Research articles for the 2019-05-22

A Banking Union for the Euro Area
Goyal, Rishi,Brooks, Petya Koeva,Pradhan, Mahmood,Tressel, Thierry,Dell'Ariccia, Giovanni,Leckow, Ross B.,Pazarbasioglu, Ceyla
A banking unionâ€"a single supervisory-regulatory framework, resolution mechanism, and safety netâ€"for the euro area is the logical conclusion of the idea that integrated banking systems require integrated prudential oversight.The case for a banking union for the euro area is both immediate and longer term. Moving responsibility for potential financial support and bank supervision to a shared level can reduce fragmentation of financial markets, stem deposit flight, and weaken the vicious loop of rising sovereign and bank borrowing costs. In steady state, a single framework should bring a uniformly high standard of confidence and oversight, reduce national distortions, and mitigate the buildup of concentrated risk that compromises systemic stability. Time is of the essence. Progress is required on all elements. A single supervisory mechanism (SSM) must ultimately supervise all banks, with clarity on duties, powers and accountability, and adequate resources. But without common resolution and safety nets and credible backstops, an SSM alone will do little to weaken vicious sovereign-bank links; they are necessary also to limit conflicts of interest between national authorities and the SSM. A single resolution authority, with clear ex ante burden-sharing mechanisms, must have strong powers to close or restructure banks and be required to intervene well ahead of insolvency. A common resolution/insurance fund, sized to resolve some small to medium bank failures, with access to common backstops for systemic situations, would add credibility and facilitate limited industry funding.The challenge for policymakers is to stem the crisis while ensuring that actions dovetail seamlessly into the future steady state. Hence, agreeing at the outset on the elements, modalities, and resources for a banking union can help avoid the pitfalls of a piecemeal approach and an outcome that is worse than at the start. The December 2012 European Council agreement on an SSM centered at the European Central Bank (ECB) is an important step, but raises challenges that should not be underestimated. Meanwhile, to delink weak sovereigns from future residual banking sector risks, it will be important to undertake as soon as possible direct recapitalization of frail domestically systemic banks by the European Stability Mechanism (ESM). Failing, non-systemic banks should be wound down at least cost, and frail, domestically systemic banks should be resuscitated by shareholders, creditors, the sovereign, and the ESM.A banking union is necessary for the euro area, but accommodating the concerns of non-euro area European Union (EU) countries will augur well for consistency with the EU single market.

A Study on the Impact of Earning News on Investors’ Decision
Joshi, Dr. Divyang,Pradhan, Tushar S
The movement of the share price is always being the interesting topic for the researcher. The growing researches focus on the impact of bonus share announcement, stock split, right share, earning announcement, dividend announcement, and business announcement. There are more than 500 papers had published in known journals which confirmed that stock prices react to news (Kothari and Warner (2006). But they are failed to integrate the sentiment of the published earning specific news and its impact. Secondly, the studies which focused on long term, they failed to consider the potential problem of publication bias (Antweiler and Frank (2006). In this paper, the impact on investors’ decision is measured in terms of price reaction due to earning specific News. Total 369 earning specific news of 5 companies for 5 years were collected and analyzed. To check the impact of news, if any, the volume reactions were examined. The result indicates that there is an impact of news. Secondly, AAR and CAAR were tested and concluded that informed investors can earn abnormal high return. Lastly, the positive and negative sentiment of the news information was identified by using wordstat software. And it was concluded that there is no significant difference between AAR of positive earnings news and negative earnings news.

Active Risk-Based Investing
Jurczenko, Emmanuel,Teiletche, Jerome
Risk-based investment solutions are seen as incorporating no views. In this article, we propose an analytical framework that allows the introduction of explicit active views on expected asset returns in risk-based solutions. Starting from a Black-Litterman approach, we derive closed-form formulas for the weights of the active risk-based portfolio, and identify their main determinants. We discuss implementation aspects and show how our framework is related to other popular active investing methodologies. We illustrate the methodology with a multi-asset portfolio allocation problem using views based on macroeconomic regimes over the period 1974-2013.

Analysing monetary policy statements of the Reserve Bank of India
Mathur, Aakriti,Sengupta, Rajeswari
In this paper we quantitatively analyse monetary policy statements of the Reserve Bank of India (RBI) from 1998 to 2017, across the regimes of five governors. We first ask whether the content and focus of the statements have changed with the adoption of inflation-targeting as a framework for conducting monetary policy. Next, we study the influence of various aspects of monetary policy communication on financial markets. Using natural language processing tools, we construct measures of linguistic and structural complexity that capture governor-specific trends in communication. We find that while RBI's monetary policy communication is linguistically complex on average, the length of monetary policy statements has gone down and readability has improved significantly in the recent years. We also find that there has been a persistent semantic shift in RBI's monetary policy communication since the adoption of inflation-targeting. Finally, using a simple regression model we find that lengthier and less readable statements are linked to both higher trading volumes and higher returns volatility in the equity markets, though the effects are not persistent.

Arithmetic and Continuous Return Mean-Variance Efficient Frontiers
Ferguson, Robert,Leistikow, Dean,Yu, Susana
The arithmetic mean-variance efficient frontier shows that taking more risk is always rewarded with higher expected arithmetic return. However, expected arithmetic return is a poor indicator of long-term arithmetic return, which corresponds to expected continuous return. For the continuous return mean-variance efficient frontier, expected continuous return initially rises, then declines and becomes negative without limit as risk increases. Too much aggressiveness can lead to disaster, even without borrowing.

Behavioral Efficient Markets
Statman, Meir
Discussions about market efficiency in finance are unfocused when they fail to distinguish between the price-equals-value market hypothesis and the hard-to-beat market hypothesis. And discussions are further lacking when they fail to explain why so many investors believe that markets are easy to beat when, in truth, they are hard to beat.

Black Swans in Emerging Markets
Estrada, Javier
Do investors in emerging markets obtain their long term returns smoothly and steadily over time, or is their long term performance largely determined by the return of just a few outliers? Are investors likely to successfully predict the best days to be in and out of these markets? The evidence from 16 emerging equity markets and over 110,000 daily returns shows that a few outliers have a massive impact on long term performance. On average across all 16 markets, missing the best 10 days resulted in portfolios 69.3% less valuable than a passive investment; and avoiding the worst 10 days resulted in portfolios 337.1% more valuable than a passive investment. Given that 10 days represent 0.15% of the days considered in the average market, this evidence strongly suggests that the odds against consistently successful market timing in emerging markets are staggering.

Corporate Bond Use in Asia and the United States
Duffee, Gregory R.,Hördahl, Peter
We examine the determinants of Asian firms' decisions to participate in the corporate bond market and the determinants of the magnitude of bond debt for firms that do issue bonds. We compare the behaviour of Asian firms with US firms and investigate what drives differences in their financing decisions. We also analyse how firms alter their mix of bank and bond debt as their demand for cash varies. Our results show that firm characteristics account for only a very small portion of the difference in corporate bond use between Asian and US firms. Asian firms are simply less likely to issue bonds than US firms. The wedge in bond use between US and Asian firms is primarily driven by the likelihood that a firm issues bonds, rather than the magnitude of bond debt conditional on issuance. These results point to weak infrastructure, ie markets and institutions, as an important factor behind much of the lower use of bond financing in Asia. However, while policies aimed at facilitating the use of bond debt by Asian firms may result in increased bond issuance, it may not necessarily give firms more flexibility in meeting their financing needs. Even firms with a substantial presence in the corporate bond market primarily adjust their bank debt rather than their bond debt as demand for cash varies.Full Publication: Asia-Pacific Fixed Income Markets: Evolving Structure, Participation and Pricing

Deconstructing the Low-Vol Anomaly
Ciliberti, Stefano,Lemperiere, Yves,Beveratos, Alexios,Simon, Guillaume,Laloux, Laurent,Potters, Marc,Bouchaud , Jean-Philippe
We study several aspects of the so-called low-vol and low-beta anomalies, some already documented (such as the universality of the effect over different geographical zones), others hitherto not clearly discussed in the literature. Our most significant message is that the low-vol anomaly is the result of two independent effects. One is the striking negative correlation between past realized volatility and dividend yield. Second is the fact that ex-dividend returns themselves are weakly dependent on the volatility level, leading to better risk-adjusted returns for low-vol stocks. This effect is further amplified by compounding. We find that the low-vol strategy is not associated to short term reversals, nor does it qualify as a Risk-Premium strategy, since its overall skewness is slightly positive. For practical purposes, the strong dividend bias and the resulting correlation with other valuation metrics (such as Earnings to Price or Book to Price) does make the low-vol strategies to some extent redundant, at least for equities.

Discount Rates and Cash Flows: A Local Projection Approach
Lof, Matthijs,Nyberg, Henri
We develop a volatility decomposition derived from flexible and robust local projections to quantify the relative contributions of expected discount rates and cash flows to the variation of dividend yields. Local projections enable the incorporation of large information sets, the use of monthly data in addition to annual data, and the consideration of time variation of the volatility decomposition. While the variation of expected discount rates remains the dominant contributor to market volatility, we find that the contribution of expected cash flows is non-negligible when moving beyond the standard model with the dividend yield as the single state variable.

Do Political Connections Promote Innovation in Environmentally Polluting Enterprises?
Zhang, Jianhua,Li, Xiaoqing,Fung, Hung-Gay,Qiao, Peng
We use an unbalanced panel data analysis to examine the effect of political connections (PCs) in state‐owned enterprises (SOE) and non‐SOEs on the innovation of Chinese environmentally polluting enterprises listed on the Shanghai and Shenzhen Stock Exchanges from 2007 to 2016. Our sample consists of 792 firms and 4587 firm‐year observations. There are several interesting findings. First, SOEs that are politically linked to the central government promote more innovation in general and more environmental innovation than SOEs without these links. Second, privately‐owned enterprises (non‐SOEs) with PCs promote less environmental innovation than non‐SOEs without PCs. Third, environmental regulation does not affect the environmental innovation of SOEs but it drives non‐SOEs with PCs to become more environmentally innovative. Our results enable us to better understand how PCs and regulations affect environmental innovation.

Does Bank Competition Spur Firm Innovation?
Liu, Peisen
This article contributes to the literature by examining how the increase in bank competition impacts firms’ innovation and how firm size and firm ownership impact the effect of bank competition. Using data which includes the banking sector and firm information across Chinese prefecture-level city over the period 1998-2011. The robust evidence shows that bank competition improves firm-level innovation by firms headquartered within competing regions and find that the positive effect of bank competition is stronger for small and medium-sized enterprises (SMEs), non-state-owned enterprises (non-SOEs) and domestically-owned firms compared to large firms, SOEs, and foreign-owned firms, respectively. We also find that bank competition poses more beneficial effects on innovative performance for firms with more opaque, more dependent on external financing, high debt cost, and short operating years. Overall, these results provide light on the determinants of innovation and the real effects of bank competition.

Dominant Currency Debt
Eren, Egemen,Malamud, Semyon
We propose a "debt view" to explain the dominant international role of the dollar. We develop an international general equilibrium model in which firms optimally choose the currency composition of their nominal debt. Expansionary monetary policy in downturns prevents Fisherian debt deflation through its effects on inflation and exchange rates, and alleviates financial distress. Theoretically, the dominant currency is the one that depreciates in global downturns over horizons of corporate debt maturity. Empirically, the dollar fits this description, despite being a short-run safe-haven currency. We provide broad empirical support for the debt view. We also study the globally optimal monetary policy.

Financial Deepening and International Monetary Stability
Goyal, Rishi,Marsh, Chris,Raman, Narayanan,Wang, Shengzu,Ahmed Hannan, Swarnali
Recent discussions at the IMF and the G-20 on strengthening the international monetary system have emphasized, among other efforts, increasing the financial depth of emerging markets. Such deepening is widely believed to confer important stability benefits, helping countries limit swings in asset prices, find alternative sources of funding, and attenuate the need for reserve accumulation.This paper seeks to shed light on the role of financial deepening in promoting the stability of the system as a whole. A simple balance sheet metric of financial depth shows a growing divergence in the financial depth of advanced versus emerging markets, pointing to scope for catch-up. But catch-up has implications for global imbalances, insofar as international adjustment requires slower growth of domestic claims in advanced deficit countries (slower credit growth lowers domestic demand) and faster growth in surplus economies and emerging markets (which would raise domestic demand). Deepening is also related to crisis incidence and costs. Crisis risks and costs are high in the initial stages of deepening, during which policymakers tend to build reserve buffers, constrain capital mobility, and limit exchange rate flexibility. In later stages, alongside flexible exchange rates, open capital accounts and smaller reserve buffers, crisis incidence is found to decline.Although financial deepening can contribute to lowering imbalances and crisis incidence and costs, it is a long-term process. Therefore, it remains crucial to make progress in the near term to strengthen the international monetary system, including building a strong global financial safety net and developing a framework for coping with capital flows.

Fund Management Skill and Noise Trading
Dong, Feng,Doukas, John A.
In this research authors show that institutional investors’ skill matters the most during high sentiment periods when market signals are noisy. The results reveal that fund managers with the highest (lowest) skill add (lose) $7.71 ($5.64) million of value during high sentiment periods, compared with $3.74 million gain realized by the average manager during the entire sample period. When the market sentiment is low, high-skilled fund managers incur a value loss of only $0.18, much smaller than the $30.32 million loss realized by their low-skilled counterparts.

Guidelines for Integrating Socially Responsible Investment in the Investment Process
de Graaf, Frank Jan,Slager, Alfred
This paper addresses the implementation of Socially Responsible Investment (SRI) in the investment process. We argue that a clear distinction needs to be made between (1) ethical based, (2) investment driven and value-ensuring objectives in SRI. This distinction enables trustees and investors to effectively address the SRI strategies in the hierarchy of the investment process.

Hedging Climate Change News
Engle, Robert F.,Giglio, Stefano,Kelly, Bryan T.,Lee, Heebum,Stroebel, Johannes
We propose and implement a procedure to dynamically hedge climate change risk. We extract innovations from climate news series that we construct through textual analysis of newspapers. We then use a mimicking portfolio approach to build climate change hedge portfolios. We discipline the exercise by using third-party ESG scores of firms to model their climate risk exposures. We show that this approach yields parsimonious and industry-balanced portfolios that perform well in hedging innovations in climate news both in sample and out of sample. We discuss multiple directions for future research on financial approaches to managing climate risk.

How Does the Interaction of Macroprudential and Monetary Policies Affect Cross-Border Bank Lending?
Takáts, ElÅ'd,Temesvary, Judit
We combine a rarely accessed BIS database on bilateral cross-border lending flows with cross-country data on macroprudential regulations. We study the interaction between the monetary policy of major international currency issuers (USD, EUR and JPY) and macroprudential policies enacted in source (home) lending banking systems. We find significant interactions. Tighter macroprudential policy in a home country mitigates the impact on lending of monetary policy of a currency issuer. For instance, macroprudential tightening in the UK mitigates the negative impact of US monetary tightening on USD-denominated cross-border bank lending outflows from UK banks. Vice-versa, easier macroprudential policy amplifies impacts. The results are economically significant.

How to Alleviate Correlation Neglect
Laudenbach, Christine,Ungeheuer, Michael,Weber, Martin
We experimentally study how presentation formats for return distributions affect investors' diversification choices. We find that sampling returns alleviates correlationneglect and constitutes an effective way to improve financial decisions. When participants get a description of probabilities for outcomes of the joint return distribution, we confirm the common finding that investors neglect the correlation between assets in their diversification choices. However, when participants sample from the joint distribution, they incorporate correlation into choices as predicted by normative theory. Results are robust across three experiments with varying expertise and experience of participants (students vs. investors), and varying return distributions (discrete, continuous).

IFRS 9 Expected Loss: A Model Proposal for Estimating the Probability of Default for Non-Rated Companies
Delgado-Vaquero, David,Morales-Díaz, José,Zamora-Ramírez, Constancio
Under the IFRS 9 impairment model, entities must estimate the PD (Probability of Default) for all financial assets (and other elements) not measured at fair value through profit or loss. There are several methodologies for estimating this PD from market or historical information. However, in some cases entities do not possess market or historical information concerning a counterparty. For such cases, we propose a model called Financial Ratios Scoring (FRS), by means of which an entity can obtain a “shadow rating” for a counterparty as a first step in estimating the PD. The model differentiates from other recent models in several aspects, such as the size of the database and the fact that it is focused on non-rated companies, for example. It is based on scoring the counterparty according to its key financial ratios. The score will place the counterparty on a percentile within a previously constructed sector distribution using companies with a credit rating published by rating agencies or financial vendors. We have tested the model reliability by calculating the internal credit rating of several companies (which have an official/quoted credit rating), and by comparing the rating obtained with the official one, and obtained positive results.

Institutional Investors and Medical Innovation
Unsal, Omer,Rayfield, Blake
In this research paper, we investigate if institutional investors influence corporate innovation in the US pharmaceutical industry. We hand collect unique datasets from the Food and Drug Administration (FDA), including drug patents, drug approvals, medical device approvals, and Phase I-II-III drugs under clinical testing. We find that higher institutional ownership has a positive, causal effect on firm innovation. We document that institutional ownership increases the number of FDA approved products. Then, we examine the innovation quality and find that institutional ownership reduces the likelihood of both drug recalls and market withdrawals. Our results investigate possible underlying mechanisms through which institutional investors provide faster and more frequent innovation outcomes: Institutional holdings act as active monitors by providing insurance for firm executives against innovation failures. Our article sheds new lights on the real effects of institutional investors on pharmaceutical firms’ innovation.

Investor Learning and Mutual Fund Advertising and Distribution Fees
Haslem, John A.
Barber, Odean, and Zheng’s [2005] analysis of mutual fund front-end loads, sales commissions, and operating expenses finds that over the past several decades ordinary investors have “learned” what they value in choice of funds. And, fund advisers learned early on to provide what attracts ordinary investors to particular funds: larger advertising.

Islamic Banking System: A Credit Channel of Monetary Policy â€" Evidence from an Emerging Economy
Rafay, Abdul,Farid, Saqib
Since its inception, Islamic banking in Pakistan has shown remarkable growth and development. Most recent statistics unveil that industry has captured around 13% of the total banking market in Pakistan. This outstanding augmentation of the industry highlights the crucial role of Islamic banks for monetary policy considerations. The study aimed to evaluate the role of Islamic banks in monetary transmission process in Pakistan. The study examined the role of two most crucial balance sheet items of Islamic banks in monetary transmission process; (1) Islamic deposits and (2) Islamic financing. The paper employed time serious techniques like JJ-cointegration test, vector auto regression (VAR), Variance Decomposition Analysis (VDC) and Impulse Response Function (IRF) to investigate the role of Islamic banks in monetary transmission process. The study sample covered the time period of 2007-17. The results unveiled the significant role of Islamic banks in transmitting monetary decisions to the real economy. Moreover, the evidence demonstrated active bank lending channel of Islamic banking in Pakistan. The findings also corroborated the functional role of Islamic banks along with their conventional counterparts for effective formulation of monetary policy in Pakistan.

Liquidation, Bailout, and Bail-In: Insolvency Resolution Mechanisms and Bank Lending
Lambrecht, Bart M.,Tse, Alex S. L.
We present a dynamic, continuous-time model in which risk averse inside equityholders set a bank's lending, payout, and financing policies, and the exposure of bank assets to crashes. We study how the prevailing insolvency resolution mechanism affects these policies, the insolvency rate, loss in default, value at risk (VaR), and the net value created by the bank. VaR depends non-trivially on jump (crash) risk, diffusion risk and the horizon. We examine the commonplace assertion that bailouts encourage excessive lending and risk-taking compared to the liquidation and bail-in regimes, and explore whether bailouts could be financed by banks without taxpayers' money.

Local Currency Bond Returns in Emerging Market Economies and the Role of Foreign Investors
So, Inhwan,Valente, Giorgio,Wu, Jason
Foreign investors play a key role in sovereign bond markets in emerging market economies (EMEs), in part because their portfolio flows are sensitive to bond returns and are therefore pro-cyclical in nature. This note discusses the implications of the framework proposed by So et al (2019), which incorporates the risk that arises from the portfolio performance and flows of actively managed bond funds. When the framework is applied to the data, using local currency sovereign bonds of 16 EMEs, preliminary calculations show that local currency sovereign bonds that positively covary with the returns of active funds receive risk premia as compensations for active fund risk. Furthermore, and in line with theory, the price of this risk increases when bond funds experience outflows and the exposure to active funds risk increases with the heightened price of risk. This double effect helps explain why spikes in returns of some EME local currency bonds can be especially large. These results demonstrate how the portfolio performance and flows of actively managed funds help transmit shocks across EMEs.Full Publication: Asia-Pacific Fixed Income Markets: Evolving Structure, Participation and Pricing

Man vs. Machine: Comparing Discretionary and Systematic Hedge Fund Performance
Harvey, Campbell R.,Rattray, Sandy,Sinclair, Andrew,Van Hemert, Otto
We analyse and contrast the performance of discretionary and systematic hedge funds. Systematic funds use strategies that are rules-based, with little or no daily intervention by humans. In our experience, some large allocators shy away from systematic hedge funds altogether. A possible explanation for this is what the psychology literature calls “algorithm aversion”. However, we find no empirical basis for such an aversion. For the period 1996-2014, systematic and discretionary manager performance is similar, after adjusting for volatility and factor exposures, i.e., in terms of their appraisal ratio. It is sometimes claimed that systematic funds’ returns have a greater exposure to well-known risk factors. We find, however, that for discretionary funds (in the aggregate) more of the average return and the volatility of returns can be explained by risk factors.

Mimicking Portfolios
Roll, Richard,Srivastava, Akshay
Mimicking portfolios have many applications in the practice of finance. Here, we present a new method for constructing them. We illustrate its application by creating portfolios that mimic individual NYSE stocks. On the construction date, a mimicking portfolio exactly matches its target stock’s exposures (betas) to a set of ETFs, which serve as proxies for global factors, and the portfolio has much lower idiosyncratic volatility than its target. Mimicking portfolios require only modest subsequent rebalancing in response to instabilities in target assets and assets used for portfolio construction. Although composed here exclusively of equities, mimicking portfolios show potential for mimicking non-equity assets as well.

Modelling Socio-Economic Differences in Mortality Using a New Affluence Index
Cairns, Andrew J. G.,Kallestrup Lamb, Malene,Rosenskjold, Carsten,Blake, David P.,Dowd, Kevin
We introduce a new modelling framework to explain socioeconomic differences in mortality in terms of an affluence index that combines information on individual wealth and income. The model is illustrated using data on older Danish males over the period 1985-2012 reported in the Statistics Denmark national register database. The model fits the historical mortality data well, captures their key features, generates smoothed death rates that allow us to work with a larger number of subgroups than has previously been considered feasible, and has plausible projection properties.

Modelling UK House Prices with Structural Breaks and Conditional Variance Analysis
Begiazi, Kyriaki,Katsiampa, Paraskevi
This paper differs from previous research by examining the existence of structural breaks in the UK regional house prices as well as in the prices of the different property types (flats, terraced, detached and semi-detached houses) in the UK as a whole, motivated by the uncertainty in the UK housing market and various financial events that may lead to structural changes within the housing including structural break tests strengthens our analysis. Our empirical results support the existence of four property types, and in the variance equation in six regions and three property types. In addition, using a multivariate GARCH approach we examine both the behaviour of variances and covariances of the house price returns over time. Our results have significant implications for appropriate economic polilcy selection and investment management.

Mutual Fund Arbitrage and Transaction Costs
Haslem, John A.
The 2003 mutual funds scandal that exploded upon the public revealed something that had long been known to insiders: Mutual fund advisers often approve and allow frequent trading, frequent trading arbitrage, and late trading arbitrage to selected traders. To increase adviser profits, fund advisers often require approved arbitrage traders to make "sticky asset" purchases of fund shares to "grow" fund assets. These costly mutual fund adviser practices increase transaction costs along several dimensions and lower current fund and shareholder assets, along with opportunity costs of dilution in fund share values and returns to long-term shareholders. Independent directors have either not been informed or have acquiesced in the decisions. In any case, independent directors have not performed their primary fiduciary duty as "shareholder watchdogs".

New copulas based on general partitions-of-unity (part III) - the continuous case (extended version)
Dietmar Pfeifer,Andreas Mändle,Olena Ragulina,Côme Girschig

In this paper we discuss a natural extension of infinite discrete partition-of-unity copulas which were recently introduced in the literature to continuous partition of copulas with possible applications in risk management and other fields. We present a general simple algorithm to generate such copulas on the basis of the empirical copula from high-dimensional data sets. In particular, our constructions also allow for an implementation of positive tail dependence which sometimes is a desirable property of copula modelling, in particular for internal models under Solvency II.

Open Source Finance
Kane, David
Open source finance brings the benefits of open source development to academic research and professional practice in finance. The three main parts of open source finance are: 1) the use of open source software in testing hypotheses and implementing investment strategies, 2) cheap access to financial data, and, 3) replication to confirm published research results. Although neither open source software nor replication are widely employed in finance today, their use is growing and their advantages substantial. Academics and professionals who embrace these changes are more likely to be successful than those who do not.

Optimizing Value
Leshem, Ran,Goldberg, Lisa R.,Cummings, Alan
We investigate how the choice of accounting metric and implementation affect the performance of a value strategy. We find that:

Performance and Characteristics of Actively Managed Institutional Equity Mutual Funds
Baker, H. Kent,Haslem, John A.,Smith, David M.
In this study, we provide extensive evidence on the performance characteristics of 1,118 U.S. domestic, actively managed institutional equity mutual funds. We measure performance using such measures as three-year Sharpe ratios, Jensen's alphas, and Miller's active alphas as well as annualized Russell Index-adjusted returns over multiple periods (1, 3, 5, 10, 15 years). We relate performance to fund attributes including expense ratio class, net assets, 12b-1 fees dummy, turnover ratio, beta, cash, and dividend yield.

Portfolio Allocations Using Fundamental Ratios: Are Profitability Measures Effective in Selecting Firms and Sectors?
Hughen, J. Christopher,Strauss, Jack
Our study assesses the performance of portfolios formed using out-of-sample sector forecasts and past firm fundamental ratios. Portfolio allocations based on profitability measures - gross profit, operating profit, and EBITDA - generate performance substantially better than the benchmark. Long/short portfolio allocations using these fundamentals possess alphas over 14% and increase Sharpe ratios by over 60%. A composite variable provides the highest payoff for firm allocations, while EBITDA produces the most profitable out-of-sample sector allocations. Profitability metrics are superior indicators of sustainable economic performance because these ratios are more strongly linked to future returns and cash flows than net income.

Pure Quintile Portfolios
Liu, Ding
In this paper we propose a new portfolio construction framework called Pure Quintile Portfolios. These portfolios overcome the main drawback of naïve quintile portfolios based on single sorts, namely, not having pure exposures to the target factor. Each pure quintile portfolio has the same exposure to the target factor as its naïve counterpart, but also has zero exposures to all other factors. Therefore pure quintile portfolios more accurately reflect the cross sectional distribution of true factor returns. In addition, when we long Q1 and short Q5 to capture factor premia as is most commonly done in research and practice, we find that pure Q1-Q5 portfolio has lower risk and higher Sharpe ratio than naïve Q1-Q5 portfolio for a group of widely used factors, thus providing evidence that our new framework creates more efficient and stable factor premia than naïve quintile portfolios.

Quantitative vs. Fundamental Analysis in Institutional Money Management: Where's the Beef?
Gregory-Allen, Russell B.,Shawky, Hany A.,Stangl, Jeffrey Scott
In the money management industry, there is a "quiet" controversy over who does a better job, Traditional Managers (Fundamentalists), or Quantitative Managers. This issue has been examined by Gruber (1996), and Pastor and Stambaugh (2003) and more recently by Zhao (2006) and Wermers, Yao and Zhao (2007) using mutual fund portfolios. We reexamine this issue using the Plan Sponsor Network Database (PSN), a survivorship free database, which reports on how managers actually manage investment portfolios with respect to both style and types of stock selection methods used. Our empirical results indicate that when examining performance purely attributable to the use of a distinct Primary Investment Process, only the Fundamental approach is shown to significantly add value. However, when examining marginal performance of a Secondary Process, over and above a Primary approach, no process adds value, and in fact some detract.

Sentiment and the Performance of Technical Indicators
Feng, Shu ,Wang, Na,Zychowicz, Edward J.
This paper studies the effectiveness of technical trading approaches in market environments of varying sentiment. Due to short-sale constraints, overpricing with high sentiment (i.e. relatively optimistic sentiment) is more prevalent compared to underpricing with low sentiment (i.e. relatively pessimistic sentiment) and this effect is stronger on difficult-to-arbitrage securities. The authors find consistent evidence over the period of 1993-2010 that the examined set of technical indicators perform better during periods of high sentiment than during periods of low sentiment. Moreover, this sentiment effect is relatively more pronounced for small stocks. These findings hold after a number of robustness checks are applied and highlight the importance of incorporating the sentiment effect when using technical indicators.

The Diversification Delta: A Different Perspective
Salazar, Yuri,Bianchi, Robert J.,Drew, Michael E.,Trück, Stefan
Vermorken et al. (2012) introduce a new measure of diversification, the Diversification Delta based on the empirical entropy. The entropy as a measure of uncertainty has successfully been used in several frameworks and takes into account the uncertainty related to the entire statistical distribution and not just the first two moments of a distribution. However, the suggested Diversification Delta measure has a number of drawbacks that we highlight in this article. We also propose an alternative measure based on the exponential entropy which overcomes the identified shortcomings. We present the properties of this new measure and illustrate its usefulness in an empirical example of a portfolio of U.S. stocks and bonds.

The Effect of Value Estimation Errors on Portfolio Growth Rates
Ferguson, Robert,Leistikow, Dean,Rentzler, Joel,Yu, Susana
This paper analyzes the impact of value estimation errors on portfolios' growth rates and relative growth rates (i.e. long-term returns and long-term relative returns) for several portfolio weighting methods. The portfolio weighting methods include capitalization weights, estimation error neutral weights, estimation error independent weights, Funda-mental weights, and Diversity weights. The paper provides theoretical support, in the context of estimation error, for the empirical findings that many non-capitalization weighted portfolios beat the market's capitalization weights. It also provides a theory for the size effect.

The Geographic Flow of Bank Funding and Access to Credit: Branch Networks, Local Synergies, and Competition
Aguirregabiria, Victor,Clark, Robert,Wang, Hui
Geographic dispersion of depositors, borrowers, and banks may prevent funding from flowing to areas of high loan demand, limiting credit access. We provide evidence of geographic imbalance of deposits and loans, and develop a methodology for investigating the contribution to this imbalance of (i) branch networks, (ii) market power, and (iii) scope economies, using US bank-county-year level data. Results are based on a novel measure of deposits and loans imbalance, and estimation of a structural model of bank competition that admits interconnections across locations and between deposit and loan markets, thereby permitting counterfactuals highlighting the role of the three factors.

The Role of Different Institutional Investors in Asia-Pacific Bond Markets during the Taper Tantrum
Ng, David T.,Shim, Ilhyock,Pastor, Jose Maria Vidal
Emerging markets have grown rapidly over the past two decades, and sovereign and corporate borrowers are increasingly reliant on bond financing. Given widespread concern over what will happen to emerging market bonds as central banks in major advanced economies start to unwind quantitative easing policies and raise interest rates, this paper examines the behaviour of different investors buying and selling emerging market government and corporate bonds around the 2013 taper tantrum. Using detailed security-level data on bond holdings by institutional investors from Thomson Reuters eMAXX, we find that mutual funds â€" which are subject to outflow pressures â€" tended to liquidate their bond holdings of emerging Asian bond markets, while insurance companies, annuities and pension funds â€" all of which are not subject to outflow pressures â€" bought extra bonds in these markets. We also find some evidence of global retrenchment during the taper tantrum. In particular, local (Asiadomiciled) funds bought emerging Asian bonds, and global (US-, UK- and Europedomiciled) funds sold these bonds. These results suggest that policymakers need to foster a stable domestic investor base and make efforts to better understand the behaviour and incentives of different bond investors.Full Publication: Asia-Pacific Fixed Income Markets: Evolving Structure, Participation and Pricing

The perils of automated fitting of datasets: the case of a wind turbine cost model
Claude Klöckl,Katharina Gruber,Peter Regner,Sebastian Wehrle,Johannes Schmidt

Rinne et al. conduct an interesting analysis of the impact of wind turbine technology and land-use on wind power potentials, which allows profound insights into each factors contribution to overall potentials. The paper presents a detailed model of site-specific wind turbine investment cost (i.e. road- and grid access costs) complemented by a model used to estimate site-independent costs. We believe that propose a cutting edge model of site-specific investment costs. However, the site-independent cost model is flawed in our opinion. This flaw most likely does not impact the results presented in the paper, although we expect a considerable generalization error. Thus the application of the wind turbine cost model in other contexts may lead to unreasonable results. More generally, the derivation of the wind turbine cost model serves as an example of how applications of automated regression analysis can go wrong.

Unhedgeable Inflation Risk within Pension Schemes
Beetsma, Roel M. W. J.,Chen, Damiaan,van Wijnbergen, Sweder
Pension schemes generally aim to protect the purchasing power of their participants, but cannot completely do this when due to market incompleteness inflation risk cannot be fully hedged. Without a market price for inflation risk the value of a pension contract depends on the investor's risk appetite and inflation risk exposure. We develop a valuation framework to deal with two sources of unhedgeable inflation risk: the absence of instruments to hedge general consumer price inflation risk and differences in group-specific consumption bundles from the economy-wide bundle. We find that the absence of financial instruments to hedge inflation risks may reduce lifetime welfare by up to 6% of certainty-equivalent consumption for commonly assumed degrees of risk aversion. Regulators face a dilemma as young (workers) and old participants (retirees) have different capacities to absorb losses from unhedgeable inflation risks and as a consequence have a different risk appetite.

Why Do Mutual Fund Investors Employ Financial Advisors?
Haslem, John A.
The actual returns on mutual funds earned by investors are much lower than the rational behavior paradigm of financial economics would suggest. Certainly this is evidenced in the performance of funds distributed through the advisor channel. From the evidence here and elsewhere, much (if not most) of how and where investors go about investing in funds has behavioral biases as well as other behavioral and knowledge overtones. It is difficult to clearly differentiate these biases from the other behavioral and knowledge influences.