HW1-3 True and False
"Value" stocks tend to have positive media coverage.
False
An analyst has three years of return data for a U.S. equity fund. Calculating the fund's beta on the S&P 500 Index using weekly or monthly returns will produce the same beta.
False
For quantitative investing purposes, when ranking stocks according to valuation ratios one must compare firms to other firms in the same economic industry. Comparisons across industries are fundamentally flawed for quantitative investing purposes.
False
Most Finance professors believe that U.S. stock markets are very close to being fully efficient
False
Quantitative investors calculate the Fundamental Value of a stock using cash flow projections, and compare it to its market price. Stocks in for which the calculated Fundamental Value is well below the market price are labeled "Value" stocks.
False
The overwhelming majority (e.g., more than 90%) of the largest 3000 U.S.‐based and exchange-listed stocks consistently report positive Net Income on a trailing twelve-month basis.
False
The Piotroski Score is a combination of 5 binary indicators based on valuation ratios and recent stock return performance.
False 9 Binary Signals
An equity carve‐out is a situation in which separate businesses are contractually brought together as a new corporation.
False A carve out is a situation in which the subsidiary of a business entity separates from the parent company via a partial IPO. Generally, followed by a spin-off, in which the remaining shares are given to parent company shareholders in proportion to holdings of the parent company.
A short‐squeeze is a situation in which short‐sellers quickly put a great amount of downward pressure on the price of a stock.
False A short-squeeze is where a group of people look to reduce the supply of shares on the borrowing market, raising the borrowing rate in order to force short-sellers to cover their shares. This creates upward pressure in the price of stock, which can consequentially push the price even higher as more short-sellers decide to close or are force out of their position.
Because they are more skilled and less prone to panic than individual investors, over the long haul professional portfolio managers as group have outperformed the Market Portfolio even after trading costs are taken into account.
False As a group, professional portfolio managers outperform the market portfolio before transaction costs, but not after. Before transaction costs - Market Portfolio Quarterly Average Return 2.09% versus Professional Manager 2.18% After transaction costs - Market Portfolio Quarterly Average Return 2.09% versus Professional Manager of 2.03%
"Value" stocks tend to have higher returns than "Glamour"/"Growth" stocks because Value stocks tend to have higher CAPM betas and/or be more volatile.
False As shown throw a risk-adjusted analysis of a value against glamour portfolio
Backtesting the P/E ratio quantitative signal in Portfolio123 shows that stocks that currently have low P/E ratios have delivered relatively high stock returns in the past.
False Backtesting P/E in Portfolio123 shows that stocks with lower P/E at the time of rebalancing have higher subsequent returns over the period compared to those with higher P/E at the time of rebalancing over the same period. It indicates that stocks that current have a low P/E, on average, will provide higher subsequent/future returns.
Looking at the result of backtesting the P/E ratio quantitative signal, one can conclude that stocks that currently have a high P/E ratio tend to have had low returns over the past.
False Backtesting is a forward-looking test: Groups stocks based on P/E at the beginning of a specified period and measures their performance over that period. Then, the buckets are resorted given the new P/E at the beginning of the period and their performance measured. You cannot conclude that stocks that current have a high P/E tend to have had low returns over the past because their P/E could have increased in the prior period.
The composition of the Russell 3000 Value index is defined based on P/E, EV/EBITDA, and P/Book.
False Based on P/B
Time‐weighted returns are always smaller or equal than dollar‐weighted returns
False Dollar-weighted returns depends on client cash flows and assigns greater weight to periods with more assets under investment. Therefore, depending the amount under management (timing of cash inflows and outflows) and the variability of single period returns, the dollar-weighted average may be higher or lower than the time-weighted return. The time-weighted return indicates total return on investment if all money were invested at time zero and held until liquidation of the position/present day.
Enterprise Value is defined as the value of the entire corporation as determined by the consensus of sell‐side analysts.
False EV = Equity + Debt - Cash
The Enterprise Value of a corporation is always positive no matter how much cash the corporation has.
False EV = Equity + Debt - Cash
The Piotroski Score of a stock can assume any value between 0 and 9. For example, it could be 5.5.
False Each stock get either a 1 or 0 in 9 categories; this then summed.
Although cognitive biases come in many different flavors, Nobel‐prize winning economist Daniel Kahneman thinks that the ultimate source of cognitive biases is human stupidity.
False Humans have two Systems of Thinking: 1 and 2. 1 is fast and intuitive, yet gullible. 2 is slow, but controlled, deliberate, statistical, and suspicious. Cognitive biases occur because sometimes System 2 in the mind does not always engage. Humans are hardwired to make some decisions using System 1 by default depending on the way the information is presented, first seen, or first processed.
If a quantitative signal forecast relative stock returns, then the returns of all buckets in a backtest will be above the benchmark's return.
False If the benchmark is equally weighted, the average return on all the buckets will equal to benchmark. Furthermore, a quantitative signal's ability is determined by spread between the top and bottom bucket and the gradation between buckets.
The P/E ratio is as good as an indicator of divergence between Price and Fundamental Value among firms with similar leverage ratios as it is among firms with very different leverage ratios.
False P/E is susceptible to changes in capital structure.
It is impossible to forecast relative stock returns using only information in publicly available financial statements.
False Quality Signals rely on forecasting through information sourced purely from financial statements
Because markets are fast‐moving are constantly evolving, backtest of quantitative signals discard older data and focus on the most recent three-year period.
False Quantitative signals look at historical data to ensure the signal can be properly tested and the approach is data-driven.
A corporations "float" refer to the number of shares that have been issued in the most recent equity offering.
False Refers to the number share available for trade. Float = Outstanding - (Share's Held by the Corporation/Insiders/Block Interests)
Two independent consultants have three years of return data for a U.S. equity fund. Assuming both consultants are competent, they must obtain exactly the same numbers for the fund's Sharpe Ratio and CAPM alpha over that three year period.
False Sharpe and CAPM calculations can differ if the returns are calculated arithmetically or geometrically, decision to annualize with or without compounding, decision of which market portfolio to calculate the equity fund's beta, using different time periods for analysis: daily, weekly, monthly, etc..
Assume there are 6000 U.S.‐based stocks listed on exchanges. In that case, the Russell 3000 Index would cover about 50% of the U.S. stock market capitalization.
False The Russell 3000 Index contains the 3000 largest stocks by market capitalization; therefore, the Russell 3000 covers more than 50% of the U.S. stock market capitalization as it holds the biggest 50% of all U.S. stocks.
A fund does not report the return of the last 10 years. However, you found yearly reports for each of the previous 10 years. The arithmetic average return of such 10 years is 10% per year. If an investor had invested $100 in the fund 10 years ago and let the investment ride untouched (no additions or withdrawals), the client would have $100*(1+10%)10 today (ignore fees or taxes).
False The arithmetic average does not take into account compounding. You need the geometric/time-weighted return.
Because of U.S. regulations are very strict, the number of U.S. corporations that "manage" reported earnings in order to misrepresent economic performance is very small.
False The premise of 2 of the 4 quality ratios is based quality of information provided by the business.
Regulators require fund managers to report dollar‐weighted returns because those adjust for the total amount of assets under management.
False While dollar-weighted returns do add weight to period in which there are more assets under management, regulators do not require this be disclosed as dollar-weighted is dependent on client cash flows not under control of the manager. Time-weighted returns are more indicative of a fund's and fund manager's performance.
Quantitative investors necessarily use complex mathematical models to make investing decisions.
False While some complex mathematical models may be used, a lot of quantitative investment is sorting between stocks in buckets by predictive factors.
When calculating EV/EBITDA, it is better to focus on EBITDA over the most recent quarter than to use EBITDA accumulated over the most recent four quarters.
False You want TTM to avoid seasonality bias
The CAPM alpha is like a Sharpe Ratio when benchmark is the Market Portfolio.
False CAPM Alpha measures excess return relative to the market: (rportfolio - rF) - β(rmarket - rF) . Sharpe Ratio is a ratio measuring excess return over an investment's total risk.
"Value" signals work in forecasting relative stock returns across industries but does not within an industry. That is, within a given industry, stocks with cheap valuations (e.g., low P/E) do not tend to have higher subsequent returns than stocks with expensive valuations (e.g., high P/E).
False Data shows that value signals transcends industry regarding forecasting relative returns.
Active management necessarily implies very high portfolio turnover in an attempt to beat the Market Portfolio.
False Portfolio turnover refers to frequent trading. Frequent trading actually hurts performance as such results in higher transaction fees. The best portfolio managers trade efficiently to reduce transaction fees.
Quantitative investors choose stocks based on thorough valuation of individual stocks, including detailed discounted cash flow calculations.
False Quantitative investors choose groups of stocks based on predictive factors which are unequivocally quantifiable that historically have been able to identify groups of stock tending to higher or lower future returns relative to a benchmark.
An investment with a Sharpe Ratio much smaller than the Market Portfolio cannot be attractive to investors.
False The client could be well diversified, in which case, CAPM alpha would be a better indicator, or the investment with smaller Sharpe Ratio could provide additional diversification benefit to the client's overall portfolio.
The typical fee for borrowing stock is not far from 5% per year.
False - .4% a year
In theory, as well as in practice, high risk stocks tend to have higher expected returns than low risk stocks when risk is measured as CAPM beta.
False - in theory, yes; in practice, no.
Short‐sellers pay lending fees to those from whom they borrow shares. These fees are determined by the management of the firm being shorted.
False - lending fee is determined by supply and demand in the borrowing market for the given stock.
To avoid being exposed to fluctuating borrowing rates, and to allow for time for prices to adjust, short‐sellers typically arrange to borrow stock for stock lenders for at least one month with a fixed rate.
False - no fixed rate on borrowing rate/lending fee. They are adjusted daily.
To perform a typical backtesting of a quantitative signal in the Russell 3000 stock Universe over the last 20 years ones does not need to have data from stocks that are not currently part of the Russell 3000 index.
False, this could introduce survivorship bias.
"Value" stocks tend to have had relatively low growth rates in revenues and earnings over the recent past (e.g., recent one to three years). On the other hand, "Glamour" stocks tend to have had relatively high growth rates.
True
A fund has a reported return of 10% per year over the last ten years. If an investor had invested $100 in the fund 10 years ago and let the investment ride untouched (no additions or withdrawals), the client would have $100*(1+10%)10 today (ignore fees or taxes).
True
A fund has a reported return of 10% per year over the last ten years. It is possible that, in aggregate, the fund has lost invest money for its clients if clients had additions and withdrawals within the 10 years.
True
A quantitative signal backtest can be seen as is similar to simulating how a rule‐based investing strategy would have performed historically in the following sense. In a backtest of the P/E ratio with 10 buckets, the return associated with the 10th bucket represents the return of investing in an equally‐weighted portfolio containing the top 10% stocks with the lowest P/E ratios as determined at each rebalancing date.
True
A quantitative stock factor/signal is an unequivocally quantifiable stock characteristic that historically has been able to identify stocks tending to relatively higher future returns and stocks tending to relatively lower future returns.
True
A short‐squeeze will occur when stock lenders suddenly demand the return of a large fraction of stocks that they had lent out to short‐sellers. As short‐sellers rush to return those shares, the stock price goes up.
True
All else equal, the more internally generated intangible assets (e.g., patents) a corporation has, the higher will be its Price/Book ratio.
True
American Depositary Receipts are non‐U.S. based stocks that trade on U.S. markets.
True
Asset allocation refers to portfolio choice among broad asset classes. Security selection refers to portfolio choice of specific securities within an asset class.
True
Assume that, rather than having historical corporate financial statements as originally reported, Bloomberg uses restated financial statements. If that is true, then backtests using Bloomberg data are not fully reliable because they are subject to a look‐ahead bias.
True
At rebalancing date D, stock ABC was part of bucket 7 in a P/E ratio backtest with 10 buckets. Even if the stock's P/E ratio fall substantially, it is possible that it will belong to bucket 7 at the next rebalancing date provided that the P/E ratio of other stocks also drop substantially.
True
Because there is room for discretion in applying accounting rules, and corporate accounting choices vary within that spectrum, corporate financial statements across companies should ideally be standardized before backtesting a quantitative signal that relies on corporate financial statement data.
True
Both under‐reaction to news and herding/over‐reaction can contribute to generating the Momentum pattern in stocks returns.
True
EBIT/Sales is a conceptually better valuation ratio than Price/Sales because it does not violate the principle of capital structure consistency.
True
Enterprise Value/EBITDA is a more powerful predictor of relative stock returns than Price/Book.
True
Firms with high Beneish scores and high Accruals‐to‐assets ratio may be "managing" their financial statements in order to misrepresent economic performance. If the market is temporarily fooled by such manipulations, then the stock prices of these firms are temporarily overvalued, which indicates that they are likely to have low subsequent stock returns.
True
Geometric average returns are always smaller or equal than arithmetic average returns.
True
In a spin‐off, existing shareholders get shares in a new company that has been detached from the existing company without having to separately pay for those shares.
True
In order to capture stock level momentum, it is better to focus on returns calculated over an 11‐month period starting one month ago than on returns calculated over the most recent three‐month period.
True
In principle, a stock's P/E ratio can be calculated using two types of earnings: backward‐looking earnings from corporate financial statements, and forward‐looking earnings as forecasted by sell‐side analysts.
True
It is possible that markets are efficient in processing information even if the typical stock investor is affected by cognitive biases.
True
It makes sense to binarize/booleanize a signal when the signal only flags two types of stocks (e.g., "future losers" versus "the rest"), as opposed to indicating a continuous gradation from "very bad" to "excellent" stocks.
True
Momentum is a return‐predicting factor that is present in various asset classes.
True
Most corporations in the S&P 500 index buy back their own stock, and, as a whole, S&P500 corporations return more cash to the market via stock buy backs than via dividend distributions.
True
Over‐the‐counter stocks are not listed in exchanges and face less stringent disclosure requirements.
True
Piotroski's original backtesting of his score uses data before 1999. His score continues to forecast relative stock returns out‐of‐sample, that is, in sample periods that begin in 1999.
True
Professional managers doing security selection are evaluated on the basis on how their performance compares to that of a corresponding asset class benchmark.
True
Quantitative investors in the stock market rely on large portfolios, in the sense that they have are at least 50 distinct stocks in the portfolio. The idea is to have stock‐specific news and developments matter very little for the portfolio's overall result, which will be determined by how the stocks perform as a group while the group shares characteristics that have been historically associated with relatively high future stock returns.
True
Quantitative professional portfolio managers that take no leverage and do not short‐sell typically expect to beat their benchmarks by 2 to 3% per year net of transaction costs.
True
Stocks with high CAPM betas (measured using stock returns over the recent past, e.g., three years) tend to have lower subsequent returns in the U.S. and in international markets.
True
The Beneish Score is a purely quantitative measure to flag firms that might be manipulating their financial statements in order to misrepresent its economic performance.
True
The Enterprise Value of a corporation is typically calculated using the Book Value of Debt rather than the market value of debt. This is because the market value of debt is often hard to observe.
True
The Market Portfolio (of stocks) contains all stocks available, each in proportion to its capitalization.
True
The Russell 3000 is a Universe consisting of the largest 3000 U.S.‐based stocks that are listed on exchanges. The Index is re‐constituted at end of June each year, so it may not literally contain the largest 3000 stocks at other points through the year.
True
The Value Spread measures how disperse valuation ratios are across stocks at a given point in time. It changes over time and achieved a peak in the U.S. at the peak of the dot‐com bubble.
True
The theoretical case for Market Efficiency made by Fama and other proponents relies on the existence of "sharks", that is, well capitalized marginal investors that behave competitively and monitor markets in order to seek to profit from mispricings (situation in which market price is different from fundamental value).
True
The typical stock lending contract works like this. Investor A borrowed stocks from investor B and then immediately short‐sold those stocks. The agreed borrowing rate was X% per year. Tomorrow investor B can request his stocks to be returned to him and investor; A has to return the stocks.
True
There are at least two types of number of shares outstanding that can be calculated for each corporation. While "Basic" only considers existing shares outstanding, "Diluted" includes shares that may be created if employee stock options are exercised or convertible debt is converted.
True
Time‐weighted returns are calculated such that the timing of client inflows or outflows into a fund does not affect the fund's time‐weighted return.
True
When the Value Spread is unusually high, "Value" stocks tend to subsequently beat "Glamour"/"Growth" stocks by a wider margin.
True
When the long‐short returns computed using two different quantitative signals are weakly correlated historically, chances are that a combination of these signals will predict relative returns better than each signal in isolation.
True
While some non‐quantitative investors using quantitative signals to pre‐screen stocks for further evaluation using expert (non‐quantitative) judgment, pure quantitative investors believe that such additional layer of subjectivity harms portfolio performance.
True
Stocks that have done well relative to their industry over the last month tend to have lower returns over the subsequent one month period.
True 4-week reversal
Stocks with high Accruals as a fraction of assets tend to have low subsequent returns.
True Indicative of potential earning manipulation which must be undone before raising SEC-suspicion, leading to subsequent lower returns.
The CAPM model assumes that any investor can borrow an unlimited amount of money at the risk‐free rate. In practice, some investors cannot lever as much as they would like to, and this is one of the potential reasons why the CAPM model fails in practice.
True Leverage Constraint
Corporate financial statements are sometimes restated. That is, for example, a corporation may have initially reported that Net Income for Q1/2007 was equal to X, but in later filings changes the value of Net Income for Q1/2007 to Y. A correct backtest uses data as originally reported to avoid a look‐ahead bias.
True Look-ahead bias refer to using information not available at time of computation for backtesting, which could skew results. For backtesting, "point-in-time" data is necessary.
Price/Cash flow and Price/Sales are examples of valuation ratios that violate the principle of capital structure consistency.
True Price are equity-only factors whereas Cash Flow and Sales are enterprise-wide.
It is possible to forecast future relative stock returns using only past stock returns.
True Quantitative Signal Category for Price Trends
Corporate R&D is classified an expense rather than an investment in U.S. accounting rules. Therefore, all else equal, stocks with higher R&D appear to have lower profitability as measured by ROA or ROE.
True R&D is an expense and reduced net income which is the numerator of ROA and ROE This why when using the Gross Profitability Signal, Revenue is only reduced by CGS.
The Sharpe Ratio is a risk‐adjustment procedure that better applies to a situation in which an investor has all his money in the investment under consideration. In contrast, the CAPM alpha is a risk‐adjustment procedure that better applies to when the investor has a very small part of his money in the investment under consideration.
True Sharpe Ratio considers the total risk of the investment under consideration. Therefore, for investors will all a majority of their wealth in one investment, the total risk/volatility of the single investment has greater implications on their overall wealth than market volatility. CAPM alpha considers market, undiversifiable risk. For an investor that has only a small amount of money in the investment under consideration, and has spread his wealth out across other investments, market volatility has greater implications on their total wealth. Consequently, it makes more sense to use CAPM alpha as their investment is more affected by market volatility, not the volatility of any single investment.
The Sharpe Ratio is an Information Ratio when the risk‐free asset is the benchmark.
True The Information Ratio measures the excess/active return of rportfolio - rbenchmark divided by active risk sportfolio - sbenchmark. Because Excess Returns are used to calculate the return and standard deviation they are the same.
In theory, stocks that are highly profitable businesses should not necessarily be good investments if such profitability is public information. This is because the current price of the stock would already reflect the high profitability. In practice, however, highly profitable stocks tend to produce relatively high subsequent returns.
True This is an indication of market inefficiency
The arithmetic average monthly return of a fund over a three‐year period is 2.00%. The monthly beta of the fund over the same period is 0.50. The arithmetic average monthly return of the Market Portfolio over the same period is 3%. The risk‐free was constant at zero over the entire three‐year period. An analyst is correct when he calculates that the alpha of the fund is 6% per year.
True • α = (2% - 0%) - 0.50(3% - 0%) • α = .5% / monthly • α = .5% * 12 = 6.00% / year. No compounding and using arithmetic averages to calculate - to annualize multiply the periodic rate by the number of period per year.
Depending on the length of the period over which past returns are calculated, high past returns can signal lower or higher future stock returns.
True 4-week reversal: relative to industry 1-year momentum 5.5-year reversal
It is typically better to capture the divergence between market price and fundamental value using a collection of valuation ratios than using a single valuation ratio.
True Measurement Error Reduction Principle - not one indicator is perfect, by combining/blending one is typically better able to capture market inefficiency.
Because of the additional costs and risks associated with short‐selling, it is much rarer to have a stock trade at 1/3 of its Fundamental Value than a stock trade at 3 times its Fundamental Value.
True - as shorting produces downward pressure and longing produces upward pressure. The risks involved in shorting make it more likely mispricing exists above the fundamental value from excessive buying that exists below the fundamental value from excessive shorting.
"Earnings‐per‐share" in the P/E ratio can be calculated as Net Income divided by shares outstanding. Shares outstanding can be either "Diluted" or not.
True - diluted is more common.
The Grossman‐Stiglitz paradox implies that there will always be room for active management.
True - so long as their enough inefficiency in a stock market prices to justify the cost of obtaining the information.
Prices can remain wrong even if some smart market participants realize that they are wrong. This is in part because most of these smart market participants manage client money or use leverage, and as such worry that short‐term underperfomance (as wrong prices become wronger) lead to client withdrawals and cuts in credit lines.
True - sometimes arbitrage gets worse before correcting: cheaper stocks become cheaper and expensive stocks more expensive.
