Long-Term Investment in Infrastructure: Objectives, Roadmap and Recent Progress
2014
This paper proposes an approach to benchmark long-term investments in infrastructure, where long-term investment simply refers to any unlisted and illiquid asset. It first highlights the reasons why benchmarking long-term infrastructure investments has become a sine qua non to match the supply and demand of long-term capital, improve asset allocation outcomes for investors and support the development of the economy.
A Proposal for an Interest Rate Dampener for Solvency II to Manage Pro-Cyclical Effects and Improve Asset-Liability Management
2014
The aim of this study is to propose the introduction of a Dampener adjustment in the risk measure for bond instruments — which takes economic cycles into account. Firstly, we have revisited the regulator’s chosen method for measuring bond risk (bond Solvency Capital Requirement), highlighting the main limitations, and thereby showing the need for an equity-type dampener within the regulatory bond risk measure. Secondly, we have built a proposal of a Dampener model based on a three-factor mean reversion which reduces the pro-cyclical effect of the Solvency II standard formula.
Why Some Futures Contracts Succeed and Others Fail: A Survey of Relevant Research
2014
Why do some futures contract succeed and others fail? Numerous researchers have provided case studies on both new and existing futures contracts, so this paper is fortunate to have a wealth of material from which to directly cite. Accordingly, this article will survey a number of textbooks, trade publications, academic papers, and think-tank articles from which one can distill lessons from over 160 years of (largely) U.S. experience with commodity trading. It turns out that even though the U.S. futures markets have evolved in a trial-and-error fashion, one can nonetheless identify the key...
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About EDHEC
Operating from campuses in Lille, Nice, Paris, London and Singapore, EDHEC is one of the world’s top 15 business schools. Fully international and directly connected to the business world, EDHEC commands a strong reputation for research excellence and the ability to train entrepreneurs and managers capable of breaking new ground. EDHEC functions as a genuine laboratory of ideas and produces innovative solutions valued by businesses. The School’s teaching is inspired by its research work and a focus on “learning by doing”, all with the aim of equipping people with the skills to succeed in business.
