Archive for July, 2007

Investment Advisory Fees

Investment managers are typically paid fees on an ad valorem (percentage of assets) basis, a performance-based basis, or a combination of the two.

Ad valorem fees are typically based on the amount of assets being managed, with higher allocations resulting in lower fees as a percentage of assets. This is because many of the costs associated with active management are of a fixed nature. Ad valorem fees have the advantages of simplicity and predictability for both investors and managers.

Performance fees usually awarded when the manager’s performance exceeds that of a predetermined benchmark, and are awarded based on a percentage of the outperformance. Sometimes the performance fee is capped, and often investors require a high water mark provision, which requires the manager to generate cumulative outperformance since the previous performance fee was paid. Performance fees typically have complicated structures, but benefit the manager and investor in the same way.

Posted on 31st July 2007
Under: Active Management, FInancial Planning, Investing in Stocks, Investment Returns, Portfolio Management | No Comments »

The Disposition Effect

Investors seek to avoid actions that will cause regret and seek actions that will cause pride. According to behavioral finance theory, this action manifests itself through the disposition effect – a greater likelihood that investors will sell winners and keep losers. This can result in higher taxes (capital gains) and poorer returns.

Odean found that winning stocks that were sold generally beat the market by an average 2.35% over the following year, while the losing stocks investors held underperformed by an average 1.06%. Thus, investors keeping the losing stocks too long increased their losses, while those selling winners missed out on further gains and increased their tax bill.

Source: Psychology of Investing, The (2nd Edition)

Posted on 30th July 2007
Under: Active Management, Behavioral Finance, Investing in Stocks, Investment Returns, Research | No Comments »

Portable Alpha

A market-neutral long-short portfolio should, in theory, have no beta exposure. Thus, any return would be attributable to alpha. An investor seeking to outperform a particular benchmark needn’t find a manager who consistently beats the same benchmark. Instead, the investor could purchase a low-cost index fund for the beta exposure, and add on the alpha from any market-neutral long-short strategy.

For example, an investor could buy a NASDAQ 100 index fund for the beta exposure, then add on (port) the alpha from a manager who excels at selecting emerging market stocks through a long/short market neutral emerging market strategy.

Posted on 27th July 2007
Under: Active Management, Asset Allocation, Hedge Funds, Investing in Stocks, Investing in bonds, Investment Returns, Portfolio Management | 1 Comment »

Translating A Foreign Subsidiary’s Results into the Parent Company’s Currency

Companies that have foreign subsidiaries must translate the results of those subsidiaries into their own currency in order to consolidate results. The question is, at what currency exchange rate should each financial statement be translated? There are two basic methods, generally known as the temporal or remeasurement method and the translation or all-current method.

Under the temporal method, any monetary assets and liabilities such as cash, accounts payable and accounts receivable that will be paid or received in a fixed amount of foreign currency, are translated at current exchange rates. All other assets and liabilities are translated at the exchange rate prevalent when the asset or liability was first acquired.

Under the all-current method, as the name suggests, all assets and liabilities are translated using the exchange rate in effect as of the date of the balance sheet.

Posted on 27th July 2007
Under: Accounting, Financial Statement Analysis, Fundamental Analysis | No Comments »

What Works on Wall Street

In What Works on Wall Street, O’Shaughnessy found that equity and fixed income valuations run in cyclical patterns, supporting both momentum and mean reversion depending upon the time horizon. He also found that valuation counts – the less one pays for a given level of sales, earnings or assets the more return one is likely to earn.

In a recent CFA Institute conference, O’Shaughnessy presented some updated findings supporting the original work but also offering food for thought for investment planning. Many investors plan on the assumption that their investments will earn the long-term average return – about 10% in the case of equities. But in time horizons of up to 20 years the annual returns have ranged from as low as zero (adjusted for inflation) to as high as 14%. Although flat real returns have been rare, it is important for investors to at least consider the possibility.

For fixed income investments, the findings are even more stark. There have been long periods of time over which the real returns for fixed income investing have been negative.

On a rolling 20-year basis, O’Shaughnessy’s charts show that the cyclical returns appear to have peaked. If the cyclical patterns persist into the future returns should be expected to continue to fall.

Posted on 26th July 2007
Under: Active Management, Asset Allocation, FInancial Planning, Fixed income investments, Investing in Stocks, Investing in bonds, Portfolio Management, Security Selection | No Comments »

The Equity Risk Premium

The equity risk premium is a cornerstone of modern finance, but identifying it is often a puzzle. In the November 2006 Financial Review, Faugere and Van Erlach derive two models for estimating the equity premium and test them against historical data.

The first model assumes that the equity premium is directly related to per capita GDP growth.

The second model uses put-call parity to show that the equity premium is directly related to the desire to avoid downside risk. The model estimates the equity risk premium as the value of a put option on the S&P 500 index, compounded at the after-tax dividend yield.

Posted on 26th July 2007
Under: Investing in Stocks, Investment Returns, Portfolio Management, Research, Valuation | No Comments »

Mental Accounting and Investment Decisions

Mental accounting is the term used to describe the propensity of individuals to put financial decisions into mental categories, within which they tend to stay. This can have implications for wealth, according to behavioral theorists.

For example, consider an investor who buys stock in an auto maker anticipating a rebound for the industry. The investor’s timing is off and the stock loses money, but the investor still believes there will be an industry recovery. The investor could sell the shares of the company he owns for a tax loss and buy shares in another automaker to capture the recovery in a trade known as a tax swap. The strategy is seldom used, and one explanation may be mental accounting in conjunction with loss aversion.

Posted on 25th July 2007
Under: Behavioral Finance | No Comments »

Losses and Risk Taking

After experiencing a loss, many people become less willing to take a risk. Having been unlucky, the people expect their lack of luck to continue and fail to take judicious risks. In investing, this can manifest itself in a new investor trying the stock market, getting burned and then avoiding the market entirely.

However, other studies have shown that losers seek excessive risk in an effort to break even. Students who lost a coin toss gamble were anxious to accept “double or nothing” bets even if told the coin was not fair. Racetrack gamblers who are losing money tend to bet on long-shots as the day progresses. Commodity traders who are losing money take more risky positions later in the day.

Source: Psychology of Investing, The (2nd Edition)

Posted on 25th July 2007
Under: Behavioral Finance | No Comments »

Substitution as a Sell Discipline

One of the most important investment decisions revolves around when to sell an existing holding. Many investors use a sell discipline to trigger that decision. One such discipline is substitution, which involves selling a security whenever a better one is found.

A substitution discipline should be based on risk-adjusted expectations, and should consider transaction costs and tax consequences.

Posted on 25th July 2007
Under: Investing in Stocks, Investment Returns | No Comments »

The House Money Effect

Investors who have experienced a gain or profit are often willing to take more risk. Gamblers call this “playing with the house’s money.” Since they don’t yet consider the money to be their own, they are willing to take more risk with it.

The house money effect predicts investors will be more likely to purchase risky stocks after closing out a profitable trade.  Behavioral finance theory suggests that overcoming this bias may help investors profit more over the long term.

Source: Psychology of Investing, The (2nd Edition)

Posted on 24th July 2007
Under: Behavioral Finance | No Comments »