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Following the "quant meltdown" of August 2007, market observers became concerned that quant strategies were leading to crowded trades. This paper analyzes the impact that a risk model used in portfolio construction has on manager crowding by identifying the drivers of crowding and by illustrating their impact. A risk model's effect on manager crowding depends, in part, on how alphas used by different managers are related to each other, and to the risk model factors. We explain how this works with some simple, intuitive examples, and with the aid of a well established analytical framework.
Many portfolio managers use multi-factor models, but not all factor models are equally effective in forecasting risk. Flawed model construction can result in optimized portfolios that are not efficient. This paper addresses the concern of portfolio managers that some risk models used in optimization may not be forecasting risk accurately, or may be creating suboptimal portfolios. We review pitfalls in portfolio construction and explain how MSCI’s best practices in model building are designed to overcome these challenges.
The rash of controversies in the banking sector has been covered by our ESG research for several years. Rate-rigging, as in the cases of LIBOR, TIMOR, and EURIBOR, as well as sanctions violations, as in the case of the transaction ID "stripping", exemplify the governance lapses we highlight that can have potential long-term reputational and litigation costs to the company.
Continue reading Standard Chartered and Sanctions Violations
MSCI ESG Research has initiated coverage of Facebook with an MSCI ESG IVA rating of 'B'. The company's privacy practices present the single biggest risk to its business from an ESG perspective, and we have serious concerns about Facebook's vulnerability on this issue in the medium to long term. As with other Internet services companies in the Software & IT Services industry, we also evaluated the company's approach to data center energy management, civil liberties, human capital development, and clean technology opportunities.
Continue reading MSCI ESG Research Publishes First ESG Rating of Facebook
As fiscal and sovereign wealth problems in the US and Europe weigh on global financial markets, another problem is brewing in agricultural markets that could blunt a sustained economic recovery. World food prices have reached record levels, and show few signs of abating. Low-income consumers in the developing world have been hit especially hard, with ripple effects spreading around the globe.
Continue reading Better Access to Nutrition: A Growing Challenge for Food Producers
The classic active mean variance optimization problem, without constraints, has a unique analytical solution that can be computed easily. However, portfolio managers can rarely work in a constraint-free environment. The full set of solutions is not often explored because the feasible region may be restricted due to constraints. The optimizer might be missing a solution with higher utility located outside the feasible region spanned by the constraints.
Continue reading The Impact of Constraints on Portfolio Construction and Optimization
Over the last three years, the volatility in equity markets has led many investors to rethink their investment strategies and the companies they choose to invest in. Some investors have begun assessing ESG (Environmental, Social and Governance) risks and opportunities in order to make more informed decisions about the sustainable earnings growth of their investments.
These investors understand that ESG research supplements traditional investment sources (balance sheet, profit and loss and cash flow statements) which are largely backward looking, with a forward looking analysis of events that have the potential to materially impact earnings. As well as managing investment risks, investing in companies that exhibit strong ESG characteristics over those that have poor ESG characteristics can have a positive influence on long term sustainable economic growth.
Put simply, ESG research aims to drive sustainable growth through educating the investment dollar. It provides a powerful means for investors to influence the shape of our future economy. Investing in funds that integrate ESG encourages investment in sustainable companies and de-capitalizes poorly rated ESG companies. At the same time, there are reports that indicate ESG research can add to performance.
Continue reading Encouraging Sustainable Growth with ESG Research
Cluster munitions, also known as cluster bombs, are a collection of ten to several hundred individual sub-munitions, weighing less than 20 kilograms each, designed to scatter and explode over an area as large as several football fields. Cluster munitions are fired from the ground or dropped from the air and explode mid-flight. Sub-munitions that fail to detonate become de facto landmines, causing harm for decades. Human rights organizations, non-governmental organizations (NGOs), media, and local governments have campaigned against cluster munitions due to the widespread and indiscriminate damage inflicted upon both soldiers and civilians. Cluster munitions, along with other indiscriminate weapons such as landmines, are covered by international humanitarian law. The landmark international initiative to ban the use, manufacture and stockpiling of cluster munitions, as well as the Convention on Cluster Munitions (CCM), introduced in Dublin, Ireland in May 2008, opened the door for national parliaments to pass binding prohibitive legislation. The article reviews the international and country-specific cluster munitions mandates, including recent developments in the Netherlands, and provides a focused view on the legislation prohibiting investments, where direct investments refers to a financial institution that buys shares or bonds of a company for their own account and indirect investments refers to a financial institution that buys shares or bonds of a company on behalf of a third party, for example, the purchase of one or more shares of an investment fund.
Strengthening chemicals-related legislation and an increasing consumer interest in health and wellness are putting heightened pressure on consumer companies to remove hazardous chemicals from their products. Despite strong lobbying campaigns against regulatory reforms and uncertainties around the actual stringency of future restrictions, consumer trends indicate heightened concerns as evidenced by a 200-fold increase in the number of articles in online forums referring to substances such as Bisphenol A or Parabens from 2004 to 2010. Companies lacking a long term strategy to address the most controversial substances could be adversely affected, in particular if chemical restrictions are enacted.
The world of investment is changing: asset owners and managers have become increasingly aware of the potential risk and value impact of environmental, social, and governance (ESG) factors, and their potential effect on an investment profile.
The sudden impact of large scale events, many of which are not just caused by financial mismanagement per se, have lead to billions in aggregate lost retirement savings. The aftershocks of these events are steadily eroding aspects of the old guard’s traditional analytical framework, and the potential risks of ESG factors are becoming more widely recognized.
These developments have put more emphasis on the financial impact of ESG, and in this brief analysis, MSCI ESG Research aims to evaluate how ESG factors are being increasingly integrated into investment processes by the asset management industry.