RPA 2 | Module 5

four conditions necessary for an efficient market

(1) A large number of rational, profit-maximizing investors who are price takers; that is, one person alone cannot affect the price of a stock. (2) Information is costless and widely available to market participants at about the same time. (3) Information is generated in a random fashion. (4) Investors react quickly and fully to new information

efficient market hypothesis has three cumulative forms

(1) The weak form of efficiency states that above-avg profits should not be expected by studying past stock prices and volume data. (2) The semistrong form of efficiency is concerned with all publicly available information. (3) The strong form states that stock prices reflect all information, public and nonpublic. This form goes beyond the semistrong form in considering the value of information contained in announcements

Common approaches used to derive expected returns:

1. Measured as the return of a broad market index (S&P 500); appropriate if stock has approximately avg risk 2. Measured as the return predicted by an asset pricing model such as the market model, the Capital Asset Pricing Model (CAPM) or any of the multifactor models 3. Measured as the return for a firmthat has comparable characteristics to firm being considered; EX: comparison firm is of approx the same size, comparable price multiples, and operates in same industry

In 1970, Fama proposed dividing the EMH into 3 categories based on the extent to which security prices quickly and fully reflect available info

1. Strong Form (all information, public and private) •Most stringent form of efficiency; asserts that prices fully reflect all info, public and nonpublic •If market is strong form, no group of investors should expect to earn abnormal returns by using any info in a superior manner •Incorporates private info - info not publicly available because its restricted to certain groups such as corp insiders and specialists on exchanges •Holds that no one with private info can make money using this info; needless to say, such an extreme belief isn't held by many 2. Semistrong Form (all publicly available info) • More comprehensive level of market efficiency (than weak form) involving not only known & publicly available market data but also all publicly known and avail data (earnings, dividends, announcements,..) • Market that quickly incorporates all such info into prices is said to show semi efficiency. • It encompasses the weak form of the hypothesis, because market data are part of the larger set of all publicly available info • Implies that investors can't act on public info after its announcement and expect to earn above-average risk-adjusted (abnormal) returns • If lags exist in adjustment of prices to certain announcements & investors can exploit these lags and earn abnormal returns, then the market is not fully efficient in the semistrong sense 3. Weak Form (market data) • Refers primarily to all past price info; if security prices are determined in a market of this kind, historical price data should already be reflected in current prices and should be of no value in predicting future price changes • Since market data are basis of tech analysis, its of no value if market is weak form efficient; use of market data wouldn't be expected to offer opportunities for investors to earn abnormal R's • Tests of usefulness of market data are called weak form tests of the EMH; if weak form of EMH is correct, past price changes should be unrelated to future price changes in an economic sense o Market can be said to be weakly efficient if the current price reflects all past market data • The correct implication of a weak form efficient market is that the past history of price info is of no value in assessing future changes in price

how equity index funds have performed over time relative to actively managed equity mutual funds

According to Morningstar, for the five-year period ending in 2010, passive equity index funds outperformed active funds within each asset class, except for one, when results were adjusted for survivorship bias. Balanced funds showed the most pronounced level of outperformance while international funds were the lone category where active funds outperformed passive funds. According to S&P, over a recent five-year period, 75% of actively managed mutual funds failed to outperform the market.

quality of analysts' earnings per share forecasting

Analysts spend much of their time forecasting earnings. Regardless of the effort by analysts, investors should be cautious in accepting analysts' forecasts of earnings per share (EPS). The forecasts for long-term EPS are typically overly optimistic. Errors can be large and occur often.

Bear Market

Bear Market: stock market decline of 20% or more; stocks typically recover from bear markets quite quickly, so since the long-run average annual return is approx 9.5% they are still likely to exceed bond returns.

money market funds

Considered as safe investments and are regulated under the Investment Company Act of 1940. T-bills, CDs, corporate commercial paper

Efficient Market View on Rationality

Efficient market concept doesn't say all investors are rational and react quickly to new info, only that markets in aggregate are rational; many investors with substantial resources are generally rational and ready to act on info

Testing for Weak-Form Efficiency

If prices follow nonrandom trends, stock price changes are dependent on previous changes; otherwise they're dependent. Therefore these tests involve the Q of whether all info in the sequence of past prices is fully reflected in the current price. 1) Statistically test the independence of stock price changes; if test suggests that price changes are independent, the implication is that knowing and using past sequence of price info are of no value to investor 2) Test specific trading rules that attempt to use past price data; if tests legitimately produce abnormal returns, it suggests that the market is not weak-form efficient. When considering weak-form tests of market efficiency, important to distinguish btw statistical dependence and economic dependence in stock price changes

Type of Investor for each Form

Investor who believes in strong form should be passive investor; investor who accepts the weak form but rejects the other 2 could be aggressive investor, trading actively in pursuit of inv gains

Characteristics of Investment Decision

Investors often consider the investment decision - based on objectives, constraints, and preferences - as consisting of 2 steps: 1. Asset Allocation (allocate total PF wealth to various classes: stocks, bonds, RE, cash equiv...) 2. Security Selection In many respects, asset allocation is most important decision investor makes; having made decision, largest part of success or failure is locked in

Beta

Is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. Beta is used in the capital asset pricing model (CAPM), which calculates the expected return of an asset based on its beta and expected market returns.

Most important risk factor affecting common stocks

Market risk is the single most important risk affecting the price movements of common stocks. For well-diversified PFs, market effects can account for 90% or more of the variability in the PFs return.

What Value Effect can mean for Investors

Money manager David Dreman recommends investors ignore advice and select stocks with low price-to-earnings (P/E) ratios; hypothesis is that low P/E stocks may currently be unwanted but if have strong finances, high yields, and good earning records, they almost always do well eventually A diversified PF is critical though and this could result in reverse; Dreman says he takes a min of 25 stocks in 15-18 industries and points out that most low P/E's have significant problems or very good reasons why you don't want to own them - only about 1 in 10 candidates pass his additional screens (such as dividend yields higher than avg and accelerating earnings growth); suggests an emphasis on large stocks not small

Semistrong Form Tests

Most of these tests are tests of the speed of price adjustment to announcements of publicly available info. The question is whether investors can use publicly available info to earn abnormal returns, after adjusting for transaction costs. Empirical research often involves event study, which examines the speed of investors' reaction to a material announcement. Event studies allow us to control for agg market returns while firm-unique events are examined •Examines abnormal returns around the event's announcement date •Want to ensure the R measures the effect of the event & not some other econ factor @ same time •Studies include multiple firms experiencing the same event on different dates in rorder that other econ factors cancel each other out; this allows us to calc an avg abnormal return (AR) across firms • The cumulative abnormal return (CAR) is the sum of the avg abnormal returns over the period of time under examination

The Value Effect Anomaly

Numerous studies show that in long run, an investment in firms with low price multiples (value firms) has generated positive abnormal returns, where a long-term investment in firms with high price multiples (growth firms) has earned negative abnormal returns

PE ratio

One of the most widely used tools for stock selection. It is calculated by dividing the current market price of the stock by its earning per share (EPS). It shows the sum of money you are ready to pay for each $ worth of the earnings of the company.

two ways to test for weak-form efficiency.

One way to test for weak-form efficiency is to statistically test the independence of stock price changes. In other words, if trends (patterns) in stock prices do not exist, the market has (at least) weak-form efficiency. Another way to test for weak-form efficiency is to test specific trading rules that use past stock price and volume data. If such trading rules produce risk-adjusted returns beyond that of simply buying and holding, after deducting costs, the market would not be efficient—even in a weak form.

The January effect does not appear to exist for large-cap stocks such as those found in Dow Jones Industrial Avg (DJIA) and the S&P 500

Problem with small cap stocks is their liquidity; relatively wide bid-ask spreads can reduce the gains from trying to capture a Jan effect with these stocks

Delta

Ratio that compares the change in the price of an underlying to the corresponding change in the option's price. If the position has a delta of .5, that means that for every dollar that the underlying goes up, the option price will go up by $.50/share. Inversely, if the position has a delta of -.5, then the option price will go down by $.50/share for every dollar that the stock price increases by. Delta is essentially a raw view of what will happen to the option price as the stock price moves. For example, if you beta weighted your portfolio to the $SPY and your portfolio delta is 20.0, this means theoretically that for every $1.00 $SPY increases, your portfolio will increase by $20.00.

Data Mining

Refers to the search for patterns in security returns by examining various techniques applied to a set of data. In most cases, the patterns do not stand up to independent scrutiny or application to a different set of data or time period.

How SEC regulates insider trading

SEC requires insiders (officers, directors and owners of more than 10% of a co's stock) to report their monthly purchase or sale transactions to SEC within two business days except when SEC may determine that the two-day period is not feasible. This information is then made public. Though insiders previously were required to report their prior monthly transactions by the tenth of the following month, reporting to SEC was changed to two business days by the Sarbanes-Oxley Act of 2002. Several studies have indicated that corporate insiders consistently earned abnormal (excess) investment returns on their stocks. These investors substantially outperformed the market when they made large trades. Nevertheless, investors should be aware that, for a variety of reasons, insider transactions can be very misleading or simply of no value as an indicator of where a company's stock price is likely to go. Subsequent research has disputed some of these findings after deducting transaction costs and adjusting for differences in firm size and price multiples.

Purpose of SUE

Seeks to find an opportunity in unexpected earnings for a company and quickly act on it •Actual Q earnings are earnings reported by Company; predicted earnings are estimated from historical before report •As each Co earning is announced, SUE can be calculated and acted on •Cos with high (low) unexpected earnings are expected to have a positive (negative) price response

event studies

Studies of stock returns to determine the impact of a particular event on the stock price; these studies allow researchers to control aggregate market returns while firm-unique events are examined

sources of information analysts use in evaluating common stocks

The major sources of information used by analysts are presentations from the top management of the companies being considered, annual reports, and Form 10-K reports that must be filed with the Securities and Exchange Commission (SEC). (The 10-K is an annual filing with SEC for publicly traded companies. Financial statements and supporting details are provided. Form 10-K typically contains more financial information than the annual report to stockholders.)

How much should be invested in international markets

Typical investor should have 30-50% of PF in international markets over the long run Emerging markets are tpyically more risky than established countries so may want to have smaller % in that.

Market-capitalization weighted indexes

Weight their securities by market value as measured by capitalization: that is: current security price * outstanding shares. The vast majority of equity indexes today are cap-weighted, including the S&P 500 and the FTSE 100. In a cap-weighted index, changes in the market value of larger securities move the index's overall trajectory more than those of smaller ones. The advantage of a cap-weighted index is obvious: It reflects the way markets actually behave. Larger companies do in fact have more dramatic effects on the overall market than smaller companies. It's also a self-rebalancing methodology, in that as a company's price or outstanding share quantity changes, so too does the proportions of stocks in the index basket.

`Beta weighting with Deltas

a great tool because it allows you to assess your risk and exposure to any theoretical market move. Some positions may have a conservative delta by themselves, but may have extreme delta values when beta weighted to SPY. In many cases, we believe it is better to view deltas in a beta-weighted manner, rather than delta values not weighed to the market.

Standardized Unexpected Earnings (SUE) Anomaly

a variable used in the selection of common stocks, calculated as the ratio of unexpected earnings to a standardization factor SUE = Actual - Predicted / standardization factor unexpected earnings / standard error of the estimate

Abnormal Return

amount returned beyond what was expected

price multiple

analyst compares a stock price multiple to a benchmark value based on an index, industry group of firms, or a peer group of firms within an industry.

Cash Equivalents

are investments securities that are for short-term investing, and they have high credit quality and are highly liquid. Although there is some leeway for judgment, common examples of cash and cash equivalents include bank accounts, money market funds, marketable securities, and Treasury bills.

Efficient Market Hypothesis (EMH)

argument that stocks are always priced about right, and that bargains are hard to find because they are closely watched by so many investors

Securities market

component of the wider financial market where securities can be bought and sold between subjects of the economy, on the basis of demand and supply

zero-coupon bond

debt security that doesn't pay interest (a coupon) but is traded at a deep discount, rendering profit at maturity when the bond is redeemed for its full face value

Effect of Competition between investors seeking abnormal returns

drives stock prices to their equilibrium (correct) values

Study by Odean and Barber

examined 60K investors and found the average investor earned 15.3% over a 5-yr period, while the most active traders (turning over about 10% of holdings each month) averaged only 10%

Importance of Equity Index Funds

in 2014 they comprised 20% of all equity MFs

According to the efficient market hypothesis or concept, the primary factor in determining stock prices..

information

Sector Rotation

investment strategy that involves shifting among cyclicals, growth and value stocks; shifting sector weights in the PF in order to take advantage of those sectors that are expected to do relatively better and to avoid or deemphasize those sectors that are expected to do relatively worse. It is clear that effective strategies involving sector rotation depend heavily on an accurate assessment of current economic conditions. Investors can pursue the sector investing approach using what are called sector mutual funds, or sector exchange-traded funds (ETFs).

January Effect Anomaly

observed tendency for small co stock returns to be higher in January relative to other months •Commonly attributed to end of year, tax-based trading •Info of a possible January Effect anomaly has been available for years and widely discussed in press; the question is whether a January effect could continue to persist in the face of widespread knowledge about this anomaly -Study shows that after adj for the illiquidity and higher transaction costs of trading small stocks, the Jan anomaly is largely diminished •Against the claim above, some claim on avg the first few days of year is great for returns on small cap, beaten down stocks, which studies support •Alternative anomaly "Santa Claus rally" refers to abnormal performance last 5 days of December and first 2 days of January

capital gains distribution

payment to shareholders that is prompted by a fund manager's liquidation of underlying stocks and securities in a mutual fund, or derived from dividend and interest earned by the fund's holdings minus the fund's operating expenses

The risk-free rate

represents the interest on an investor's money that he'd expect from an absolutely risk-free investment over a specified period of time

Types of Active strategies

stock selection, rotation strategies, market timing Most important active is stock selection; rotation strategy is a variation of this activity

key to testing the validity of any of the 3 forms of market efficiency

the consistency with which investors can earn abnormal returns, conditional on the information set involved

Size Effect Anomaly

the observed tendency for smaller firms to have positive abnormal stock returns Generates considerable attention; research shows stocks of small NYSE firms earn higher risk-adj returns than large NYSE firms on average and that this size effect persisted for many years. Many investors don't argue that small caps outperform large, based on results from Ibbotson Associates data showing on average "small" have outperformed the S&P 500 by roughly 2 percentage points per year; however small used in this context means bottom 20% of NYSE stocks based on market value (remember that small firms should return more than large bc they have greater risk; the identified anomaly is that even after adj for risk differences, small firms outperformed and provided abnormal positive returns) Dreman argues that the size myth is based on stocks that trade thinly or not at all; James O supports his view as he claims returns associated with small stocks are mostly associated with microcap stocks, which have very small caps and not easily bought by individuals or even institutions bc of large spreads & commissions

Risk-free return

the theoretical return attributed to an investment that provides a guaranteed return with zero risk

Tradeoff between Required ROR and risk

viewed as linear and upward sloping line, meaning required return increases as risk increases (Linear: straight line)

secondary markets

where existing securities can be bought and sold

Primary markets

where new securities are issued

Case For Index Funds

• According to Malikiel: typical actively managed fund underperforms the index by about 2 % points a year; and that ignores the sales charges that are imposed by some actively managed funds and the extra taxes investor pays on funds that turn their PFs over rapidly •According to him (Malkiel), are 4 reasons indexing works: 1. Securities markets are very efficient in digesting info (see def below) 2. Indexing is cost-efficient, with expenses much lower than actively managed funds 3. Actively managed funds incur heavy trading expenses; trading costs can amount to 0.5% to 1.0% per year 4. Indexing has a tax advantage, deferring the realization of capital gains

Buy and Hold Strategy (Passive)

• Holds until some future time in order to meet some objective • Emphasis: avoid transaction costs, taxable transactions, additioanl search costs, time commitment to PF management, etc. • Investor believes strategy will produce results as good as alternatives that require active management • The alternatives incur greater search taxes, etc. that are trying to be avoided and inevitably involve investment mistakes • Strategy is applicable to any PF no matter the composition; large, small, emphasis on various types of stocks • Investor must select which stocks to buy • Must still perform certain functions; EX: investment decision regarding income generated by PF; or if a few stocks perform so well that they dominate total market value of PF and reduce PF diversification, if no longer compatible with risk tolerance, adjustments may be required

Enhanced Index Funds

• Index funds that are tweaked by their managers to be a little different • EX: could track the S&P 500 and have the same sector weighings as it but hold somewhat different stocks, maybe with lower P/E (Price/Earning) ratios (see def below) • Study of 40 of these shows that about half of funds outperformed their benchmark and half didn't

Rational Markets & Active Strategies

• One of most significant developments recently is proposition that securities mkts are efficient & rational asset pricing models predominate • Investors are assumed to make rational, informed decisions on basis of best info available at time • In rational mkt, security prices accurately reflect investor expectations about future cash flows • Much evidence supports basic concepts of market efficienct and rational asset pricing • If stock mkt is efficient, prices reflect their fair economic value as estimated by investors; even if not completely true, prices may reflect their approx fair value after transaction costs taken into account, condition known as: economic efficiency • In such market, where prices of stocks depart only slightly from their fair economic value, investors shouldn't employ trading strategies designed to 'beat the market' by identifying undervalued stocks nor should they attempt to time market; sector rotation will also be unsuccessful on average in a highly efficient market • Proponents say should spend less time analyzing possible securities in PF and more time considering reducing taxes and transaction costs and maintaining chosen risk level of PF over time

Tax Efficiency of Index Funds

• They basically buy and hold, selling only when necessary, where actively managed do more frequent trading and generate larger tax bills, some may be short term gains taxable at ordinary income rates • Some were hit hard in 2001 when paying taxes from 2000 on funds that made large distributions based on prior years of good returns, but the value of the funds themselves declined in 2000 so they watched value decline while paying taxes on prior gains

Market Timing

• Try to earn excess returns by varying the % of PF assets in equity securities • When equities are expected to do well, timers shift from cash equivalents (MMFs) to common stocks; vice versa when expected to do poorly • Could rise the betas of PF when expected to rise or decrease in opposite scenario • Important factor to consider is the $ paid toward brokerage commissions & taxes compared to buy and hold • Some believe popularity of mkt timing follows a cycle of its own; if mkt strongly up, timing is unpopular and buying and holding is the popular strategy; severe decline however, mkt timing is popular, and the buy and hold strategy isn't as popular • Is controversial: can investors really time well enough to provide excess returns on risk-adjusted basis..? o Several studies of MFs found no evidence that funds were able to time mkt changes and change their risk levels in response o Overall studies found this strategy does not outperform a passive strategy; MF managers not able to successfully time large market changes o Financial Digest follows Timing strategy and found approx 80% underperform market indexes *Considerable research shows the biggest risk of market timing is that investors won't be in the market at critical times, therby significantly reducing their overall returns

Index Funds

• Unmanaged fund designed to replicate as closely as possible to performance of a specified group of securities •Arose in response to the large body of evidence supporting the efficiency of the market, and have grown as evidence of the inability of MFs to outperform the market continues to accumulate

ETF's

• Vanguard also offers a number of ETFs which can accomplish same objectives as index fund • Expenses are usually even lower than for an index fund and shares can be bought & sold any time market is open ETFs can be traded more easily than index funds and traditional mutual funds, similar to how common stocks are traded on a stock exchange investors can also buy ETFs in smaller sizes and with fewer hassles than index funds. By purchasing ETFs, investors can avoid the special accounts and documentation required for index funds, for example.

Coffeehouse PF Strategy

•Only easier strategy = to put 100% in 1 stock •Created by an ex-Smith Barney broker named Bill Schulthisis; involves no trading, no rebalancing, no security analysis and no strategizing •40% of PF is allocated to bonds & 60% to equity •Can be accomplished with index funds or ETFs •Over the 5 period starting with bear mkt of 2000-2002, this PF outperformed the indexes with no additional costs or effort •Over 10 year period ending 2014, the annualized rate of return was 6.45% •The S&P 500 compound annual ROR during this period of 10 years was 9.37% •Such a PF usually doesn't outperform the mkt when booming which is why it was laughed at in 1999 at the height of dotcom frenzy but in 2008 when mkt lost 36.55%, Coffeehouse PF dropped by only 20.21% •Illustrates importance of good asset allocation

Strong Form Tests

•States that prices quickly adjust to reflect all info, including private info •Way to test is to examine the performance of groups presumed to have access to "true" nonpublic info; if groups can consistently earn abnormal returns, strong form will not be supported •Another aspect of strong form is ability of any investor to earn excess returns as a result of using info in a superior manner; can investor or group, use the value of the info contained in an announcement to earn abnormal returns? If not, market is strong form efficient. •Profitable insider trading is a violation of strong form, which requires a market in which no investor can consistently earn abnormal profits

Value Line Ranking System

•The Value Line Investment Survey is the largest and best known investment survey in the country •Ranks each of the 1700 stocks it covers from 1-5 as to its "timeliness"-probable relative price performance within the next 12 months •These timeliness ranks started in 1965 •Performance of the 5 rankings categories has been very strong, based on their calculations The Value Line Investment Survey rankings and changes in the rankings do contain useful information. However, there is evidence that the market adjusts quickly to this information (one or two trading days following the Friday release) and that true transaction costs can negate much of the price changes that occur as a result of adjustments to this information.