Financial Education

Many have characterized Chinese stock markets as inefficient, casino-like and speculative. In the November 2007 Pacific Basin Finane Journal Eun and Huang show that China’s markets may be more rational than many credit.

China’s markets, more than others, are characterized by small investors with undiversified portfolios. Only 37% of shares are publicly tradable, and only 10% of listed companies can offer the B- or H- class shares available to foreign investors. In studying various preferences, the authors find the following:

1. Stocks are priced according to company-specific rather than systematic risk. There are strong size and value effects, similar to the results found in U.S. markets.
2. Investors will pay a premium for more liquid stocks.
3. Investors will pay a premium for dividend paying stocks, possibly because dividends may reduce the ability of managers to expropriate funds.
4. Investors require lower returns for A-share companies that also issue B- or H-shares, possibly because such companies must meet more stringent disclosure requirements.

Many studies have questioned the ability of mutual funds and pension funds to time the market. In an article published in the December 2007 Journal of Financial and Quantitative Analysis, Chen and Liang examine the returns of 221 hedge funds self-identified as market timers. They find that, for the 1994-2005 period, evidence supports timing ability - especially in volatile or bear markets.

The results are robust to model specification and volatility timing. They do not appear to result primarily from option-like trading or luck.

The authors conclude that the flexible strategies associated with hedge funds are useful for professional market timers, and that funds promising market-timing results are likely to deliver them.

Various studies have documented that the four-day period starting with the last trading day of a month and ending on the third trading day of the subsequent month accounts for the bulk of stock market returns. In the March/April 2008 Financial Analysts Journal McConnell and Xu show that this effect has persisted, and is not confined to small capitalization or low priced stocks. It occurs in 31 of the 35 countries they examined and does not appear to be caused by month-end buying pressure as measured by trading volume or equity fund money flows.

Portfolio monitoring includes monitoring changes in the characteristics of individual securities or asset classes. Over time, underlying average returns, volatility and correlations with other asset classes can change. Such changes alter the appropriate mix of assets for meeting an investor’s objectives and constraints. If the changes are perceived as temporary, they may also present opportunities to make tactical changes.

The market and economic environment also require monitoring. Of particular importance can be the yield curve, market risk premia, central bank policy, and unusual deviations from normal relationships between securities or asset classes.

High quality securities markets are those that supply liquidity, transparency and assured completion.

Liquidity can be defined a number of ways:

• Tightness (low bid/ask spread)
• Depth (limited price impact from large trades)
• Resiliency (rapid adjustments for discrepancies between market price and intrinsic value)

Transparency means access to quotes is quick, easy and inexpensive. It also requires that trade details (size and price) are rapidly disseminated to the public.

Assurity of completion simply means that the counterparties of a trade can be trusted to honor the trade.

Accounting systems take the cash and accruals from various transactions and generate financial reports and statements.

The first step is to create journal entries and adjusting entries. The journal is a chronological list of each transaction, the amount, and the accounts affected. Some systems allow entries to include notes or authorizations. Adjustments are typically made at the end of accounting periods to record accruals not yet reflected in the accounting system.

Next, the general ledger and T-accounts can show the transactions sorted by the accounts affected rather than in chronological order. This can be useful for reviewing the activity in an account such as inventory.

Third, a trial balance lists the balance of each account on a given date. Unlike a ledger, only the ending balance is presented. Trial balances represent the first step in producing financial statements.

Finally, financial statements are prepared as a final product of the system, based on the totals from an adjusted trial balance.

Persistent mispricings should attract profit-seeking investors to exploit them. This, in turn, should eventually cause the anomaly to disappear. There are several potential reasons for anomalies to persist.

Misunderstood Mispricings

Certain anomalies may not have a logical explanation, causing investors to be wary of trying to exploit them.

Costly Arbitrage

Particularly for less liquid securities, there may be significant costs involved in trading them. The higher the costs, the greater a mispricing must be in order for arbitrageurs to try to exploit it.

Insufficient Profit

Large investors, in particular, may find that certain mispricings do not offer a significant return for the time involved in identifying and exploiting them.

Trading Restrictions

Many investors have limits imposed on their activity, such as a prohibition on short selling. Such prohibitions can prevent investors from exploiting opportunities when identified.

Using the Monte Carlo method to estimate Value at Risk (VaR) produces a set of random outcomes reflecting the effects of particular sets of risks. Each set of outcomes is based on a probability distribution for each variable of interest. The distributions for each variable can be normal or non-normal.

Monte Carlo simulations are frequently the only method that provides a practical means to generate necessary risk management information. However, it can become quite a hog of computer resources for large portfolios.

In behavioral finance, escalation bias causes investors to invest more in money-losing investments for which they feel responsible than they invest in an ongoing successful investment. The popular concept of “averaging down” to reduce the average price paid for the investment may be representative of this bias.

The rational, traditional finance model would expect investors to re-evaluate holdings for potential bad news that they had failed to incorporate into their initial valuation. If the re-evaluation supports the investment, then more could be added. Otherwise, it would be wiser to exit the position and take the loss.

A number of factors affect performance evaluation for hedge funds, particularly with respect to using the Sharpe ratio to measure risk-adjusted return.

Starting with return, typically monthly returns are compounded to an annualized rate of return. However, entry and exit opportunities may be permitted only quarterly or even less frequently. In addition, some measures of downside risk such as the maximum drawdown are not compounded. Measures comparing return (compounded) and drawdown (not compounded) may not fully reflect the risk/return profile.

The Sharpe ratio is defined as:

• Numerator is the difference between annualized return and the annualized risk-free rate
• Denominator is the annualized standard deviation of returns

The Sharpe ratio increases proportionately with the square root of time, and is not appropriate when returns are asymmetrical. In particular, the Sharpe ratio tends to be overestimated when returns are serially correlated or assets are illiquid. Furthermore, the correlations between the fund and an investor’s other portfolio assets are not considered.

There are a number of ways managers can “game” the Sharpe ratio, including:

• Lengthening the measurement interval
• Compounding monthly returns but calculating standard deviations without compounding
• Writing out of money put or call options to produce asymmetric returns
• Smoothing returns
• Using swaps to eliminate extreme outlying returns

In part because of these deficiencies, the Sharpe ratio has not been found to be a good predictor of hedge fund returns.