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The following is derived from the Editor’s Snapshot podcast summary of the latest issue of the CFA Institute Financial Analysts Journal. Institutional subscribers and logged-in CFA Institute members have full access to all the articles.
What’s in the CFA Institute Financial Analysts Journal 2021 third quarter issue?
Contributions explore Volmaggedon, American Depositary Receipts (ADRs), soft commissions, carbon emissions, the end of the hedge fund era, and the predictability of bonds.
But first, Andew Lo helps celebrate the Journal‘s first 75 years with “The Financial System Red in Tooth and Claw: 75 Years of Co-Evolving Markets and Technology.” Lo is well known for his “Adaptive Markets Hypothesis,” and here he reflects on the adaptation or evolution of financial practice with that of technology. He defines eight eras of financial evolution from 1945 to the present, mapping each against the technological development of the era as well as financial and regulatory milestones. From Bretton Woods to bitcoin, he charts how we got here and explores what’s next.
“Volmageddon” is the nickname for the market crash of short volatility strategies on 5 February 2018 that led to the demise of some inverse VIX exchange-traded products in the United States and continues to hold lessons for us today. In “Volmageddon and the Failure of Short Volatility Products,” Patrick Augustin, Ing-Haw Chen, and Ludovic Van den Bergen walk readers through the steps of the negative feedback loop that created Volmageddon and demonstrate the pitfalls of hedge and leverage rebalancing when markets are concentrated and volatility spikes.
For those looking to go deeper, “Levered and Inverse Exchange-Traded Products: Blessing or Curse,” by Colby J. Pessina and Robert E. Whaley, from this year’s first quarter edition of the Journal, makes for a good companion read.
ADRs allow US investors to participate in foreign equity on the US markets and enable foreign companies to achieve a sort of cross-listing that potentially lowers their cost of capital. For firms in markets such as China where IPO legislation can be tricky, ADRs can be an attractive alternative. But they are not without controversy. In “Chinese and Global ADRs,” the authors review the performance of ADRs of firms from across the world from the 1950s to the present and provide an excellent introduction to ADRs’ breadth, history, and diversity. Investors have enjoyed significant performance benefit and diversification through this market, particularly with respect to Chinese firms. But the researchers express concern that the “Holding Foreign Companies Accountable Act,” among other legislation, could limit the future of Chinese ADRs in particular.
Speaking of legislation, it’s been more than three years since MiFID II became applicable in Europe and some re-bundling legislation will take effect next year. Soft commissions, or the bundling of execution and research, has been debated and legislated for years. In “To Bundle or Not to Bundle? A Review of Soft Commissions and Research Unbundling,” researchers systematically review all the literature to this point to inform the road ahead. They report a consensus in the literature so far about agency conflicts and the costs of bundling. Research post-MiFID legislation in Europe, collectively points to higher research quality but reduced research coverage. But it also highlights the difficulty of cross-border broking, presents conflicting results on the effect of unbundling on smaller firms, and conjectures about mixed models in the future. It provides an excellent cheat sheet on all the work done on soft commissions so far: The consensus and the conflicts are summarized beautifully with recommendations on the path forward.
Having unbundled, let’s decarbonize! In “Decarbonizing Everything,” authors from Harvard and State Street analyze how the use of different climate risk measures lead to different portfolio carbon outcomes and risk-adjusted returns. They explain the origin, strengths, and weaknesses of the different types of carbon metrics: scope 1, 2, and 3 emissions, operational emissions, total value chain, analysts ratings, etc. The researchers attempt to construct a “decarbonizing” factor by designing long–short portfolios combining various metrics. Their results are enlightening, particularly along sector or industry lines and especially for investors and managers looking to manage climate risk within portfolio construction.
The issue concludes with some bad news about hedge funds and good news about bonds. In “Hedge Fund Performance: End of an Era?” Nicolas P.B. Bollen, Juha Joenväärä, and Mikko Kauppilad demonstrate that hedge fund performance really did take a turn for the worse after 2008. Aggregate performance has declined across funds. Moreover, the ability of established models to select hedge funds hasn’t helped investors much. The authors test a number of different theories and conclude that post-2008 reforms and central bank interventions were the likely turning point. Their advice for investors? Calibrate return expectations from hedge funds downward from here on.
The good news is that government bonds are predictable and therefore well worth the effort for an active manager. In “Predicting Bond Returns: 70 Years of International Evidence,” Robeco contributors Guido Baltussin, Martin Martens, and Olaf Penninga examine bonds in major markets around the world over a much longer period than other studies. They demonstrate robust results to very tradeable strategies with all the details for replication. They attribute the premium available for active bond fund management not to market or macro-economic risks, nor to transaction costs or other investment frictions, but rather to market inefficiency.
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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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