MSCI Factor Indexes

Youssef_Louraoui

In this article, Youssef LOURAOUI (ESSEC Business School, Global Bachelor of Business Administration, 2017-2021) presents the MSCI Factor Indexes. MSCI is one of the most prominent actors in the indexing business, with approximately 236 billion dollars in assets benchmarked to the MSCI factor indexes.

The structure of this post is as follows: we begin by introducing MSCI Factor Indexes and the evolution of portfolio performance. We then delve deeper by describing the MSCI Factor Classification Standards (FaCS). We finish by analyzing factor returns over the last two decades.

Definition

Factor

A factor is any component that helps to explain the long-term risk and return performance of a financial asset. Factors have been extensively used in portfolio risk models and in quantitative investment strategies, and documented in academic research. Active fund managers use these characteristics while selecting securities and constructing portfolios. Factor indexes are a quick and easy way to get exposure to several return drivers. Factor investing aims to obtain greater risk-adjusted returns by exposing investors to stock features in a systematic way. Factor investing isn’t a new concept; it’s been utilized in risk models and quantitative investment techniques for a long time. Factors can also explain a portion of fundamental active investors’ long-term portfolio success. MSCI Factor Indexes use transparent and rules-based techniques to reflect the performance characteristics of a variety of investment types and strategies (MSCI Factor Research, 2021).

Performance analysis

Understanding portfolio returns is crucial to determining how to evaluate portfolio performance. It may be traced back to Harry Markowitz’s pioneering work and breakthrough research on portfolio design and the role of diversification in improving portfolio performance. Investors did not discriminate between the sources of portfolio gains throughout the 1960s and 1970s. Long-term portfolio management was dominated by active investment. The popularity of passive investment as an alternative basis for implementation was bolstered by finance research in the 1980s. Through passive allocation, investors began to effectively capture market beta. Investors began to perceive factors as major determinants of long-term success in the 2000s (MSCI Factor Research, 2021). Figure 1 presents the evolution of portfolio performance analysis over time: until the 1960s, based on the CAPM model, returns were explain by one factor only: the market return. Then, the market model was used to assess active portfolio with the alpha measuring the extra performance of the fund manager. Later on in the 2000s, the first evaluation model based on the market factor was augmented with other factors (size, value, etc.).

Figure 1. Evolution of portfolio performance analysis.
Evolution_portfolio_performance
Source: MSCI Research (2021).

MSCI Factor Index

MSCI Factor Classification Standards (FaCS) establishes a standard vocabulary and definitions for factors so that they may be understood by a wider audience. MSCI FaCS is comprised of 6 Factor Groups and 14 factors and is based on MSCI’s Barra Global Equity Factor Model (MSCI Factor Research, 2021) as shown in Table 1.

Table 1 Factor decomposition of the different factor strategies.
MSCI_FaCS
Source: MSCI Research (2021).

The MSCI Factor Indexes are based on well-researched academic studies. The MSCI Factor Indexes were identified and developed based on academic results, creating a unified language to describe risk and return via the perspective of factors (MSCI Factor Research, 2021).

Performance of factors over time

Figure 2 compares the MSCI factor indexes’ performance from 1999 to May 2020. All indexes are rebalanced on a 100-point scale to ensure consistency in performance and to facilitate factor comparisons. Over a two-decade period, smart beta factors have all outperformed the MSCI World index, with the MSCI World Minimum Volatility Index as the most profitable factor which has consistently provided excess profits over the long run while (MSCI Factor research, 2021).

Figure 2. Performance of MSCI Factor Indexes during the period 1999-2017.
MSCI_performance
Source: MSCI Research (2021).

Individual factors have consistently outperformed the market over time. Figure 2 represents the performance of the MSCI Factor Indexes for the last two decades compared to the MSCI ACWI, which is MSCI’s flagship global equity index and is designed to represent the performance of large- and mid-cap stocks across 23 developed and 27 emerging markets.

It is possible to make some conclusions regarding the performance of the investment factor over the previous two decades by dissecting the performance of the various factorial strategies. The value factor was the one that drove performance in the first decade of the 2000s. This outperformance is characterized by a movement towards more conservative investment in a growing market environment. The dotcom bubble crash resulted in a bear market, with the minimal volatility approach helping to absorb market shocks in 2002. When it comes to the minimal volatility approach, it is evident that it is highly beneficial during moments of high volatility, acting as a viable alternative to hedging one’s stock market exposure and moving into more safe-haven products. Several times of extreme volatility may be recognized, including the dotcom boom, the US subprime crisis, and the European debt crisis as shown in Figure 3.

Figure 3. Table of performance of MSCI Factor Indexes from 1999-2017.
MSCI_historical_performance
Source: MSCI Research (2021).

Why should I be interested in this post?

If you are a business school or university undergraduate or graduate student, this content will help you in understanding the evolution of asset management throughout the last decades and in broadening your knowledge of finance.

Smart beta funds have become a trending topic among investors in recent years. Smart beta is a game-changing invention that addresses an unmet need among investors: a higher return for lower risk, net of transaction and administrative costs. In a way, these investment strategies create a new market. As a result, smart beta is gaining traction and influencing the asset management industry.

Useful resources

Business analysis

MSCI Factor Research, 2021.MSCI Factor Indexes

MSCI Factor Research, 2021. MSCI Factor Classification Standards (FaCS)

Related posts on the SimTrade blog

Factor investing

   ▶ Louraoui Y. Factor Investing

   ▶ Louraoui Y. Origin of factor investing

   ▶ Louraoui Y. Smart beta 1.0

   ▶ Louraoui Y. Smart beta 2.0

Factors

   ▶ Louraoui Y. Size Factor

   ▶ Louraoui Y. Value Factor

   ▶ Louraoui Y. Yield Factor

   ▶ Louraoui Y. Momentum Factor

   ▶ Louraoui Y. Quality Factor

   ▶ Louraoui Y. Growth Factor

   ▶ Louraoui Y. Minimum Volatility Factor

About the author

The article was written in October 2021 by Youssef LOURAOUI (ESSEC Business School, Global Bachelor of Business Administration, 2017-2021).

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Carbon Disclosure Rating

Carbon Disclosure Rating

Anant Jain

In this article, Anant JAIN (ESSEC Business School, Grande Ecole – Master in Management, 2019-2022) talks about Carbon Disclosure Rating.

Introduction

Carbon disclosure rating (CDR) is a medium to measure the environment sustainability of a company. It is calculated based on the voluntarily disclosure by a company itself. This rating is useful for an ethical investor who wish to incorporate environmental, social, and governance (ESG) factors into their investment decision making process. It focuses on the environmental factor.

Environmental, social, and governance (ESG) criteria constitute a framework that helps socially conscious investors to screen potential investments which incorporate their personal values/agendas. The ESG criteria screen companies based on sound environmental practices, healthy social responsibilities and moral governance initiatives into their corporate policies and daily operations.

The most commonly used carbon disclosure rating is administered by Carbon Disclosure Project (CDP), a United Kingdom based non-profit organization. It is comparable with Global Reporting Initiative (GRI) which is a Netherlands based organization. GRI works with businesses and organizations while CDP works with individual companies.

Framework of Carbon Disclosure Rating

Carbon Disclosure Rating is calculated by a general framework based on questionnaire generated by CDP. About 6,800 companies, which participated as of year 2020, usually submit responses to a series of industry specific questions depending on the industry of a specific company. The responses are then evaluated, analyzed, and graded. They are finally made accessible to institutional investors and other interested parties as well.

The grading separate companies based on their comprehension and application of climate-related changes. The grading mention below is stated from CDP.

Figure 1. Carbon Disclosure Project (CDP) Scoring Board.
Carbon disclosure rating table
Source: Carbon Disclosure Project (CDP) .

A and A- | Leadership level
B and B- | Management level
C and C- | Awareness level
D and D- | Disclosure level
F | Failure to provide sufficient information to be evaluated

CDP then publishes a list of most favorable companies that were graded at “Leadership Level A and A-”. In the year 2020, 313 companies were features on the list. Majority of those companies were large multinational corporations who are a leader in their specific industry. It included many prominent companies, such as Ford Motor Company, Apple, Bank of America, Johnson & Johnson, and Walmart.

Benefits of CDR

There is a constant increasing demand for environmental disclosure due to rise in ethical investing. As a result, there are numerous tangible benefits gained by a company when it discloses the requested informed asked by the CDP. They are as follows:

  • Improve and protect a company’s reputation as it builds confidence via transparency and concern for environment
  • Helps gain a competitive edge while performing on the stock market
  • More preparedness for mandatory environmental reporting regulations
  • Discover new opportunities and mitigate potential risks by identifying emerging environmental risks and opportunities which might have been overlooked otherwise
  • Assessing and tracking progress in comparison to the competition in the same industry

Criticism

The biggest criticism of carbon disclosure rating is that the score does not reflect an honest depiction of the actions taken by a company to alleviate its impact on climate change or reduce its carbon footprint. It may simply reflect a that a company didn’t disclose information with CDP. For instance, Amazon in the year 2020 was given a score “F” by CDP because it did not respond to CDP’s request for information.

Therefore, an “F” score may simply mean that a company failed to provide enough information to receive an evaluation. It does not necessarily mean that company’s inability to reduce its carbon footprint. As a result, CDP’s rating is termed to be inconclusive since many companies do not provide information to CDP on thier actions to reduce their carbon footprint and actions to limit their impact on climate change.

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About the author

The article was written in October 2021 by Anant JAIN (ESSEC Business School, Grande Ecole – Master in Management, 2019-2022).

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Carbon Trading

Carbon Trading

Anant Jain

In this article, Anant JAIN (ESSEC Business School, Grande Ecole – Master in Management, 2019-2022) talks about Carbon Trading.

Introduction

Carbon trading is a market-based system focused on alleviating greenhouse gases, particularly carbon dioxide which is emitted by burning fossil fuels. Carbon trading is essentially the purchasing and selling of credits that allows a country, company, or entity to emit a specific quantity of carbon dioxide. The credits are authorized by governments with the aim to gradually reduce the overall carbon emission and alleviate its contribution to climate changes.

China, in July 2021, started a national emission-trading program. The program currently involves 2,225 companies in the power sector. The program is designed to aid the country reach its goal of achieving carbon neutrality by 2060. This program will overtake the European Union Emissions Trading System to become the world’s largest carbon trade market.

How does Carbon Trade work?

The carbon trade commenced with the Kyoto Protocol. It was a United Nations treaty set in 2005 with the aim to alleviate the global carbon emission and mitigate climate change.

The carbon trade works in the following way. Each country is allocated with a certain number of permits to emit carbon dioxide. For instance, if a country does not utilize all of its permits, it can sell the unused permits to another country. However, a slightly small number of new permits is allocated to each country every year.

The main agenda is to motivate each country to cut back on its carbon emission as an incentive to sell its new permits. The bigger and wealthier nations used to buy the credit from the poor and higher polluting countries. But over time, those wealthier countries reduced their emissions. As a result, those nations don’t need to buy as many on the market now.

The Cap-and-Trade System

The cap-and-trade system is a variation on carbon trade, in which, the trade is conducted between companies and is authorized and regulated by the government. Each firm is given a maximum carbon pollution allowance and unutilized allowances can be sold to the other firms. The main aim is to ensure that companies as a whole do not exceed the baseline level of pollution, which is reduced annually.

In the U.S. and Canada, a group of states and provinces got together to start the Western Climate initiative while the state of California has its own cap-and-trade program.

Countries don’t pay for the harsh effects of burning the fossil fuels and producing carbon dioxide, they incur some costs such as the price of the fuel. While the price of the fossil fuel is a cost itself, there are other costs as well, which are known as externalities. Externalities are the cost or benefits received by the society at large who may or may not consume products that cause such externalities. Even though externalities can be positive in nature, they are usually negative which means that consumption causes adverse effects on third party. For example, using fossil fuel as a source of energy causes environmental harm and global warming which are negative externalities experienced by the almost everyone despite people who might not indulge in fossil fuel consumptions.

Does carbon trading work to reduce emission?

Carbon trading is extensively criticized, especially because of the carbon dioxide emissions in industrialized countries is not declining at the necessary rate to avert the catastrophic climate change.

Many scientists believe that the best way is to shift to a low carbon energy, transport, agriculture, and industrial world now. They believe that we don’t have time to wait on the high price on carbon, thus, we need to directly regulate the use of the fossil fuel. There has been no evidence to prove that carbon trading has provided us with any form of monetary gain. However, the concept of pollution trading keeps appearing in proposals to reduce the environmental harm, despite the flaws.

Advantages of Carbon Trading

The argument is that companies have a choice to use the most cost-effective method of meeting the requirements. For instance, these firms have incentives to reduce the carbon emissions and develop better technology to promote that. However, it is said to believe that if the price of permits is low, these companies might decide to buy more.

The main idea behind carbon trading is to gradually reduce the number of permits given every year by the government. Thus, forcing the companies to find more ways to reduce carbon emissions.

Disadvantages of Carbon Trading

  • Deciding the number of permits to allow is a complex task. For instance, in the initial period of 2005 – 2007, when the EU introduced the system of carbon trading, the price of the carbon permits came down to zero as the EU misinterpreted the number of permits.
  • It is very difficult to measure the carbon emissions of a company. Hence, making it a complicated system as well as difficult in measuring the constant transaction costs involved in the buying and selling of permits.
  • If carbon trading is effective in one country but not being followed in the other countries, it may cause a production shift to the others, known as the Free rider problem. Excess carbon emissions are a global issue and requires a global solution. Thus, countries don’t want to start carbon trading due to the fear of other countries free riding on their efforts.
  • Carbon tax might be a much simpler and easier to administer. Carbon trading might have greater impact on the low-income areas who have opportunities to change their lifestyle.

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About the author

The article was written in October 2021 by Anant JAIN (ESSEC Business School, Grande Ecole – Master in Management, 2019-2022).

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Green Investments

Green Investments

Anant Jain

In this article, Anant JAIN (ESSEC Business School, Grande Ecole – Master in Management, 2019-2022) talks about Green Investments.

Introduction

Green investments, also known as eco investments, are investment activities that target companies focusing on environmentally conscious business projects or practices. This includes, but is not limited to, protection of natural resources, production of clean energy resources, or execution of sustainable projects. Green investments are a type of Socially Responsible Investing (SRI) but they are much more specific than SRI.

Green investments, according to some investors, are investments in any company that has eco-friendly policies and practices guiding its day-to-day operations and future growth. Other investors argue that a company can only be considered a green investment if it is directly involved in environmentally beneficial products or services, such as renewable energy or compostable materials. However, the idea is simple: a green investment should have a positive environmental impact. As a result, green investments are becoming increasingly popular among those seeking to align their financial lives with their environmental values.

Green issues have taken the center stage in the financial world. Many investors started looking for companies that were “better than their competitors in terms of managing their environmental impact” in the 1990s. While some investors continue to concentrate their funds on avoiding only “the most atrocious polluters”, many investors have shifted their focus to using money in a positive, transformative way.

Since 2007, over $1.248 trillion has been invested in solar, wind, geothermal, ocean/hydro, and other green sectors, according to the Global Climate Prosperity Scoreboard, which was launched by Ethical Markets Media and The Climate Prosperity Alliance to track private investments in green companies. This figure includes investments from North America, China, India, and Brazil, as well as investments from other developing nations.

SRI, ESG, and green investing: what is the difference?

Environmental, Social, & Governance (ESG) criteria refers to healthy practices undertaken by firms. It helps investors to analyze potential investments that may have a prominent impact on the environment/society. ESG criteria are integrated to enhance the traditional financial analysis of investment by identifying potential risks and opportunities beyond purely financial valuations. The main objective of ESG evaluation remains financial performance, even though social performance is also taken into account.

Socially Responsible Investing (SRI) is a step up to ESG since the investment process actively eliminates or selects investments according to specific ethical agendas. SRI uses ESG criteria (which facilitate valuation) to apply negative or positive screens on the investments.

While green investing is often lumped together with SRI or ESG criteria, it is technically not the same thing. To be clear, green investing could be considered a type of SRI and ESG criteria. But while SRI and ESG criteria also includes companies that make quality choices with regards to human rights, social justice or other positive social impacts, green investing sticks solely to companies with environmentally beneficial policies and products.

Understanding Green Investing

Green investments that generate all or majority of their profits from green activities are termed as pure-play green investments. Despite its widespread use, the term “green” can be ambiguous. When people talk about “green investments,” they are referring to activities that, in a popular sense, are either directly or indirectly beneficial to the environment.

What qualifies as a “green investment” is a bit of a grey area because individual beliefs on what constitutes a “green investment” differ. Some investors prefer pure-play investments, such as companies that conduct research or manufacture renewable fuels and energy-saving technology. Other investors back businesses that not only follow good business practices in terms of how they use natural resources and manage waste but also generate revenue from a variety of sources.

For some, buying stock in a company that pioneers environmentally conscious business practices in a traditionally “ungreen” industry may be a green investment, but for others, it isn’t. For example, an oil company that has a good track record in terms of environmental practices. While it is environmentally sound for the company to take precautions to limit direct environmental damage, some people may object to buying its stock as a green investment because such companies are a primary cause of global warming since they indulge in burning of fossil fuels.

Advantages and disadvantages of green investing

Green investing is a fantastic way to financially support companies that share your environmental values. However, all investments have advantages and disadvantages, and green investing is no exception.

Advantages of green investing

Supports environmentally conscious businesses

When it comes to bringing positive environmental change, it can sometimes feel like an individual does not have much power as an individual. However, by investing in environmentally friendly businesses, an individual investor can, directly and indirectly, encourage them to make environmentally sound decisions.

Aids in the financing of new environmental innovation

As the climate changes, our world faces a slew of new challenges. Dealing with these issues requires a significant investment of financial resources. As a result, investing in environmentally friendly businesses can aid in the development of new green technologies.

Long-term growth potential

As countries around the world seek to mitigate the effects of climate change, renewable energies and other environmentally friendly products and services are well-positioned for long-term growth. This means that a small investment in a green business now could pay off handsomely in the future.

Disadvantages of green investing

The potential for short-term losses

While there is a lot of hope that green investments will be financially successful in the long run, they may not be as successful in the short term as other businesses. Green investments may result in losses or only modest gains in the near future, as eco-conscious companies will not compromise their values for financial gain.

Finding green investments is difficult

While many companies believe that slapping some green packaging on a product qualifies them as an environmentally conscious company, this is far from the case. This could make it more difficult for someone to find good green investments as an investor. To determine whether a company is truly committed to positive environmental policies and action, one must often conduct extensive research.

Policies and practices of a company can change at any time

It’s important to remember that policies and practices of a company can change at any time, and not always for the better. A new CEO or stakeholder pressure can cause a company to abandon its green initiatives, lowering the ethical value of your investments.

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About the author

The article was written in October 2021 by Anant JAIN (ESSEC Business School, Grande Ecole – Master in Management, 2019-2022).

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Conscious Capitalism

Conscious Capitalism

Anant Jain

In this article, Anant JAIN (ESSEC Business School, Grande Ecole – Master in Management, 2019-2022) talks about Conscious Capitalism.

Introduction

Conscious Capitalism is mainly focused on creating a more ethical business, whilst pursuing profits. The main premise behind conscious capitalism is to make businesses more socially responsible in their economic and political philosophies. Ideally, these businesses should consider benefitting all its stakeholders including employees, suppliers and customers, and the environment and society at large, not just the shareholders and the top management team.

Conscious capitalism is not only about funding charitable events or about the different programs. It is driven by an ongoing and integrated approach to self-awareness, social responsibility and purposeful decision making.

Comprehending Conscious Capitalism

The concept of Conscious Capitalism has been founded by John Mackey, co-founder and CEO of Whole Foods Market as well as Professor Raj Sisodia (Marketing department, Tecnológico de Monterrey, Mexico), who wrote a book together on this philosophy “Conscious Capitalism: Liberating the Heroic Spirit of Business” and founded a non-profit organization called “Conscious Capitalism” which has chapters in more than two dozen U.S. cities and 10 other countries.

While the conscious capitalism credo acknowledges free market capitalism being the most powerful system to ensure human progress and social cooperation, firms and other organizations can still achieve more. It does not mean that profit seeking will take a backseat in conscious capitalism, but it encourages to incorporate all common interests into the plan. Conscious capitalism includes competition, entrepreneurship, freedom to trade, and voluntary exchange. But the credo is also built on the foundation of traditional capitalism as well as elements including trust, compassion, value creation and collaboration. Although profit seeking is not minimized in conscious capitalism, the concept focuses on integrating the interests of all major stakeholders in a company.

There are four guiding principles behind this philosophy:

Higher Purpose

A company that sticks to the main principles of conscious capitalism focuses on profits as well as the purpose beyond this profit. This purpose inspires and engages with the key stakeholders.

Stakeholder Orientation

Companies have various stakeholders including customers, employees, suppliers, and investors among others. Some companies focus on return to their stakeholders, barring everything else. On the other hand, a conscious business, focuses on the business as a whole to create and optimize its value for all its shareholders.

Conscious Leadership

Conscious leaders focus on the value of “we” rather than “I” to drive their businesses. This in turn cultivates a culture of conscious capitalism in the company.

Conscious Culture

The sum of the values and principles that constitute the social and moral fabric of a business is known as corporate culture. A conscious culture, on the other hand, is where the policy of conscious capitalism enters a business and creates a spirit of trust and cooperation among all its shareholders.

What is the difference between Conscious Capitalism and Corporate Social Responsibility?

The main difference between conscious capitalism and Corporate Social Responsibility (CSR) is that conscious capitalism is rooted in a company’s philosophy, it is a more comprehensive and holistic approach connecting companies to the society. On the other hand, CSR employs the traditional business models to different entities.

Moreover, conscious capitalism works to create new ethics and values for its stakeholders. In their book, “Conscious Capitalism: Liberating the Heroic Spirit of Business”, Mackey and Sisodia explain how conscious companies do not necessarily have to do anything outside of its normal functions to become socially responsible, which in turn creates value for its internal and external stakeholders. But at times such businesses also employ various CSR initiatives.

Benefits of Conscious Capitalism

A growing number of businesses including Whole Foods Market, Starbucks, The Container Store, and Trader Joe’s have adopted the practices and principles of conscious capitalism, making it an increasingly popular concept in the business world. Companies that choose to reject this may notice an adverse effect on their profits and revenues.

Companies that have chosen to adopt this philosophy reap significant rewards. Nowadays, many investors and consumers consider the impact of businesses on the environment. These stakeholders look for businesses that give equal importance to moral principles as well as corporate values. According to Nielsen’s 2014 report titled, “Global Survey on Corporate Social Responsibility”, 55% of consumers worldwide, said they would prefer to spend more on products and services that support worthwhile causes.

Criticism of Conscious Capitalism

There has been an overall favorable sentiment towards the philosophy of conscious capitalism, but there has been some criticism as well. The critics are opposed to the philosophy that conscious capitalism can fix the issues within the corporate world. They also believe that adopting such practices might not sit well with the shareholders of the company who are solely after good returns. Some critics believe that the responsibility of conscious capitalism should not only fall on the private sector. They believe that through the collective efforts of the leaders and public policy the responsibility can be shared, and change can be brought out.

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About the author

The article was written in October 2021 by Anant JAIN (ESSEC Business School, Grande Ecole – Master in Management, 2019-2022).

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Sin Stocks

Sin Stocks

Anant Jain

In this article, Anant JAIN (ESSEC Business School, Grande Ecole – Master in Management, 2019-2022) talks about sin stocks.

Introduction

Sin stocks are shares of publicly traded companies that are indulged in business activities or industries considered unethical, corrupt, or unpleasant. It is referred for companies involved in sectors dealing with morally dubious actions. Traditionally, the sectors mainly included weaponry, alcohol, gambling, and tobacco. Ethical investors, that is investors who believe in socially responsible investing, exclude sin stocks since such companies tend to make money by exploiting society and the environment.

Diverse cultures have different opinions on what constitutes a sin, making it a relative concept. Generally, sin stocks include alcohol but for instance, brewing beer or making wine is considered a noble tradition in different parts of the world. While some investors disregard weapon production on account of ethical basis, serving in the military can be considered as an act of patriotism by others.

Understanding Sin Stocks

Sin stock sectors often include tobacco, alcohol, gambling, weapon manufacturers, and sex related industries. They can also be categorized by the regional and societal expectations of our society which varies across the world. Political beliefs can also influence what is considered as a sin stock. Some people include military contractors, while others consider supporting the military a sign of patriotism. Sin stocks, also known as “sinful stock”, are on the opposite side from ethical and socially responsible investing whose main aim is to find investments that give an overall benefit to the society.

It is difficult to categorize sin stocks, as sin relies on the personal feeling of the investor towards the industry. Alcohol producers like Anheuser-Busch and tobacco firms like Phillip Morris are often on the list of sin stock. Even weapon manufacturers like Smith & Wesson are on those lists. A company like General Dynamics may not make the list, depending upon the investor’s views on supplying weapon systems to the military. Many gambling stocks are linked to hotels, such as Caesars Entertainment Corporation or Las Vegas Sands Corp. Therefore, it can also be difficult to disentangle the sin portions of some businesses.

Benefits of Sin Stocks

Investing in sin stocks may be objectionable to some investors. However, many of these sin stocks are sound investments. The essence of their business ensures that they have a steady flow of customers. The demand for their products or services is relatively inelastic (an increase in the price of the good does not decrease the demand of that good to a great degree and vice versa), making their business more recession-proof than other companies. Due to the social and regulatory risks, competitors get discouraged from entering the market, thus adding to the downside protection. The lesser level of competition ensures big margins and stable profits for sin stocks.

Some researchers suggest that sin stocks may also be undervalued. The negative depiction of sin stocks causes analysts and institutional investors to avoid them, making them more attractive to investors willing to take the risk. Several of the biggest sin stocks generate amazing long-term record of shareholder value.

Disadvantages of Sin Stocks

Sin stocks face a greater political risk than most other stocks, which may translate into higher risk of declaring bankruptcy. Furthermore, sin stocks face a greater risk of being declared unethical and forced out of business. The first step towards outlawing an industry is directly related to its public perception. For instance, prohibitions on drugs and alcohol would’ve seemed very strange in the 18th century in the U.S. while, it seemed completely normal during parts of the 20th century. This is due to the public who began to associate alcohol and drugs with various crimes taking place in the 19th century before these bans.

Sin taxes are a threat that is faced by sin stocks even when they are not outlawed. This is due to the political and economic factors. Politically speaking, many conservatives who are generally opposed to taxes are willing to cast their vote for taxes on practices they consider immoral. From an economic standpoint, sin taxes are supported, resulting in higher taxes for sin stocks. Whenever a good or service is taxed, some people reduce its consumption in response to the tax, resulting in, not producing any tax revenue. Moreover, it decreases the happiness of people who would otherwise consume the good or service. Such a typical result of a tax is a deadweight loss for community. However, it can be argued that taxing a sin stock, for instance, tobacco, benefits the society as lower tobacco consumption eventually progresses health and lowers medical expenses.

Conclusion

In conclusion, the decision to invest in stocks questions the general issue of socially responsible and ethical investing – and whether you feel that your principles should influence your principal.

Some investors believe that it is up to individuals to decide whether they want to smoke, drink, or gamble, despite the risks. Other investors think that the companies producing these products are partly to blame for individuals’ consumption, especially when that consumption becomes addictive, and products are engineered to be addictive.

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About the author

The article was written in October 2021 by Anant JAIN (ESSEC Business School, Grande Ecole – Master in Management, 2019-2022).

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United Nations Global Compact

United Nations Global Compact

Anant Jain

In this article, Anant JAIN (ESSEC Business School, Grande Ecole – Master in Management, 2019-2022) talks about the United Nations Global Compact.

Introduction

The United Nations (UN) Global Compact is a worldwide initiative to assist and support companies devoted to responsible business practices in human rights, environment, labor, and corruption. This UN-led initiative supports activities that contribute to sustainable development goals to build a better world.

The UN Global Compact is formulated on Ten Principles that should define a company’s core value system and its approach to conducting business. Within the compact (an agreement between the UN and any company becoming a member), member companies are expected to engage in specific business practices that help people and the planet while seeking profitability with integrity. Beyond the agreement, the UN assist and support member companies in different ways:

  • Networking opportunities with other UN Global Compact participants from over 160 countries
  • Local network support by the UN Global Compact’s country specific teams in over 85 countries
  • Access for partnership with a range of stakeholders
  • Access to tools, resources, and training along with the best practical guidance by the UN Global Compact.

The Ten Principles of the United Nations Global Compact

The Ten Principles of the UN Global Compact, as stated on its website, are mentioned below:

Human rights

Principle 1: Businesses should support and respect the protection of internationally proclaimed human rights.

Principle 2: Make sure that they are not complicit in human rights abuses.

Labor

Principle 3: Businesses should uphold the freedom of association and the effective recognition of the right to collective bargaining.

Principle 4: The elimination of all forms of forced and compulsory labor.

Principle 5: The effective abolition of child labor.

Principle 6: The elimination of discrimination in respect of employment and occupation.

Environment

Principle 7: Businesses should support a precautionary approach to environmental challenges.

Principle 8: Undertake initiatives to promote greater environmental responsibility.

Principle 9: Encourage the development and diffusion of environmentally friendly technologies.

Anti-corruption

Principle 10: Businesses should work against corruption in all its forms, including extortion and bribery.

Companies that join the UN Global Compact initiative are expected to integrate the ten principles of the UN Global Compact into their corporate strategies, organizational culture, and daily logistics. The companies are also expected to promote the principles publicly. Any company may join the UN Global Compact and commit to uphold the principles, but it is not legally binding and purely voluntary.

Benefits for companies to join the UN Global Compact

Companies may choose to join the UN Global Compact because of the significance of corporate codes of conduct for growing and sustaining healthy relationships with clients, employees, and other stakeholders. It is also essential to avoid governing and judicial problems.

Moreover, companies that pledge to sustainability might gain the upper hand in untapped markets, attract and retain business partners, develop new products and services in a lower-risk environment, and boost employee satisfaction and efficiency.

UN Global Compact Strategy 2021-2023

The United Nations Global Compact is positioned to assist companies to align with their sustainable practices while recuperating from the COVID-19 pandemic. With the aid of all 193 participant countries of the United Nations General Assembly, the UN Global Compact continues to be the exclusive global regulating authority and the reference point for action and leadership within a developing global corporate sustainability transition. Its latest strategy intends to leverage this position and upgrade the expected outcomes of businesses to incorporate the principles laid down by UN Global Compact.

The UN Global Compact provides a blueprint to companies. The COVID-19 global pandemic and ongoing climate crisis already hindered the progress, the world attained by embracing the global goals in 2015. Therefore, this strategy aims to regain that lost grip and advance much further by persuading global businesses to scale up their contributions.

The 2021–2023 UN Global Compact Strategy is formulated around five chief elements. Each element follows a fixed set of preferences, engagement with specific personnel, programs to be emphasized, and operations methodology. The impact for this mission will be derived through two main media, which are as follows:

  • Accountable companies: Businesses dedicated to fastening their own individual company’s progress to implement and sustain the Ten Principles, and to contribute to the Global Goals.
  • Enabling ecosystems: Global and local communities and networks that inspire, support and aid combined effort to attain the goal.

The new global strategy for 2021–2023 covers five essential transformations to increase the actions and the scale of these actions of businesses. The five primary shifts are mentioned below:

1) Making Companies Accountable

One of the main elements of the new strategy is to fasten the pace and the growth rate of the participating companies’ corporate sustainability and responsible practices while keeping the companies accountable. The UN Global Compact will use explicit, measurable targets within an intensified reporting framework to hold the participating companies accountable.

2) A Harmonious Growth of Local and Regional Networks

The UN Global Compact will empower the Global Compact Local Networks and the base of all their work. They will also build more dynamic national ecosystems for business sustainability. This step should help start new national and regional Global Compact networks. The focus areas will be the Global South, the United States, and China.

3) Mapping Impact in Priority Areas

UN Global Compact programs will concentrate on the Ten Principles to direct action on five priority Global Goals. These programs will be co-created with the Local Networks that will finally deliver these programs. All programs will be adapted to country-specific requirements. The priority areas are as follows:

  • Gender Equality (SDG 5): to achieve gender equality and empower all women and girls.
  • Decent Work and Economic Growth (SDG 8): to promote sustained, inclusive and sustainable economic growth, full and productive employment and decent work for all.
  • Climate Action (SDG 13): to take urgent actions to combat climate changes and its impacts.
  • Peace, Justice and Strong Institutions (SDG 16): to promote peaceful and inclusive socities for sustainable development, provide access to justice for all and build effective, accountable and inclusive institutions at all levels.
  • Partnerships (SDG 17): to strengthen the means of implementation and revitalize the global partnership for sustainable development.

4) Harnessing the Combined Action of Small and Medium-Sized Businesses (SMEs)

The UN Global Compact includes most of the world’s businesses and employers. They will leverage this to establish targeted and cross-cutting SME programs that will utilize digital tools and value chains to improve the scale.

5) More active engagement with the United Nations and its partners

The UN Global Compact will increase their collaboration at the global and nation level with United Nations agencies and UN country-specific teams. The main agenda for this is to increase the outreach to promote responsible business practices around the world.

Useful resources

Related posts on the SimTrade blog

Jain A. Impact Investing

Jain A. Environmental, Social & Governance (ESG) Criteria

Jain A. Socially Responsible Investing

About the author

The article was written in October 2021 by Anant JAIN (ESSEC Business School, Grande Ecole – Master in Management, 2019-2022).

Posted in Contributors | Tagged | Leave a comment

Smart beta 2.0

Youssef_Louraoui

In this article, Youssef LOURAOUI (ESSEC Business School, Global Bachelor of Business Administration, 2017-2021) presents the concept of Smart beta 2.0, an enhancement of the first generation of smart beta strategies.

The structure of this post is as follows: we begin by defining smart beta 2.0 as a topic. We then discuss then the characteristics of smart beta 2.0.

Definition

“Smart beta 2.0” is an expression introduced by Amenc, Goltz and Martellini (2013) from the EDHEC-Risk Institute. This new vision of smart beta investment intends to empower investors to maximize the performance of their smart beta investments while managing their risk. Rather than offering solely pre-packaged alternatives to equity market-capitalization-weighted indexes, the Smart beta 2.0 methodology enables investors to experiment with multiple smart beta indexes to create a benchmark that matches their own risk preferences, and by extension increase their portfolio diversification overall.

Characteristics of smart beta 2.0 strategies

The main characteristic of smart beta 2.0 strategies compared to smart beta 1.0 strategies is portfolio diversification.

If factor-tilted strategies (i.e., portfolios with a part specifically invested in factor strategies) do not consider a diversification-based goal, they may result in very concentrated portfolios in order to achieve their factor tilts. Investors have lately started to integrate factor tilts with diversification-based weighting methods to create well-diversified portfolios using a flexible strategy known as Smart beta 2.0 (EDHEC-Risk Institute, 2016).

This method, in particular, enables the creation of factor-tilted indexes that are also adequately diversified by using a diversification-based weighting scheme. Because it combines the smart weighting scheme with the explicit factor tilt (Amenc et al., 2014), this strategy is also known as “smart factor investment”. In order to achieve extra value-added, investors are increasingly focusing on allocation choices across factor investing techniques.

The basic foundation for the smart beta has been substantially outstripped by its success with institutional investors. It is clear that market-capitalization-weighted indices have no counterpart when it comes to capturing market fluctuations (Amenc et al., 2013). Even the harshest detractors of market-capitalization-weighted, in the end, use market-capitalization-weighted indices to assess the success of their own new indexes (Amenc et al., 2013). In fact, because smart beta strategies outperform market-capitalization-weighted indexes, the great majority of investors are likely to pick them. While everyone believes cap-weighted indexes provide the most accurate representation of the market, they do not always provide an efficient benchmark that can be used as a reference for a strategic allocation. It’s worth noting that smart beta 2.0 seeks to close the gap in terms of exposure to factors from the first generation, but it doesn’t guarantee outperformance over market-capitalization-weighted strategies (Amenc et al., 2013).

Why should I be interested in this post?

If you are a business school or university undergraduate or graduate student, this content will help you in understanding the evolution of asset management during the last decades and in broadening your knowledge of finance.

Smart beta funds have become a hot issue among investors in recent years. Smart beta is a game-changing invention that addresses an unmet need among investors: a higher return for lower risk, net of transaction and administrative costs. In a way, these strategies (smart beta 1.0 and then smart beta 2.0) have created a new market. As a result, smart beta is gaining traction and influencing the asset management industry.

Related posts on the SimTrade blog

Factor investing

   ▶ Louraoui Y. Factor Investing

   ▶ Louraoui Y. Origin of factor investing

   ▶ Louraoui Y. Smart beta 1.0

   ▶ Louraoui Y. Alternatives to market-capitalization weighting strategies

Factors

   ▶ Louraoui Y. Size Factor

   ▶ Louraoui Y. Value Factor

   ▶ Louraoui Y. Yield Factor

   ▶ Louraoui Y. Momentum Factor

   ▶ Louraoui Y. Quality Factor

   ▶ Louraoui Y. Growth Factor

   ▶ Louraoui Y. Minimum Volatility Factor

Useful resources

Amenc, N., F., Goltz, F., Le Sourd, V., 2016. Investor perception about Smart beta ETF. EDHEC-Risk Institute working paper.

Amenc, N., F., Goltz, F., Martellini, L., 2013. Smart beta 2.0. EDHEC-Risk Institute working paper.

Amenc, N., F., Goltz, F., Martinelli, L., Deguest, R., Lodh, A., Shirbini, E., 2014. Risk Allocation, Factor Investing and Smart Beta: Reconciling Innovations in Equity Portfolio Construction. EDHEC-Risk Institute working paper.

About the author

The article was written in September 2021 by Youssef LOURAOUI (ESSEC Business School, Global Bachelor of Business Administration, 2017-2021).

Posted in Contributors, Financial techniques | Tagged , , , | Leave a comment

Smart Beta 1.0

Youssef_Louraoui

In this article, Youssef LOURAOUI (ESSEC Business School, Global Bachelor of Business Administration, 2017-2021) presents the concept of the smart beta 1.0, the first generation of alternative indexing investment strategies that created a new approach in the asset management industry.

This post is structured as follows: we start by defining smart beta 1.0 as a topic. Finally, we discuss an empirical study by Motson, Clare and Thomas (2017) emphasizing the origin of smart beta.

Definition

The “Smart Beta” expression is commonly used in the asset management industry to describe innovative indexing investment strategies that are alternatives to the market-capitalization-weighted investment strategy (buy-and-hold). In terms of performance, the smart beta “1.0” approach outperforms market-capitalization-based strategies. According to Amenc et al. (2016), the latter have a tendency for concentration and unrewarded risk, which makes them less appealing to investors. In finance, “unrewarded risk” refers to taking on more risk without receiving a return that is commensurate to the increased risk.

When smart beta techniques were first introduced, they attempted to increase portfolio diversification over highly concentrated and capitalization-weighted, as well as to capture the factor premium available in equity markets, such as value indices or fundamentally weighted indices which aim to capture the value premium. While improving capitalization-weighted indices is important, concentrating just on increasing diversity or capturing factor exposure may result in a less than optimal outcome. The reason for this is that diversification-based weighting systems will always result in implicit exposure to certain factors, which may have unintended consequences for investors who are unaware of their implicit factor exposures. Unlike the second generation of Smart Beta, the first generation of Smart Beta are integrated systems that do not distinguish between stock selection and weighting procedures. The investor is therefore required to be exposed to certain systemic risks, which are the source of the investor’s poor performance.

Thus, the first-generation Smart Beta indices are frequently prone to value, small- or midcap, and occasionally contrarian biases, since they deconcentrate cap weighted indices, which are often susceptible to momentum and large growth risk. Furthermore, distinctive biases on risk indicators that are unrelated to deconcentration but important to the factor’s objectives may amplify these biases even further. Indexes that are fundamentally weighted, for example, have a value bias because they apply accounting measures that are linked to the ratios that are used to construct value indexes.

Empirical study: monkeys vs passive mangers

Andrew Clare, Nick Motson, and Steve Thomas assert that even monkey-created portfolios outperform cap-weighted benchmarks in their study (Motson et al., 2017). A lack of variety in cap-weighting is at the foundation of the problem. The endless monkey theory states that a monkey pressing random keys on a typewriter keyboard for an unlimited amount of time will almost definitely type a specific text, such as Shakespeare’s whole works. For 500 businesses, there is an infinite number of portfolio weighting options totaling 100%; some will outperform the market-capitalization-weighted index, while others will underperform. The authors of the study take the company’s ticker symbol and use the following guidelines to create a Scrabble score for each stock:

  • A, E, I, O, U, L, N, S, T, R – 1 point. D and G both get two points.
  • B, C, M, P – 3 points ; F, H, V, W, Y – 4 points ; K – 5 points.
  • J, X – 8 points ; Q, Z – 10 points

The scores of each company’s tickers are then added together and divided by this amount to determine each stock’s weight in the index. As illustrated in Figure 1, the results obtained are astonishing, resulting in a clear outperformance of the randomly generated portfolios compared to the traditional market capitalization index by 1.5% premium overall.

Figure 1. Result of the randomly generated portfolio with the Cass Scrabble as underlying rule compared to market-capitalization portfolio performance.

Scrabble_performance

Source: Motson et al. (2017).

In the same line, the authors produced 500 weights that add up to one using this technique, with a minimum increase of 0.2 percent. The weights are then applied to a universe of 500 equities obtained from Bloomberg in December 2015 (Motson et al., 2017). The performance of the resultant index is then calculated over the next twelve months. This technique was performed ten million times. As illustrated in Figure 2, the results are striking, with smart beta funds outperforming nearly universally in the 10 million simulations run overall, and with significant risk-adjusted return differences (Motson et al., 2017).

Figure 2. 10 million randomly generated portfolios based on a portfolio construction of 500 stocks

10m_simulations_smart_beta_portfolios

Source: Motson et al. (2017).

For performance analysis, the same method was employed, but this time for a billion simulation. This means they constructed one billion 500-stock indexes with weights set at random or as if by a monkey. Figure 9 suggests that the outcome was not accidental. The black line shows the distribution of 1 billion monkeys’ returns in 2016, while the grey line shows the cumulative frequency. 88 percent of the monkeys outperformed the market capitalization benchmark, according to the graph. The luckiest monkey returned 27.2 percent, while the unluckiest monkey returned just 3.83 percent (Motson et al., 2017) (Figure 3).

Figure 3. Result of one billion randomly simulated portfolios based on a portfolio construction of 500 stocks.

1B_portfolio_simulation

Source: Motson et al. (2017)

Why should I be interested in this post?

If you are a business school or university undergraduate or graduate student, this content will help you in understanding the various evolutions of asset management throughout the last decades and in broadening your knowledge of finance.

If you’re an investor, you’re probably aware that smart beta funds have become a popular topic. Smart beta is a game-changing development that fills a gap in the market for investors: a better return for a reduced risk, net of transaction and administrative costs. These strategies, in a sense, establish a new market. As a result, smart beta is gaining traction and having an impact on asset management.

Related posts on the SimSrade blog

Factor investing

   ▶ Louraoui Y. Factor Investing

   ▶ Louraoui Y. Origin of factor investing

   ▶ Louraoui Y. Smart beta 2.0

   ▶ Louraoui Y. Alternatives to market-capitalisation weighted indexes

Factor

   ▶ Louraoui Y. Size Factor

   ▶ Louraoui Y. Value Factor

   ▶ Louraoui Y. Yield Factor

   ▶ Louraoui Y. Momentum Factor

   ▶ Louraoui Y. Quality Factor

   ▶ Louraoui Y. Growth Factor

   ▶ Louraoui Y. Minimum Volatility Factor

Useful resources

Academic research

Amenc, N., F., Goltz, F. and Le Sourd, V., 2016. Investor perception about Smart beta ETF. EDHEC Risk Institute working paper.

Amenc, N., F., Goltz, F. and Martinelli, L., 2013. Smart beta 2.0. EDHEC Risk Institute working paper.

Motson, N., Clare, A. & Thomas, S., 2017. Was 2016 the year of the monkey?. Cass Business School research paper.

About the author

The article was written in September 2021 by Youssef LOURAOUI (ESSEC Business School, Global Bachelor of Business Administration, 2017-2021).

Posted in Contributors, Financial techniques | Tagged , , , , | Leave a comment

Alternative to market-capitalization weighting strategies

Youssef_Louraoui

In this article, Youssef LOURAOUI (ESSEC Business School, Global Bachelor of Business Administration, 2017-2021) presents the different alternatives developed to the market-capitalization weighting strategy (buy-and-hold strategy).

The structure of this post is as follows: we begin by introducing alternatives to market capitalization strategies as a topic. We then will delve deeper by presenting heuristic-based weighting and optimization-based weighting strategies.

Introduction

The basic rule of applying a market-capitalization weighting methodology for the development of indexes has recently come under fire. As the demand for indices as investment vehicles has grown, different weighting systems have emerged. There have also been a number of recent projects for non-market-capitalization-weighted ETFs. Since the first basic factor weighted ETF was released in May 2000, a slew of ETFs has been released to monitor non-market-cap-weighted indexes, including equal-weighted ETFs, minimal variance ETFs, characteristics-weighted ETFs, and so on. These are dubbed “Smart Beta ETFs” since they aim to outperform traditional market-capitalization-based indexes in terms of risk-adjusted returns (Amenc et al. 2016).

The categorization approach will be the same as Chow, Hsu, Kalesnik, and Little (2011), with the following distinctions: 1) basic weighting techniques (heuristic-based weighting) and 2) more advanced quantitative weighting techniques (optimization-based weighting).

It’s an arbitrary categorization system designed to make reading easier by differentiating between simpler and more complicated approaches.

Heuristic-based weighting strategies

Equal-weighting

The equal weighting method assigns the same weight to each share making up the portfolio (or index)

EW_index

Where wi represents the weight of asset i in the portfolio and N the total number of assets in the portfolio.

Because each component of the portfolio has the same weight, equal weighting helps investors to obtain more exposure to smaller firms. Bigger firms will be more represented in the market-capitalization-weighted portfolio since their weight will be larger. The benefit of this technique is that tiny capitalization risk-adjusted-performance tends to be better than big capitalization (Banz, 1981).

In their study, Arnott, Kalesnik, Moghtader, and Scholl (2010) created three distinct indices in terms of index composition. The first group consists of enterprises with substantial market capitalization (as are capitalisation-weighted indices). Each business in the index is then given equal weight. This is how the majority of equally-weighted indexes are built (MSCI World Equal Index, S&P500 Equal Weight Index). The second is to create an index based on basic criteria and then assign equal weight to each firm. The third strategy is a hybrid of the first two. It entails averaging the ranks from the two preceding approaches and then assigning equal weight to the remaining 1000 shares.

Fundamental-weighting

The weighting approach based on fundamentals divides companies into categories based on their basic size. Sales, cash flow, book value, and dividends are all taken into account. These four parameters are used to determine the top 1,000 firms, and each firm in the index is given a weight based on the magnitude of their individual components (Arnott et al., 2005). The portfolio weight of the ith stock is defined as:

Fundamental_indexing

For a fundamental index that includes book value as a consideration, for example, the top 1,000 companies in the market with the most extensive book values are chosen. Firm xi is given a weight wi, which is equal to the firm’s book value divided by the total of the index components’ book values.

Fundamental indexation tries to address the following bias: in a cap-weighted index, if the market efficiency hypothesis is not validated and a share’s price is, for example, overpriced (greater than its fair value), the share’s weight in the index will be too high. Weighting by fundamentals will reduce the bias of over/underweighting over/undervalued companies based on criteria like sales, cash flows, book value, and dividends, which are not affected by market opinion, unlike capitalization.

Low beta weighting

Low-beta strategies are based on the fact that equities with a low beta have greater returns than those expected by the CAPM (Haugen and Heins, 1975). A beta of less than one indicates that the share price has tended to grow less than its benchmark index during bullish trends and to decrease less severely during negative trends throughout the observed timeframe. A low-beta index is created by selecting low-beta stocks and then giving each stock equal weight in the index. As a result, it’s a hybrid of a low-beta and an equal-weighting method. On the other side, high beta strategies enable investors to profit from the amplification of favourable market moves.

Reverse-capitalization weighting

The weight of an asset capitalization-weighted index can be defined as:

CW_index

where MC stands for “Market Capitalization”, and wi is the weight of asset i in the portfolio.

In a reverse market-capitalization-weighted index, the weight of an asset is defined as:

RCW

“Reverse market-capitalization” is abbreviated as RMC. This technique necessitates using a cap-weighted index to execute the approach. RCW methods, like equal-weight or low-beta strategies, are motivated by the fact that small caps have a greater risk-adjusted return than big caps. This sort of indexation requires constant rebalancing (Banz, 1981).

Maximum diversification

This technique aims to build a portfolio with as much diversification as feasible. A diversity index (DI) is employed to achieve the desired outcome, which is defined as the distance between the sum of the constituents’ volatilities and the portfolio’s volatility (Amenc, Goltz, and Martellini, 2013). Diversity weighting is one of the better-known portfolio heuristics that blend cap weighting and equal weighting. Fernholz (1995) defined stock market diversity, Dp, as

Diversity_Index(DI)_1

where p between (0,1) and x Market,i is the weight of the ith stock in the cap-weighted market portfolio, and then proposed a strategy of portfolio weighting whereby portfolio weights are defined as

Diversity_Index(DI)_2

where i = 1, . . . , N; p between (0,1); and the parameter p targets the desired level of portfolio tracking error against the cap-weighted index.

Optimization-based weighting strategies

The logic of Modern Portfolio Theory (Markowitz, 1952) is followed in Mean-Variance optimization. Theoretically, if we know the expected returns of all stocks and their variance-covariance matrix, we can construct risk-adjusted-performance optimal portfolios. However, these two inputs for the model are difficult to estimate precisely in practice. Chopra and Ziemba (1993) showed that even little inaccuracies in these parameters’ estimates may have a large influence on risk-adjusted-performance.

Minimum Variance

Chopra and Ziemba (1993) adopt the simple premise that all stocks have the same return expectation, based on the fact that stock return expectations are difficult to quantify. As a result of this premise, the best portfolio is the one that minimizes risk. The goal of minimal variance strategies, which have been around since 1990, is to provide a better risk-return profile by lowering portfolio risk without modifying return expectations. The low volatility anomaly justifies this technique. Low-volatility stocks have historically outperformed high-volatility equities. These portfolios are built without using a benchmark as a guide. The portfolio variance minimization equation for a two-asset portfolio is as follows:

MPT

In their research on the construction of this type of index, Arnott, Kalesnik, Moghtader and Scholl (2010) found that risk measures that take into account interest rates, oil prices, geographical region, sector, size, expected return, and growth, as calculated by the Northfield global risk model, a model for making one-year risk forecasts, reduce the portfolio’s absolute risk. This method is used in the MSCI World Minimum Volatility Index, which was released in 2008.

Global Minimum Variance, Maximum Decorrelation, and Diversified Minimum Variance are the three types of minimum variance techniques (Amenc, Goltz and Martellini, 2013). However, there are no indexes or exchange-traded funds (ETFs) based on the Maximum Decorrelation and Diversified Minimum Variance methods in actuality; they are still only theoretical notions.

Maximum Sharpe ratio

Because all stocks are unlikely to have the same expected returns, the minimum-variance portfolio—or any practical representation of its concept—is unlikely to have the highest ex-ante Sharpe ratio. Investors must incorporate useful information about future stock returns into a minimum-variance approach to improve it. Choueifaty and Coignard (2008) proposed a simple linear relationship between the expected premium, E(Ri) – Rf, for a stock and its return volatility, sigmai:

MSR_strategy

A related portfolio method proposed by Amenc, Goltz, Martellini, and Retkowsky (2010) implies that a stock’s expected returns are linearly related to its downside semi-volatility. They claimed that portfolio losses are more important to investors than gains. As a result, rather than volatility, risk premium should be connected to downside risk (semi-deviation below zero). The EDHEC-Risk Efficient Equity Indices are built around this assumption. Downside semi-volatility can be defined mathematically as

MSR_Semi_volatility

where Ri, t is the return for stock i in period t.

Maximum Sharpe ratio can be considered as an alternative beta technique that aims to solve the challenges of forecasting risks and returns for a large number of equities.

Why should I be interested in this post?

If you are a business school or university undergraduate or graduate student, this content will help you in understanding the various evolutions of asset management throughout the last decades and in broadening your knowledge of finance.

Smart beta funds have become a hot issue among investors in recent years. Smart beta is a game-changing invention that addresses an unmet need among investors: a higher return for lower risk, net of transaction and administrative costs. In a way, these investment strategies create a new market. As a result, smart beta is gaining traction and influencing the asset management industry.

Related posts on the SimTrade blog

Factor investing

   ▶ Louraoui Y. Factor Investing

   ▶ Louraoui Y. Origin of factor investing

   ▶ Louraoui Y. Smart beta 1.0

   ▶ Louraoui Y. Smart beta 2.0

Factors

   ▶ Louraoui Y. Size Factor

   ▶ Louraoui Y. Value Factor

   ▶ Louraoui Y. Yield Factor

   ▶ Louraoui Y. Momentum Factor

   ▶ Louraoui Y. Quality Factor

   ▶ Louraoui Y. Growth Factor

   ▶ Louraoui Y. Minimum Volatility Factor

Useful resources

Academic research

Amenc, Noël, Felix Goltz, Lionel Martellini, and Patrice Ret- kowsky. 2010. “Efficient Indexation: An Alternative to Cap- Weighted Indices.” EDHEC-Risk Institute (February).

Amenc, N., Goltz, F., Le Sourd, V., 2016. Investor perception about Smart beta ETF. EDHEC Risk Institute working paper.

Amenc, N., Goltz, F., Martinelli, L., 2013. Smart beta 2.0. EDHEC Risk Institute working paper.

Arnot, R.D., Hsu, J., Moore, P., 2005. Fundamental Indexation. Financial Analysts Journal, 61(2):83-98.

Arnot, R.D., Kalesnik, V., Moghtader, P., Scholl, S., 2010. Beyond Cap Weight, The empirical evidence for a diversified beta. Journal of Indexes, January, 16-29.

Banz, R., 1981. The relationship between return and market value of common stocks. Journal of Financial Economics. 9(1):3-18.

Chopra, V., Ziemba, W., 1993. The Effect of Errors in Means, Variances, and Covariances on Optimal Portfolio Choice. Journal of Portfolio Management, 19:6-11.

Chow, T., Hsu, J., Kalesnik, V., Little, B., 2011. A Survey of Alternative Equity Index Strategies. Financial Analyst Journal, 67(5):35-57.

Choueifaty, Yves, and Yves Coignard. 2008. Toward Maximum Diversification. Journal of Portfolio Management, vol. 35, no. 1 (Fall):40–51.

Fernholz, Robert. 1995. Portfolio Generating Functions. Working paper, INTECH (December).

Haugen, R., Heins, J., 1975. Risk and Rate of Return of Financial Assets: Some Old Wine in New Bottles. Journal of Financial and Quantitative Analysis, 10(5):775-784.

Markowitz, H., 1952. Portfolio Selection. The Journal of Finance, 7(1):77-91.

About the author

The article was written in September 2021 by Youssef LOURAOUI (ESSEC Business School, Global Bachelor of Business Administration, 2017-2021).

Posted in Financial news, Financial techniques | Tagged , , , | Leave a comment