Best of 2016: Active Management Fights Back
What were the most popular articles from CFA Institute Financial Analysts Journal in 2016? How about the most popular summaries of research from the dozens of top journals reviewed by CFA Digest in 2016?
The most popular Journal article, and the clear winner this year, is John Bogle’s evaluation of “The Index Mutual Fund: 40 years of Growth, Change, and Challenge.” Bogle traces the evolution and drivers behind the spectacular growth of passive mutual funds, notably their small all-in costs and portfolio turnover, low transaction costs and high tax efficiency.
But active management is fighting back. First, Jeremy Siegel, a professor at the Wharton School, argues that recent low forecasts of future equity returns using the CAPE ratio may be overly pessimistic due to changes in the computation of GAAP earnings used in the Shiller CAPE model. Next, a survey of nearly 400 CFOs explores the definition and drivers of earnings quality, with an emphasis on the prevalence and detection of earnings misrepresentation. Given that a remarkable 20% of companies intentionally distort earnings, understanding these findings could give active managers an edge.
Three of the top 10 Journal articles relate to the increasingly popular “factor” and “smart beta” strategies. In “Will Your Factor Deliver? An Examination of Factor Robustness and Implementation Costs,” four quant researchers evaluate which of the hundreds of equity factors are likely to profit investors once implemented. In “Fundamentals of Efficient Factor Investing,” the researchers find that a combination of four fully invested factor subportfolios — low beta, small size, value, and momentum — capture less than half of the potential improvement over the market portfolio’s Sharpe Ratio. And, in “The Asset Manager’s Dilemma: How Smart Beta Is Disrupting the Investment Management Industry,” the authors argue that smart beta provides an important component of active management: simple, transparent, rules-based portfolios delivered at lower fees.
“It’s Time to Retire Ruin (Probabilities)” achieved the second highest number of downloads. Author Moshe Milevsky equates portfolio longevity with biological longevity, and discusses educating clients to maximize the life of their retirement savings.
CFA Digest: Novel Insights in Accounting, Stock Picking, Currency, and Behaviors
CFA Digest summarizes research papers from dozens of leading journals to help practicing investors stay topical and current.
The most popular CFA Digest download of 2016 was an insightful paper from the Journal of Accounting Research on the declining correlation between accruals and cash flows, which, according to the authors, has been dwindling since the 1960s because of one-time and non-operating items.
In “Can Analysts Pick Stocks for the Long-Run?” — the second most downloaded CFA Digest summary — the authors present new evidence to discount the impact of post-revision return drift (PRD): the long-term return for stocks after analysts adjust their related recommendations. The role of a security analyst is clearly not getting any easier.
In a year of notable currency volatility, particularly after the UK Brexit vote and the victory of Donald Trump in the US presidential election, two currency-related papers captured readers’ attention. Researchers from the IMF, the Banque de France, and Université de Bordeaux look at the response of gross capital flows in emerging market economies to US and global financial shocks, and find that the stabilizing role played by domestic investors may offset the behavior of foreign investors. In “What Do Stock Markets Tell Us about Exchange Rates?” the authors show that country equity returns are ultimately not related to foreign exchange movements.
Also making it into the top CFA Digest summaries is an intriguing paper revisiting the run-up to the 2008 financial crisis that suggests that while institutional investors had some sense of the looming crisis by favoring nonfinancial over financial firms, corporate insiders showed no such foresight. Finally, a novel study in the Review of Finance notes how common alphabetic bias is, and goes on to explore the influence of ordering effects — alphabetization — in the stock market.
The Top 10 CFA Institute Financial Analysts Journal Articles of 2016
Some 40 years ago, a new concept of investing — one broadly regarded by the financial community as trivial and likely to fail — began its path toward implementation.
Concerned about the growing use of ruin probabilities as the guiding risk metric for retirement income planning, the author introduces the idea of portfolio longevity being parallel to biological longevity of human life and discusses how to educate clients regarding the most important factors influencing their money’s longevity.
Robert Shiller’s cyclically adjusted price-to-earnings (CAPE) ratio has served as one of the best forecasting models for long-term future stock returns. But recent forecasts of future equity returns using the CAPE ratio may be overly pessimistic because of changes in the computation of GAAP earnings (e.g., “mark-to-market” accounting) that are used in the Shiller CAPE model.
The authors conducted a survey of nearly 400 CFOs on the definition and drivers of earnings quality, with an emphasis on the prevalence and detection of earnings misrepresentation. The respondents believe that the hallmarks of earnings quality are sustainability, absence of one-time items, and backing by actual cash flows. However, they also believe that in any given period, a remarkable 20% of companies intentionally distort earnings, even while adhering to GAAP.
The multifactor investing framework has become very popular in the indexing community. Both academic and practitioner researchers have documented hundreds of equity factors, but which of these factors are likely to profit investors once implemented?
The authors used the Burgiss dataset to study private equity buyout fund performance. Their findings on performance before risk adjustments are consistent with those in the literature and indicate significant outperformance of buyout fund investments.
Combining long-only-constrained factor subportfolios is generally not a mean–variance-efficient way to capture expected factor returns. For example, a combination of four fully invested factor subportfolios — low beta, small size, value, and momentum — captures less than half or 40% of the potential improvement over the market portfolio’s Sharpe ratio.
Over 70 years ago, in 1945, the first issue of the CFA Institute Financial Analysts Journal (at that time, the Analysts Journal) was published by the New York Society of Security Analysts (NYSSA) with the objective of advancing the interests of the profession and encouraging thoughtful discussion and debate on topics of current interest.
Smart beta products are a disruptive financial innovation with the potential to significantly affect the business of traditional active management. They provide an important component of active management via simple, transparent, rules-based portfolios delivered at lower fees.
How much of the historical 7% per year equity risk premium could have been risk compensation for disasters that just happened not to have occurred?
Top Summaries in CFA Digest of 2016
Investigating the correlation between accruals and cash flows, the authors show that it has diminished constantly and significantly since the 1960’s. This decline is mainly explained by increases in such non-timing-related accruals as one-time and nonoperating items and frequency of losses.
Post-revision return drift — the long-term return for stocks after analysts adjust their related recommendations — is estimated to be insignificantly different from zero during 2003–2010. The authors investigate transaction cost changes as a primary explanation and anticipate a reduced information intermediary role for analysts.
Examining the response of gross capital flows in emerging market economies to US and global financial shocks, the authors find that the stabilizing role played by domestic investors may offset the behavior of foreign investors when these shocks occur. In particular, foreign investors tend to retrench from emerging markets during these periods, but the impact of their actions is largely offset by sizable asset repatriation by domestic investors.
Using a long–short approach designed to exploit differentials in expected equity returns across countries, the authors investigate the relationship between international equity index and foreign exchange returns. Exchange rate movements do not offset differentials in the returns of international equity indexes. Moreover, stock market returns tell us very little about exchange rates.
Analyzing the ability of informed stock market participants to foresee the 2007–2008 financial crisis, the authors find that financial analysts and institutional investors showed some perception of the looming crisis by favoring nonfinancial over financial firms. Conversely, corporate insiders showed no perception of the approaching crisis. Net insider stock purchases at financial firms over the crisis period surpassed net insider purchases at nonfinancial firms. The authors argue that these results suggest that the crisis was at least partially caused by faulty judgment.
Alphabetic bias affords US stocks at or near the top of an alphabetical listing an advantage in trading activity and liquidity.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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