Written on 18 March 2021.
Editorial signed by Raman Uppal, Professor of Finance, EDHEC Business School, Academic Director, PhD in Finance Programme
It has been a surreal year and many people and families have suffered immeasurable losses because of Covid-19. I consider myself very fortunate to have enjoyed good health during this period. Also, very early on in the lockdown, I managed to establish a well-balanced routine for each week that included time for exercise and recreation in addition to work. As a result of a good routine, and almost no travel, the pandemic has provided an opportunity to focus on research work.
I have been working on several research projects during this period, some of which are related to the pandemic.
In a paper titled, "A Multifactor Perspective on Volatility-Managed Portfolios*," (with Victor DeMiguel and Alberto Martin-Utrera) we study whether it is possible to design conditional portfolio strategies that perform well during times of high market volatility. We show how to construct a conditional mean-variance portfolio that is diversified across factors such as those in the Fama-French model. Our model allows the weights on each factor to vary with market volatility. We find that this portfolio outperforms out-of-sample and net of transaction costs both unconditional multifactor portfolios and volatility-managed individual-factor portfolios. Our conditional multifactor portfolio performs particularly well during periods of financial turmoil, such as the early 2000s recession and the Great Recession.
My work was driven by the desire to understand what kind of portfolio investors should have been holding last March when the pandemic struck. This paper was also motivated by the fact that there were three closely related papers published in the top journals: the first paper showed that volatility-managed portfolios of single factors could be profitable, and the next two showed that these strategies did not work (a) out-of-sample and (b) net of transaction costs. So, it was clear that this is an important area of research because it raises questions about the most fundamental relation in finance, that is, the relation between risk and return.
In another paper*, motivated by the empirical evidence that investor beliefs deviate from rational expectations, we combine concepts from psychology and robust control to develop a model where the deviations of beliefs about stock returns from rational expectations are an endogenous outcome of investor-firm psychological distance, which encompasses temporal, spatial, and social distance. In order to take the model to the data, we link the unobservable beliefs to the observable portfolio choices of investors. We then use data for Finland on the portfolio holdings for 405,628 households and 125 firms to show household-firm spatial distance has a significant distortionary effect on beliefs and welfare, which leads to substantial inequality across households. This is a paper that I like very much because it exploits to great advantage the material that I teach in the PhD course on Continuous Time Financial Economics.
This paper is driven largely by my desire to develop theory for behavioural finance that is rigorous and has strong foundations. This research is also motivated by the substantial interest amongst academics in recent times to understand how investors actually form expectations. From about 1960 to 2000, researchers assumed that all agents had rational expectations. However, in the face of mounting empirical evidence that investors do not have rational expectations, the last ten years have seen several very interesting research papers showing that investors' expectations are influenced by their personal experiences. For instance, expectations about inflation are very different for investors who have personally lived through periods of high inflation versus investors who have not. Similarly, investors born in East Germany have very different expectations about financial markets compared to investors born in West Germany, even though these investors have been living in a united Germany for the last 30 years. This research should make all of us wonder how the pandemic will affect the expectations of our generation.
* should you be interested in a copy of the papers, please write to Professor Raman Uppal directly
Dr Raman Uppal is also Research Fellow of the Centre for Economic Policy Research (CEPR), London and currently Editor for the Journal of Systematic Investing, and Chair of the Society of Financial Studies (SFS) Council.