SECTION I

RESEARCH DIRECTOR’S

REPORT

Laurence B. Siegel

Gary P. Brinson Director of Research

CFA Institute Research Foundation

In 2018, the CFA Institute Research Foundation published three research monographs, a literature review, and six briefs. We also posted video of an exceptional conference, “2008 Financial Crisis: A 10-Year Review,” on our website.

Research Monographs

Research monographs are books intended to have a long shelf life. In chronological order, the monographs we published in 2018 are

Alternative Investments: A Primer for Investment Professionals, by Donald R. Chambers, CAIA, Keith Black, CFA, CAIA, and Nelson J. Lacey, CFA;
The Future of Investment Management, by Ronald N. Kahn; and
Popularity: A Bridge between Classical and Behavioral Finance, by Roger G. Ibbotson, Thomas M. Idzorek, CFA, Paul D. Kaplan, CFA, and James X. Xiong, CFA.

Donald R. Chambers, CAIA, Keith Black, CFA, CAIA, and Nelson J. Lacey, CFA, Alternative Investments: A Primer for Investment Professionals

In a collaborative effort with the Chartered Alternative Investment Analyst (CAIA) Association, the authors translate the often-baffling jargon associated with alternative investing into plain English. They define alternatives expansively as any asset or asset pool that is not a long-only, unleveraged position in equities or investment-grade bonds. Thus, alternatives can include unconventional strategies or structures as well as nontraditional underlying sources of return.

The need for a thorough primer on this topic has existed for a long time. Although traditional asset managers are sometimes prolific writers, alternative asset managers tend not to be (they are often traders or entrepreneurs and not the most contemplative sort), so the literature on alternatives is quite limited and this volume is a welcome addition to it.

Chambers, Black, and Lacey describe the strategies used by, and risks associated with, each major category of alternatives: hedge funds, private equity, infrastructure funds, real estate and other real assets, commodities, and derivatives and structured products. Although the monograph is called a primer, the authors’ treatment is quite advanced and encyclopedic.

The authors also look at process issues, including due diligence, performance measurement and evaluation, and the special challenges involved in benchmarking these assets (which often do not have usable benchmarks). They conclude by summarizing the case for alternative investing, which, in their view, is supported by the high valuations of traditional assets, the need to move the efficient frontier outward by expanding beta exposures beyond the traditional stock and bond categories, and the ability to add alpha through investment skill.

Ronald N. Kahn, The Future of Investment Management

Ronald N. Kahn is one of the most respected investment managers in the industry and one of its most eloquent writers. In The Future of Investment Management, Kahn combines work he has delivered in lectures and published articles with a great deal of new material. Following the “rule of sevens,” which says that good things come in sevens (or fives or threes—no even numbers), Kahn presents seven insights into active management and seven trends in investment management. The seven trends are (1) active to passive, (2) increased competition, (3) changing market environments, (4) big data, (5) smart beta, (6) investing beyond returns (investing to achieve goals other than maximum return per unit of risk taken, for example, in environmental, social, and governance strategies), and (7) fee compression.

But first, in what will for many readers be the most elucidating part of the book, Kahn recounts the intellectual history of the investment management profession from the viewpoint of someone who participated in creating that history. As co-author (with Richard C. Grinold) of the groundbreaking book Active Portfolio Management: A Quantitative Approach for Producing Superior Returns and Controlling Risk (first published in 1994), Kahn applied the quantitative techniques pioneered by Harry Markowitz, William Sharpe, and Barr Rosenberg to the practical problems of constructing portfolios. He brings this history to life by showing how the ideas of the investment pioneers of the 1950s, 1960s, and 1970s are affecting the lives of ordinary people in a different century (e.g., through index funds, factor or “smart beta” funds, and a sophisticated and accurate system of performance measurement).

The future of investment management will involve less picking of low-hanging fruit, more effort, and possibly less personal reward. But investing will continue to be one of the most intellectually stimulating as well as economically rewarding fields of endeavor. Lest anyone be discouraged, Kahn writes that “today may not be a great time to be a 50-year-old investment manager, but . . . it is a great time to be a quantitatively oriented 28-year-old entering the field.”

Roger G. Ibbotson, Thomas M. Idzorek, CFA, Paul D. Kaplan, CFA, and James X. Xiong, CFA, Popularity: A Bridge between Classical and Behavioral Finance

In the 1970s, Roger G. Ibbotson, with co-author Rex Sinquefield, was the first to document the historical returns on a variety of different asset classes (“stocks, bonds, bills, and inflation”). Ibbotson and Sinquefield identified the return differences as risk premiums earned by investors for taking the risk of one asset class (say, stocks) compared with another (say, bonds).

In the next decade, Ibbotson, with Jeffrey Diermeier, CFA (a former CFA Institute president and CEO) and Laurence B. Siegel, conceived of—but didn’t formalize—a “new equilibrium theory” that links the returns on assets to all of their characteristics, not just risk. These characteristics include taxability, liquidity, and other attributes that any investor might like or dislike and that different investors like or dislike to different degrees.

The result of all this heterogeneity is that, unlike in the capital asset pricing model (CAPM), it is rational for different investors to hold different risky-asset portfolios—not just portfolios with different betas (positions on the capital market line) but portfolios with different underlying components. For example, someone with a long time horizon might load up on illiquid stocks, expecting to earn a higher return because other investors, needing liquidity, shun those issues.

In their 2018 monograph, Popularity, Ibbotson, Idzorek, Kaplan, and Xiong, all from Ibbotson Associates and its parent company, Morningstar, turn this set of observations into a proper theory. They note that there are “many premiums [in the market] that may or may not be related to risk, but all are related to investing in something that is unpopular in some way.” They consider premiums to be the result of characteristics that are systematically unpopular; that is, popularity makes the price of a security higher and the expected return lower, all other things being equal. This principle can be used to structure actively managed portfolios that fit a particular investor’s preferences for, or aversions to, specific characteristics.

The authors do the math. They set forth a formal popularity asset pricing model and conduct a variety of empirical tests, finding that such factors as “moats” and “brand” can be priced just as size and value can be priced.

Popularity constructs a bridge between classical and behavioral finance because the effects the authors observe can exist whether investors are rational or irrational. For example, a rational investor might want more liquidity than his neighbor and pay extra (sacrificing return) for a security offering that liquidity. But an investor can also be irrational, exhibiting behavioral biases and making cognitive errors. The popularity framework embraces both possibilities regarding investor rationality and is thus a more complete framework for understanding asset pricing than either pure rationality or a purely behavioral approach.

Literature Review

Ying L. Becker and Marc R. Reinganum, The Current State of Quantitative Equity Investing

In their incisive literature review, Professor Ying L. Becker of Suffolk University and factor investing pioneer Marc R. Reinganum (who co-discovered the small stock effect more than 40 years ago) assess the state of “quant” equity investing. They focus on factors but start with a primer on risk and return, modern portfolio theory, and the classic theories of asset pricing that prefigured the later discovery of common factors (other than the market factor) in stock returns.

The age of factor investing began in the 1970s with Barr Rosenberg’s discovery of “extra-market covariance” (exceptions to the single-factor model of William Sharpe, which says that stock returns are correlated only with the overall market) and with Stephen A. Ross and Richard Roll’s multifactor arbitrage pricing theory. But it was Reinganum himself, along with Rolf Banz, who identified the first simple, usable factor: small size. Small-cap stocks had outperformed their large-cap brethren by a wide margin at the time Reinganum and Banz did their research and have continued to perform differently from (but not always better than) large-cap stocks.

Rosenberg’s discovery set off a race to find other factors, which are now the basis for a blizzard of investment products, such as factor-based exchange-traded funds and mutual funds. Becker and Reinganum’s literature review recounts the race to find and exploit as many factors as possible, a “zoo” of factors according to American Finance Association president John H. Cochrane, who is skeptical that all of them exist.

Becker and Reinganum then turn their attention to big data and dynamic factor modeling (factor timing), which are the latest wave of quantitative techniques in equity management. Although “quant” investing received some bad press a few years ago because of the poor performance of some popular models, the authors conclude that “quantitative equity management is alive and well—and intellectually active—as investors seek to better manage risk and return.” Actually, it is hard to think of a well-managed investment effort as being anything other than quantitative, or at least analytically rigorous.

Research Foundation Briefs

Elke U. Weber and Joachim Klement, CFA, “Risk Tolerance and Circumstances”

In this contribution to the already rich literature on assessing individual investors’ behavior toward risk, Elke U. Weber and former Research Foundation board chair Joachim Klement, CFA, distinguish between various uses of the term “risk tolerance.” Risk tolerance can be an underlying and stable characteristic of an individual, or it can be an attribute that changes with circumstances, such as wealth, age, and market conditions. The authors review a number of studies, showing, for example, that investors’ risk tolerance declined during the crisis of 2008, that it declines with age, and that it is lower for women than for men. Advisers and their clients can benefit from knowledge of the research on these fine points of risk assessment. The authors’ advice to financial advisers: “Be aware . . . educate . . . nudge . . . hold hands.”

Edited by Joachim Klement, CFA, “Risk Profiling and Tolerance: Insights for the Private Wealth Manager”

With the publication of the “Risk Tolerance and Circumstances” brief, the five-part series on risk profiling and risk tolerance was complete, so the Research Foundation combined all the articles in the series, added a new foreword and preface, and published “Risk Profiling and Tolerance: Insights for the Private Wealth Manager.” This compilation brief, edited by Joachim Klement, CFA, includes the following components:

Foreword by Bob Dannhauser, CFA;
“Preface: Investing Is Rational, Money Is Emotional,” by Joachim Klement, CFA;
“Investor Risk Profiling: An Overview,” by Joachim Klement, CFA;
“Risk Profiling through a Behavioral Finance Lens,” by Michael Pompian, CFA;
“Financial Risk Tolerance: A Psychometric Review,” by John E. Grable;
“Risk Tolerance and Circumstances,” by Elke U. Weber and Joachim Klement, CFA; and
“New Vistas in Risk Profiling,” by Greg B. Davies.

Edited by Mauro Miranda, CFA, “Latin American Local Capital Markets: Challenges and Solutions”

In a compilation edited by the Research Foundation trustee Mauro Miranda, CFA, a group of authors from seven Latin American countries—Argentina, Brazil, Chile, Colombia, Mexico, Peru, and Uruguay—describes the financial system, market structure, and access to capital in those countries.

The critical event in recent Argentine history is its emergence from sovereign debt default in 2016, once again attracting foreign investors to the country’s local markets. Once-fast-growing Brazil, now recovering from a severe recession, faces such challenges as “the crowding out of private capital markets by public issuance.” Chile, which is quite prosperous, is analyzed from the perspective of the country’s fixed-income market and its domination by pension funds, which are long-term investors, resulting in little trading or foreign investment. Colombia is becoming a successful emerging economy, but its capital markets—especially its equity market—are underdeveloped. Mexico has recently experienced a period of relatively strong growth, but “the key to capital market development . . . seems to lie with the expansion of credit.” Peru suffers from “the absence of a financial culture,” so liquidity and market depth are thin; there are few equities. Uruguay is small and has less well-developed capital markets than its neighbors but is prosperous and offers a stable environment for business.

Edited by Martin Fridson, CFA, “Foundations of High-Yield Analysis”

Edited by Martin Fridson, CFA, one of the best-known and most widely published analysts of the high-yield bond markets, this brief consists of six essays relating to the market for below-investment-grade bonds. The first essay, by Fridson himself, is titled “Understanding Default Rates, Recoveries, Spreads, and Returns.” Fridson summarizes his views as follows: “You should be skeptical of even widely accepted methods of analyzing and forecasting the performance of high-yield bonds. . . . You should [also] be cautious in applying traditional fixed-income analytical techniques to high-yield bonds.”

Bill Hoffmann’s “The Art of High-Yield Credit Analysis” is a case study that analyzes Kraton Performance Polymers’ acquisition of Arizona Chemical in 2015, using substantial leverage (debt). Studying a long historical period, Diane Vazza’s “Forecasting the High-Yield Default Rate” shows how default rates on high-yield bonds are affected by macroeconomic factors and market cycles. In “Corporate Bankruptcy: Primer on Process and Prospects,” Anders Maxwell shows how “bankruptcy reorganizations—and related out-of-court restructurings—represent an opportunistic niche in high-yield credit markets.” Taking advantage of such special situations requires a keen understanding of law as well as finance. Maxwell counsels that studying corporate failure may be more revealing than studying corporate success.

In “An Introduction to High-Yield Bond Covenants,” Saish Setty provides a primer on debt covenants, which are a key element of the indentures (legal contracts) that underlie bond issuances. Covenants may be affirmative (requiring the borrower to do something) or negative (prohibiting the borrower from doing something). Readers also find out what a hookie dook is.

Finally, the late Michael F. Brown, in “Dynamics of the High-Yield Bond Market,” introduces the reader to some of the more advanced math governing the bond market and high-yield bonds in particular.

Edited by Michael J. Greis, CFA, “Mainstreaming Sustainable Investing”

This brief presents the contents of the 2016 Sustainable Investing Seminar; the seminars have been run annually by CFA Society Boston since 2013. The editor, Michael J. Greis, defines sustainable investing in terms of the 1987 Brundtland Commission report to the United Nations: “Sustainable development is development that meets the needs of the present without compromising the ability of future generations to meet their own needs.” This broad concept applies to investing through techniques now usually known as ESG (environmental, social, and governance) investing.

In addition to Greis’s introduction, the brief consists of write-ups of the four presentations at the seminar:

“Investing in an Era of Disruption and Transformational Change: The Value of Material ESG Information,” by George Serafeim, Harvard Business School;
“Machine Learning and Big Data Enable a Quantitative Approach to ESG Investing,” by Andreas Feiner, Arabesque Asset Management;
“Analyzing the Performance of ESG Factors in a Mixed Asset Setting,” by Andreas Hoepner, University College Dublin; and
“Understanding and Capitalizing on Systemic Impacts of ESG Factors,” by Steve Lydenberg, Domini Social Investments.

The unifying theme of the presentations is that, in social investing pioneer Erika Karp’s words, “sustainable investing is just investing.” In other words, the analytic tools and intellectual framework used to make any active management decision can and should be applied to investing for environmental and social goals.

Momtchil Pojarliev, CFA, “Some Like It Hedged”

In this research brief on currency hedging, currency manager Momtchil Pojarliev, CFA, notes that most currency exposure taken by investors is inadvertent: They don’t do it to make money; rather, it is a side effect of investing in securities issued outside one’s home country. Asking whether investors should hedge (and how much), Pojarliev finds that “investors whose base currency is negatively correlated with global equities, such as the US dollar and the Japanese yen, will reduce the volatility of their portfolios by fully hedging foreign currency exposure.” However, investors whose base currency is positively correlated with global equities should hedge less or not at all and may benefit from exposure to the US dollar. The author also notes that hedging is costly and must be evaluated as to whether it is worth the expense. This work builds on the renowned currency-hedging study by Fischer Black in the Financial Analysts Journal in 1989 (“Universal Hedging: Optimizing Currency Risk and Reward in International Equity Portfolios”) and on the author’s own 2012 research monograph (with co-author Richard Levich), A New Look at Currency Investing.

Future Work

In 2019, the Research Foundation will offer monographs on restoring the growth of economic productivity (a collection of works by prominent economists), structuring the responsibilities of fund fiduciaries for optimum performance, investing for a secure retirement, and assessing whether there is a systemic retirement crisis. We will also release briefs and a literature review as they are produced, and we look forward to an exciting year.