Securities and Investing - Final Exam

1) provides a benchmark rate of return for evaluating possible investments [e.g. is the return 'fair' market value for the risk?] 2) helps us make educated guess as to the expected return on assets that haven't yet been traded in the market.

Two Vital Functions of CAPM

information ratio

ratio of alpha to residual standard deviation [a.k.a. diversifiable risk]; use when evaluating a portfolio to be mixed with the benchmark portfolio.

Fama & French 3 Factor Model plus momentum factor

1) Return on market index. 2) returns to portfolio based on size and 3) Book to Market ratio.

1) resistance level: price above which it is unlikely for a stock or index to rise. 2) support level: price level below which it is supposedly unlikely for a stock or index to fall. These imply a type of "memory" to the market that allows past price history to influence current prices

2 Components to Technical Analysis

1) Fama & French 3-factor model states that size & M to B factors act as proxies for risk determinants so anomalies are premiums in EMH. 2) or markets aren't efficient; analysts are over-optimistic about firms with high projected growth and over-pessimistic about firms with low-growth prospects.

2 Interpretations of Anomalies

1) dividend yield [dividend over price ratio] goes up return goes up. 2) earnings yield 3) yield spread between high and low grade corporate bonds. All three of these are thought to be proxy for the variation in market risk premium, not market inefficiency.

3 Predictors of Broad Market Returns

1) Depending on how much of the portfolio is invested in these small firms, it might not be properly diversified. 2) Can't predict what will happen in the future. 3) Anomalies, once known, are self-destructing.

3 Reasons why taking advantage of the small-firm-in-January anomaly might not work...

style analysis

> 90% of the variation in portfolio return can be explained by the funds' allocation to a broader range of asset classes, and NOT to security selection.

Passive Portfolio Management

A buy and hold investment strategy used by EMH proponents because they believe that active portfolio management pointless in that it incurs fees from regular trading--that shouldn't happen if the market is efficient.

They are employed by brokerage firms which have a conflicting interest---they want to sell stocks.

Analysts tend to be overwhelmingly positive in their assessment of prospective firms because...

we don't expect markets to be strong-form efficient.

Because we regulate and limit trades based on inside-information...

many of these firms are also neglected firms, due to low trading volume, thus they are not part of an efficient market or offer more risk as a result of their reduced liquidity.

Counter-argument or explanation of most anomalies...

will have a steadily increasing slope [beta] (Curved upward), as opposed to a straight line where beta is constant.

Characteristics line of a portfolio using market timing

create an index fund designed to replicate the performance of a broad-based index of stocks.

Common strategy for passive portfolio management...

Assumptions supporting passive management are: 1) informational efficiency and 2). primacy of diversification motives. While Active management has the opposite assumptions, in particular, that pockets of market inefficiency exist that can be exploited.

Compare and Contrast Passive and Active Portfolio Management.

1) top & bottom lines of each box drawn at the ROR of the 95th and 5th percentile. 2) Three dotted lines are placed at the 25th, 50th & 75th percentile . 3) Diamonds are draw on fund's return 4) square is drawn at benchmark index return [S&P Index Fund] 5) draw for periods 1 qtr, 1 yr, 3 yr and 5 yr

Comparison universe rankings are displayed in a chart as follows:

Violation, reversal effect

Consistent of Violation of EMH? Stocks that perform well one period, usually do poorly the following period.

Consistent, pure luck would allow for 50%

Consistent or Violation of EMH? Half of all managers should out perform the market in any given year.

Violation, should go up immediately after announcement.

Consistent or Violation of EMH? If increased earnings reports are announced in January, the stock tends to outperform in February

Violation, no one knows what the market will do.

Consistent or Violation of EMH? Managers who outperform the market one year, should be expected to outperform it in the following years.

Consistent - volatility isn't a way to earn abnormal returns.

Consistent or Violation of EMH? Predictable higher volatility in January than any other month.

Evidence strongly supports this notion, but occasional studies (market anomalies) and events (such as the tulip mania in Holland) are inconsistent with this form of market efficiency. However, there is a question concerning the extent to which these "anomalies" result from data mining.

Degree to which evidence supports semistrong-form EMH?

Strong-Form efficiency doesn't hold since corporate officers do have access to pertinent information long enough before public release to enable them to profit [gain excess returns] from trading on this information.

Degree to which evidence supports strong-form EMH?

A strong body of evidence supports weak-form efficiency in the major U.S. securities markets. For example, test results suggest that technical trading rules do not produce superior returns after adjusting for transaction costs and taxes.

Degree to which evidence supports weak-form EMH?

the forecasting of future rates of return on asset classes and /or individual assets.

Dividing line between active and passive management is...

a waste of time because all data that is available is available to everyone---so it should already be reflected in the stock's price.

Efficient Market Hypothesis believes that both Technical and Fundamental analysis is...

1) professional managers usually don't beat passive benchmark. 2) event studies typically show stocks respond immediately to relevant news releases. 3) it's difficult to identify price trends/anomalies that can be exploited.

Empirical Evidence supporting EMH:

Fundamental Risk

Even if a security is mispriced, it may be risky to try and exploit it because the correction could happen after the trader's investment horizon. This issue may prevent traders from acting on mispricing and allow the bias to continue.

post-earnings announcement "surprise" price drift

The cumulative abnormal returns of positive-surprise stocks continue to rise [and negative continue to fall] even after the earnings information becomes public. Market appears to adjust gradually, not immediately

conventional performance benchmark that mutual funds are compared to to see if they are "beating" the market.

Fama & French 3 Factor Model plus additional 'momentum' factor make up what?

Small investors are better off investing in mutual funds or ETFs because of economies of scale. Since individual investors can't make much on their small sums of money, it's best when they pool together to create bigger gains.

How can small investors benefit from or get into active portfolio management?

growth rates of growth stocks may be consistently overestimated or extrapolated too far into the future. At any given time, growth stocks are likely to revert to lower mean returns and value stocks are likely to revert to higher mean returns, over time

How might value-stock outperform growth stock [in an inefficient market]?

it would prove an inefficient market because not all available information is included in the stock's price.

If stock price movements were predictable...

capital markets guide allocation of real resources, If markets were inefficient and securities mispriced--resources would be systematically misallocated which could cause corporations could obtain capital too cheaply [or expensively]. Think dot.com or real estate bubble.

Implications of efficient markets on resources allocation...

The Magnitude Issue

It's reasonable to state that stock prices are very close to fair value, and only managers with billion-dollar-plus portfolios can earn enough trading profits to make the exploitation of the minor mispricing worth the effort.

overall portfolio performance is determined by specific portfolio choices: 1) Broad asset allocation among types of securities 2) Industry weighting in equity portfolio 3) Security choice 4)Timing

Performance Attribution Analysis

1) identify the risk tolerance & return objectives given the investor's constraints to meet the investor's needs, rather than to beat the market 2) examine constraints: liquidity, time horizon, laws and regulations, taxes, & circumstances.

Portfolio Manager's responsibility in perfectly efficient markets?

P/E Effect

Portfolios of low P/E stocks have exhibited higher average risk-adjusted returns than high P/E Stocks--this holds true even if returns are adjusted for portfolio beta.

1) Assumes fund maintains constant level of risk which is problematic for funds engaging in active asset allocation 2) some funds will have abnormal performance each period by chance 3) Survivorship bias - Upward bias in average fund performance due to failure to account for failed funds.

Problems with Performance Measures

Treynor measure

Ratio of portfolio excess return to beta; use when evaluating the performance of a fund of funds where residual risk can be diversified away so we would compare to systematic risk instead.

1) selection of a well-diversified portfolio with investor's ideal amount of systematic risk. 2) consideration of tax implications 3) consideration of the risk profile of the investor [Toyota executive shouldn't invest in automotives, younger investors can take on more risk than older ones.]

Rational Portfolio Management calls for...

age, tax bracket, risk aversion, and employment/employer

Role of active management in efficient markets because investors' optimal positions will vary by the following factors...

sets limits on trading by corporate officers, directors, and substantial owners, requiring them to report trades to the SEC. These insiders, relatives, and associates who trade on information supplied by them are in violation.

Rule 10b-5 of the Security Exchange Act does what?

you must measure the performance of the bogey with your asset allocation weights. Superior performance relative to the bogey is achieved by overweighting investments in markets that outperformed the bogey, and underweighting the poorly performing markets.

To determine if portfolio performance is due to the departure of bogey's weighting scheme...

Risk-Adjusted Performance

To measure abnormal performance, you must measure normal performance, using:

framing

decisions are affected by how choices are posed. e.g. as gains relative to a low baseline or losses relative to a higher baseline. [another example: 10% chance of survival, vs. 90% chance of dying]

The Lucky Event Issue

Under an efficient market hypothesis, any bet on a stock is essentially a coin-toss. After the fact, there will have been at least one successful investment scheme that someone predicted--but those managers aren't monitored for continued success.

1) Weak-form: stock prices already reflect all historical information from past trading 2) semistrong-form: stock prices reflect publicly available information. 3) strong-form: stock prices reflect ALL [including insider] information

Versions of the Efficient Market Hypothesis

alpha

degree to which a stock's returns meet or exceed the returns generated by the market [abnormal return]. AKA the Jensen measure. Must establish statistical significance via regression

trin statistic

[volume declining divided by number declining] over [volume advancing divided by number advancing] in other words, the ratio of average volume in declining issues to average volume of advancing issues. > 1 is bearish.

price breaking through the moving average from below--signifying a shift from a falling trend to a rising trend.

a bullish signal of moving average of a stock price is...

breadth of the market

a measure of the extent to which movement in the market index is reflected widely in the price movements of all stocks in the market. [e.g. spread between the number of stocks that rise and fall in price.] if advances > declines market is strong.

mental accounting

a specific form of framing in which people segregate certain decisions. This explains the "house money effect" where investors are more willing to sell stocks with gains than realize losses.

market timing

a strategy that moves funds between risky portfolio and cash based on forecasts of relative performance. you can value p erfect [blank] as a call option because the lowest return

moving average of a stock price

average price of a stock over a given interval--where that interval is updated as time passes. [e.g. a 50 day moving average traces the average price over the previous 50 days, recomputed daily.]

the morningstar rating

based on the comparison of each fund to a peer group; morningstar computes fund returns as well as a risk measure based on the fund's performance in its worst years. This risk-adjusted figure is ranked and assigned stars 1 to 5. [5 being best.]

prospect theory

behavioral theory that investor utility depends on gains or losses from investor's starting point rather than on their levels of wealth. (e.g. people who lose big earlier in the day tend to double down later in the day.)

alpha capture

construction of positive-alpha portfolio with systematic risk hedged away

Law of One Price [LOOP]

effectively identical assets should have identical prices

Alpha transport

establishing alpha while using index products to both hedge market exposure and establish exposure to desired sectors

affect

feeling of "good" or "bad" that consumers may attach to a potential purchase or investors to a stock. e.g. socially responsible companies or most admired companies have prices bid up, therefore expected returns are lower

momentum effect

good or bad recent stock performance continues the abnormal performance over following periods--observable in short or intermediate horizons. [Note: long horizons indicate pronounced negative serial correlation/correction]

The Selection Bias Issue

if investors find their scheme cannot generate abnormal returns will be willing to report their findings. The outcomes we observe have been pre-selected in favor of failed attempts, so we can't fairly evaluate portfolio manager's ability.

neglected firm effect

interpret the small-firm effect as being a result of the stock's being neglected by large, institutional traders so information about these firms is less available. OR it could be that small firms might be expected to earn more as compensation for risk.

conservatism bias

investors are too slow/conservative in updating their believes in response to new evidence

bubbles and market efficiency

investors extrapolate current market stability into the future and become more willing to take on risk. Risk premiums shrink, increasing asset prices, and expectations become even more optimistic--this cycle ultimately results in burst bubble.

liquidity effects

investors will demand a rate of return premium to invest in less liquid stocks--that entails higher trading costs. this could explain both the small firm and neglected firm effects--and the abnormal returns seen.

Dollar-Cost Averaging

is an investment technique of buying a fixed dollar amount of a particular investment on a regular schedule, regardless of the share price. The investor purchases more shares when prices are low and fewer shares when prices are high.

Siamese twin companies

merged companies that continue to trade on the stock market separately. [e.g. Royal Dutch Petroleum and Shell's 60/40 profit split--stock price diverged from 60/40 parity.]

Capital Asset Pricing Model [CAPM]

model that relates the required rate of return of a security to its systematic risk/beta. In other words, it predicts relationship we should observe between an asset's risk and its expected return.

Behavioral Finance

models of financial markets that emphasize potential implications of psychological factors affecting investor behavior. Anomalies in financial theory might come from "irrationalities" in investor thinking.

1 star: 0-10th percentile; 2 stars: 10-32.5 percentile; 3 stars: 32.5-67.5 percentile; 4 stars: 67.5-90th percentile and 5 stars is 90th to 100th percentile

morningstar percentile to star breakdown

put/call ratio

ratio of put options to call options outstanding on a stock. because put options do well in falling markets, and calls in rising ones--deviations from historical norms are considered a signal of market sentiment and predictive of market movements.

confidence index

ratio of the yield of top-rated corporate bonds to the yield on intermediate-grade bonds. ratio will always be below 100%, but the closer to 100% the more bullish...since investors are willing to accept smaller default premiums on lower-rated debt.

Equity Carve-outs

partial divestiture of a business unit in which a parent company sells minority interest of a child company to outside investors; spinning the business off on its own [not core part of company business] while retaining an equity stake itself.

efficient market anomalies

patterns of returns that seem to contradict the EMH. It's difficult to interpret these because we need to adjust for portfolio risk before evaluating the success of an investment strategy. They have a self-destructive property when exploited.

representative bias

people are prone to believe that a small sample is representative of a broad population--where they may infer patterns or trends too quickly.

Overconfidence

people tend to overestimate their abilities. This accounts for the poor performance of highly-traded portfolios and it can lead to managers making poor investments in real assets.

regret avoidance

people who make unconventional decisions that turn out badly, have more regret than if the decision were more conventional.

relative strength

recent performance of a give stock or industry compared to that of a broader market index. in other words a measure of the extent to which a security has out or underperformed either the market as a whole or it's particular industry.

Fundamental Analysis

research determinants of stock value such as earnings and dividend prospects, expectations for future interest rates and firm risk. Attempts to determine present value of payments shareholder will receive from each share of stock.

M-square

return difference between a managed portfolio leveraged to match the volatility of a passive index and the return on that index.

Sharpe Ratio

reward-to-volatility ratio; a ratio of portfolio excess return to standard deviation. in other words, it's the incremental return an investor can expect for every increase of 1% of standard deviation.

past prices, fundamental data of firm's product line, quality of management, balance sheet composition, patents held, earning forecasts, and accounting practices

semistrong- form EMH includes what type of information?

small-firm effect

stocks of small firms have historically earned abnormal returns--primarily in January.

Bogey

the benchmark portfolio an investment manager is compared to for performance evaluation. For example a [blank] portfolio may contain S&P 500 as a benchmark for equities and Barclay's Capital US Aggregate Bond Index for bonds.

Efficient Market Hypothesis {EMH}

the idea that prices of securities fully reflect available information about securities.

random walk

the notion that stock price changes are random and unpredictable.

Technical Analysis or Chartist

the search for recurrent and predictable patterns in stock prices & on proxies for buy or sell pressure in the market. Theoretically stock price responds slowly enough to information to create a trend that can be exploited during adjustment phase.

comparison groups/comparison universe

the set of portfolio managers with similar investment styles that is used to assess relative performance. [e.g. high-yield bond portfolios are grouped together then the bonds are organized by average returns given a percentile ranking.]

book to market effect

the tendency for investments in shares of firms with high Book to Market ratios to generate abnormally high returns.

serial correlation

the tendency for stock returns to be related to past returns. positive [blank] means positive returns follow positive returns. negative [blank] means positive returns tend to be followed by negative ones [reversal/correction property]

disposition effect

the tendency of investors to hold onto losing investments--they seem reluctant to realize losses

reversal effect

the tendency of poorly performing stocks and well performing stocks in one period to experience reversals in the following period. [i.e. losers tend to rebound and winners tend to fade back.] This suggests the market overreacts to relevant news.

Closed End Funds

these may or may not violate the LOOP, they often sell at a premium or discount to their Net Asset Value [NAV] because they have high costs [discount] or are expected to outperform market and expenses [premium]

short interest

total number of shares currently sold short in the market. high levels are considered both bullish because it will create future demand [when covered]; bearish because generally sophisticated investors short & they have a negative outlook.

Point and Figure Chart [Xs and Os]

tracks significant up and down price moves without regard to timing. Sell signals generated when stock price penetrates previous lows and buy signals when previous highs are penetrated. congestion area is row of price reversals.

when to use the Sharpe Ratio

use when choosing among competing portfolios that will not be mixed

that trend analysis is fruitless because if past reports and data were to predict future prices---investors would have learned how to exploit the signals long ago.

weak-form EMH implies...

Forecasting Errors or Memory bias

when people give too much weight to recent experience compared to prior beliefs when making forecasts and tend to make forecasts that are too extreme given the uncertainty inherent in their information. Can explain the P/E Effect