Pub Date : 2022-10-31DOI: 10.3905/jpm.2022.49.1.198
Todd Schlanger, Brennan O’Connor, H. Ahluwalia
Retirees and other investors may prefer to use dividends from equities and interest from fixed income to fund their spending needs. This mental accounting phenomenon of spending the portfolio’s income without drawing down the invested principal makes them seek high income–producing asset classes. These investors, either directly or via advisors, adopt static high income portfolios as an investment strategy, often ignoring risk–return efficiency and tax efficiency principles. In this article, the authors introduce a methodology to systematically construct high income portfolios through an expected utility of wealth maximization approach while allowing for the incorporation of an investor’s income preferences. However, because asset return expectations are conditional on asset valuations, the authors find that popular static high income portfolios that are created on an ad hoc basis—by substituting broad market exposure with high-yielding assets—by design are not optimal. More importantly, the authors find that high income portfolios are tax inefficient when it comes to high tax bracket investors, making their use only appropriate when taxes are not a primary concern—for example, for low- to moderate-income investors or in a tax-deferred account.
{"title":"A Holistic Approach to Creating High Income Portfolios That Are Risk–Return Efficient and Tax Aware","authors":"Todd Schlanger, Brennan O’Connor, H. Ahluwalia","doi":"10.3905/jpm.2022.49.1.198","DOIUrl":"https://doi.org/10.3905/jpm.2022.49.1.198","url":null,"abstract":"Retirees and other investors may prefer to use dividends from equities and interest from fixed income to fund their spending needs. This mental accounting phenomenon of spending the portfolio’s income without drawing down the invested principal makes them seek high income–producing asset classes. These investors, either directly or via advisors, adopt static high income portfolios as an investment strategy, often ignoring risk–return efficiency and tax efficiency principles. In this article, the authors introduce a methodology to systematically construct high income portfolios through an expected utility of wealth maximization approach while allowing for the incorporation of an investor’s income preferences. However, because asset return expectations are conditional on asset valuations, the authors find that popular static high income portfolios that are created on an ad hoc basis—by substituting broad market exposure with high-yielding assets—by design are not optimal. More importantly, the authors find that high income portfolios are tax inefficient when it comes to high tax bracket investors, making their use only appropriate when taxes are not a primary concern—for example, for low- to moderate-income investors or in a tax-deferred account.","PeriodicalId":53670,"journal":{"name":"Journal of Portfolio Management","volume":"49 1","pages":"198 - 212"},"PeriodicalIF":1.4,"publicationDate":"2022-10-31","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"45296381","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":4,"RegionCategory":"经济学","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
This article investigates investment decision making under conditions of almost complete causal ignorance. Using two basic notions of causal dependence, probabilistic and counterfactual dependence, as building blocks, a formal notion of causal distance is presented that gives decision makers the ability to quantitatively assess the proximity that different causal graphs have to each other. The latter are directed acyclic graphs that can also be used to represent causal relations among economic events. Once the causal distance of each graph in a set of causal graphs is determined, it is possible to select the graph with the shortest total distance to the other graphs. This in turn allows decision makers to select a course of action that will be beneficial regardless of the particular set of causal relations that is actually driving observed economic events. The article describes how causal distance values can be used formally within an optimization to facilitate portfolio construction.
{"title":"Investment Decisions under Almost Complete Causal Ignorance","authors":"Joseph Simonian","doi":"10.3905/jpm.2022.1.426","DOIUrl":"https://doi.org/10.3905/jpm.2022.1.426","url":null,"abstract":"This article investigates investment decision making under conditions of almost complete causal ignorance. Using two basic notions of causal dependence, probabilistic and counterfactual dependence, as building blocks, a formal notion of causal distance is presented that gives decision makers the ability to quantitatively assess the proximity that different causal graphs have to each other. The latter are directed acyclic graphs that can also be used to represent causal relations among economic events. Once the causal distance of each graph in a set of causal graphs is determined, it is possible to select the graph with the shortest total distance to the other graphs. This in turn allows decision makers to select a course of action that will be beneficial regardless of the particular set of causal relations that is actually driving observed economic events. The article describes how causal distance values can be used formally within an optimization to facilitate portfolio construction.","PeriodicalId":53670,"journal":{"name":"Journal of Portfolio Management","volume":"49 1","pages":"33 - 38"},"PeriodicalIF":1.4,"publicationDate":"2022-09-16","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"44346728","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":4,"RegionCategory":"经济学","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
From an initial position engaging mainly in ex post portfolio performance monitoring, investment consultants have come to occupy the central ex ante roles in conventional arrangements, advising on objectives, strategy, asset management structure, and portfolio management selection in the five-stage process that constitutes the standard model. The author identifies the theoretical, empirical, and regulatory factors that facilitated this fundamental change, which cannot be accommodated in the existing literature. As consultants can no longer be regarded as agents but are, in effect, either quasi-principals or principals, the author examines whether they have the skills necessary to execute these enhanced responsibilities, concluding that they do not. So, clients following consultants’ recommendations may be allocating assets on false pretenses, as one recent empirical study suggested. Demonstrating that investment consultants, not asset managers, have become the dominant players in the investment chain, the author’s analysis produces other uncomfortable conclusions from the conventional perspective: first, that regulators and consultants are in a symbiotic relationship, and second, that asset management is necessarily characterized by asymmetric information but consultants are powerless to address it.
{"title":"False Pretenses in Institutional Asset Management","authors":"J. Woods","doi":"10.3905/jpm.2022.1.425","DOIUrl":"https://doi.org/10.3905/jpm.2022.1.425","url":null,"abstract":"From an initial position engaging mainly in ex post portfolio performance monitoring, investment consultants have come to occupy the central ex ante roles in conventional arrangements, advising on objectives, strategy, asset management structure, and portfolio management selection in the five-stage process that constitutes the standard model. The author identifies the theoretical, empirical, and regulatory factors that facilitated this fundamental change, which cannot be accommodated in the existing literature. As consultants can no longer be regarded as agents but are, in effect, either quasi-principals or principals, the author examines whether they have the skills necessary to execute these enhanced responsibilities, concluding that they do not. So, clients following consultants’ recommendations may be allocating assets on false pretenses, as one recent empirical study suggested. Demonstrating that investment consultants, not asset managers, have become the dominant players in the investment chain, the author’s analysis produces other uncomfortable conclusions from the conventional perspective: first, that regulators and consultants are in a symbiotic relationship, and second, that asset management is necessarily characterized by asymmetric information but consultants are powerless to address it.","PeriodicalId":53670,"journal":{"name":"Journal of Portfolio Management","volume":"49 1","pages":"22 - 32"},"PeriodicalIF":1.4,"publicationDate":"2022-09-14","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"43035335","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":4,"RegionCategory":"经济学","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
Tobin’s thoughtful admonition that the trustees of an endowed institution should guard the future against the spending needs of the present cannot be perfectly implemented in practice given today’s aggressive investment policies. The authors introduce an understandable toolkit for benchmarking and evaluating any given spending rule so that it protects future spending at some engineered level of probability. They use basic tools of finance—perpetuity math, budget constraints, economic balance sheets, well-supported assumptions for expected return, the discount rate and the growth rate, and multiperiod distribution charts—to assist the institution in achieving its desired probability of maintaining spending power in the long run. The authors address the common practice of smoothing and the problems it creates, and set forth a rule of conservation of risk: Spending risk is set by the risk of the investments used to fund the spending, not by the spending policy itself. Smoothing does not make risk go away; it just hides it for a while, deferring it to a later generation.
{"title":"Where’s Tobin? Protecting Intergenerational Equity for Endowments: A New Benchmarking Approach","authors":"M. Waring, Laurence B. Siegel","doi":"10.3905/jpm.2022.1.424","DOIUrl":"https://doi.org/10.3905/jpm.2022.1.424","url":null,"abstract":"Tobin’s thoughtful admonition that the trustees of an endowed institution should guard the future against the spending needs of the present cannot be perfectly implemented in practice given today’s aggressive investment policies. The authors introduce an understandable toolkit for benchmarking and evaluating any given spending rule so that it protects future spending at some engineered level of probability. They use basic tools of finance—perpetuity math, budget constraints, economic balance sheets, well-supported assumptions for expected return, the discount rate and the growth rate, and multiperiod distribution charts—to assist the institution in achieving its desired probability of maintaining spending power in the long run. The authors address the common practice of smoothing and the problems it creates, and set forth a rule of conservation of risk: Spending risk is set by the risk of the investments used to fund the spending, not by the spending policy itself. Smoothing does not make risk go away; it just hides it for a while, deferring it to a later generation.","PeriodicalId":53670,"journal":{"name":"Journal of Portfolio Management","volume":"49 1","pages":"47 - 80"},"PeriodicalIF":1.4,"publicationDate":"2022-09-14","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"48942937","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":4,"RegionCategory":"经济学","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
{"title":"William T. Ziemba and a Brief Look at His Journal of Portfolio Management Legacy","authors":"J. Guerard, J. Mulvey","doi":"10.3905/jpm.2022.1.423","DOIUrl":"https://doi.org/10.3905/jpm.2022.1.423","url":null,"abstract":"","PeriodicalId":53670,"journal":{"name":"Journal of Portfolio Management","volume":"49 1","pages":"7 - 9"},"PeriodicalIF":1.4,"publicationDate":"2022-09-13","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"45822931","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":4,"RegionCategory":"经济学","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
There is a myriad of financial anomalies in the cross-section of equity returns. They have been widely studied in the literature, which gives investors a large choice in terms of investment styles. In this article, the authors show a perhaps unappreciated quality of financial anomalies: They exhibit strong countercyclical behavior. Specifically, some anomalies (e.g., profitability and investment) perform particularly well when traditional portfolios (e.g., 60/40 or risk parity portfolios) exhibit prolonged periods of negative drawdowns and during National Bureau of Economic Research (NBER) recessions. With the exception of momentum strategies, the authors do not find evidence that financial anomalies are inflation hedging. Last, the authors examine whether financial anomalies lead to better portfolio performance. The results show that combining anomalies based on their style and then adding them to a traditional portfolio leads to higher Sharpe ratios overall, while also limiting portfolio losses during recessions.
{"title":"Financial Anomalies in Asset Allocation: Risk Mitigation with Cross-Sectional Equity Strategies","authors":"Redouane Elkamhi, Jacky Lee, M. Salerno","doi":"10.3905/jpm.2022.1.422","DOIUrl":"https://doi.org/10.3905/jpm.2022.1.422","url":null,"abstract":"There is a myriad of financial anomalies in the cross-section of equity returns. They have been widely studied in the literature, which gives investors a large choice in terms of investment styles. In this article, the authors show a perhaps unappreciated quality of financial anomalies: They exhibit strong countercyclical behavior. Specifically, some anomalies (e.g., profitability and investment) perform particularly well when traditional portfolios (e.g., 60/40 or risk parity portfolios) exhibit prolonged periods of negative drawdowns and during National Bureau of Economic Research (NBER) recessions. With the exception of momentum strategies, the authors do not find evidence that financial anomalies are inflation hedging. Last, the authors examine whether financial anomalies lead to better portfolio performance. The results show that combining anomalies based on their style and then adding them to a traditional portfolio leads to higher Sharpe ratios overall, while also limiting portfolio losses during recessions.","PeriodicalId":53670,"journal":{"name":"Journal of Portfolio Management","volume":"49 1","pages":"118 - 145"},"PeriodicalIF":1.4,"publicationDate":"2022-09-10","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"49224056","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":4,"RegionCategory":"经济学","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
Several industry participants have actively started managing the environmental externalities of their economic activities. As environmental policies become clear(er), the asset prices would likely evolve to drive transition to a low-carbon economy. With this article the authors intend to highlight to investors and portfolio managers the significance and financial materiality of climate change risk to the value of their developed-market corporate-bond portfolios. This article shows that, even though the broader credit market and bond spreads are yet to systematically incorporate the impact of climate policies or the potential for physical climate risk, these risks can have a material impact on the asset value of firms, and that the downside risk is large enough to adversely affect bondholders and other creditors of firms. The authors hope this article will encourage bond investors to take a more active role, along with equity holders and policymakers, in spurring firms onward in the transition to a low-carbon economy.
{"title":"Corporate Bonds and Climate Change Risk","authors":"Afsaneh Mastouri, Rohit Mendiratta, G. Giese","doi":"10.3905/jpm.2022.1.421","DOIUrl":"https://doi.org/10.3905/jpm.2022.1.421","url":null,"abstract":"Several industry participants have actively started managing the environmental externalities of their economic activities. As environmental policies become clear(er), the asset prices would likely evolve to drive transition to a low-carbon economy. With this article the authors intend to highlight to investors and portfolio managers the significance and financial materiality of climate change risk to the value of their developed-market corporate-bond portfolios. This article shows that, even though the broader credit market and bond spreads are yet to systematically incorporate the impact of climate policies or the potential for physical climate risk, these risks can have a material impact on the asset value of firms, and that the downside risk is large enough to adversely affect bondholders and other creditors of firms. The authors hope this article will encourage bond investors to take a more active role, along with equity holders and policymakers, in spurring firms onward in the transition to a low-carbon economy.","PeriodicalId":53670,"journal":{"name":"Journal of Portfolio Management","volume":"48 1","pages":"78 - 97"},"PeriodicalIF":1.4,"publicationDate":"2022-09-08","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"46215038","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":4,"RegionCategory":"经济学","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
In order to be resilient to unmodeled risks, an investment management process needs to incorporate a discipline of continuous scenario analysis. The authors describe the essential elements of such a discipline: key organizational and operating principles, the scenario building process, quantitative specification of scenarios, and application to portfolio management. They illustrate with several recent case studies: the COVID-19 pandemic, the 2021–2022 surge in global inflation, and the 2022 Russian invasion of Ukraine. They also list some potential pitfalls of scenario analysis.
{"title":"Scenario-Driven Adaptation to Emergent Risks","authors":"Julian N. Abdey, J. Franz, W. Phoa","doi":"10.3905/jpm.2022.1.419","DOIUrl":"https://doi.org/10.3905/jpm.2022.1.419","url":null,"abstract":"In order to be resilient to unmodeled risks, an investment management process needs to incorporate a discipline of continuous scenario analysis. The authors describe the essential elements of such a discipline: key organizational and operating principles, the scenario building process, quantitative specification of scenarios, and application to portfolio management. They illustrate with several recent case studies: the COVID-19 pandemic, the 2021–2022 surge in global inflation, and the 2022 Russian invasion of Ukraine. They also list some potential pitfalls of scenario analysis.","PeriodicalId":53670,"journal":{"name":"Journal of Portfolio Management","volume":"48 1","pages":"258 - 275"},"PeriodicalIF":1.4,"publicationDate":"2022-09-07","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"43605169","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":4,"RegionCategory":"经济学","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
Lera Bowman, D. Hu, Mark Hu, Amit Madaan, António Baldaque da Silva
The authors propose an approach to assess climate change’s impact on sovereign bonds by considering forward-looking climate forecasts and their economic impact and using those as overlays in a pricing model for sovereign bonds. The authors use outputs from climate models reviewed by the Intergovernmental Panel for Climate Change and published literature on the economic impact of rising temperatures, change in tropical cyclone activity, and coastal flooding caused by sea level rise. The authors improve on existing sovereign pricing models by considering sovereign segmentation into developed markets, emerging markets issuing bonds in local currency, and emerging markets issuing bonds in a hard currency. By passing climate change’s economic impacts through the pricing model, the authors can assess the relative pricing impact for each security. The authors also provide country-level climate risk scores and change in risk-neutral probability of default for each issuer. This is novel research and is likely to be improved over time as more practitioners start considering climate risks as financial risks.
{"title":"Assessing Climate Change Impact on Sovereign Bonds","authors":"Lera Bowman, D. Hu, Mark Hu, Amit Madaan, António Baldaque da Silva","doi":"10.3905/jpm.2022.1.420","DOIUrl":"https://doi.org/10.3905/jpm.2022.1.420","url":null,"abstract":"The authors propose an approach to assess climate change’s impact on sovereign bonds by considering forward-looking climate forecasts and their economic impact and using those as overlays in a pricing model for sovereign bonds. The authors use outputs from climate models reviewed by the Intergovernmental Panel for Climate Change and published literature on the economic impact of rising temperatures, change in tropical cyclone activity, and coastal flooding caused by sea level rise. The authors improve on existing sovereign pricing models by considering sovereign segmentation into developed markets, emerging markets issuing bonds in local currency, and emerging markets issuing bonds in a hard currency. By passing climate change’s economic impacts through the pricing model, the authors can assess the relative pricing impact for each security. The authors also provide country-level climate risk scores and change in risk-neutral probability of default for each issuer. This is novel research and is likely to be improved over time as more practitioners start considering climate risks as financial risks.","PeriodicalId":53670,"journal":{"name":"Journal of Portfolio Management","volume":"48 1","pages":"98 - 118"},"PeriodicalIF":1.4,"publicationDate":"2022-09-05","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"45315889","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":4,"RegionCategory":"经济学","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
Pub Date : 2022-08-31DOI: 10.3905/jpm.2022.48.9.039
Roger Aliaga-Dı́az, Giulio Renzi-Ricci, Brennan O’Connor, H. Ahluwalia
In this article, the authors define a comprehensive, rigorous and intuitive portfolio construction framework that accounts for the key aspects of private equity investing in multi-asset portfolios. These aspects are normally ignored in more conventional asset allocation approaches such as mean–variance, mainly because there are no readily available approaches that can handle the distinct assumptions of illiquid assets. In particular, the framework accounts for the illiquid feature of private equity, as well as for its cash flow features, and highlights how these fit together for constructing multi-asset portfolios with other traditional asset classes. Also, because private equity is a form of active investing, by building on previous research, the authors provide an approach that allows integrating active preferences into the asset allocation decision and accounting for active and passive risk–return trade-offs.
{"title":"Integrating Private Equity in a Liquid Multi-Asset Portfolio","authors":"Roger Aliaga-Dı́az, Giulio Renzi-Ricci, Brennan O’Connor, H. Ahluwalia","doi":"10.3905/jpm.2022.48.9.039","DOIUrl":"https://doi.org/10.3905/jpm.2022.48.9.039","url":null,"abstract":"In this article, the authors define a comprehensive, rigorous and intuitive portfolio construction framework that accounts for the key aspects of private equity investing in multi-asset portfolios. These aspects are normally ignored in more conventional asset allocation approaches such as mean–variance, mainly because there are no readily available approaches that can handle the distinct assumptions of illiquid assets. In particular, the framework accounts for the illiquid feature of private equity, as well as for its cash flow features, and highlights how these fit together for constructing multi-asset portfolios with other traditional asset classes. Also, because private equity is a form of active investing, by building on previous research, the authors provide an approach that allows integrating active preferences into the asset allocation decision and accounting for active and passive risk–return trade-offs.","PeriodicalId":53670,"journal":{"name":"Journal of Portfolio Management","volume":"48 1","pages":"39 - 60"},"PeriodicalIF":1.4,"publicationDate":"2022-08-31","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"48468471","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":4,"RegionCategory":"经济学","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
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