Financial Education

Ethical or Socially Responsible Investing usually refers to integrating investment decisions with ethical values. The ethical screening used can be positive (seeking companies that have good practices) or negative (excluding companies that engage in activities that are considered unethical.)

Common negative screens include prohibitions on companies in industries such as defense, tobacco, alcohol, gaming and other vices. Alternatively, they may target high polluters, companies that don’t adopt humane animal welfare practices or other factors.  These are the most common types of screens.

When considering the investment performance of a socially responsible fund, it is important to choose a benchmark that reflects similar goals. For example, a portfolio that excludes tobacco stocks should not be graded harshly when tobacco stocks are doing well, and should not be rewarded for avoiding them when they are doing poorly. The benchmark should have the same exclusion on tobacco stocks as the manager.

Although typical SRI portfolios employ bright-line measures such as industry exclusion, it is also possible to have a portfolio based on relative adherence to the social goals. For example, an investor concerned with pollution may choose to avoid industries that are considered polluters, or may want to invest in the least-polluting company in each industry. Advocates of this relative SRI approach argue that it encourages companies to do as well as they can by rewarding the companies that try hardest. Opponents say that the social standards are too important to reward companies that violate the principles even a little bit.

People often believe they can influence the outcome of events that are outside their control, such as by wearing a lucky jersey when watching a football game. Helping foster such an illusion in investing are several factors:

• Choice – those who choose their own investments believe they have more control than those for whom the decisions are made.
• Outcomes – positive early outcomes increase investor confidence to a greater degree than negative outcomes reduce confidence.
• Familiarity – the more investors trade, the more control they believe they have.
• Information – the more information available, the greater the sense of control.
• Involvement – active participation in investment groups, etc. foster a greater sense of control.
• Past success – during bull markets, investors often misinterpret luck as skill.

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

When asked about their driving skills, 84% of college students rated themselves above average. Clearly, this is unlikely to be the case. In investing, the overconfidence bias manifests itself through excess trading, as the investor believes his ideas more accurate and better interpreted than everyone else’s.

In a study of discount brokerage trading, men were found to trade more than women, and the excess trading did not result in higher returns. In fact, the commissions resulted in lower net returns. This study supports a thesis that men are overconfident investors. Furthermore, the overconfidence results in selecting riskier stocks on average.

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

Value investors look for stocks that are cheap, typically relative to either their assets (price/book) or their earnings (price/earnings.)  Value investors often believe that, in aggregate, other investors are willing to pay too much for popular glamour stocks and that the less popular stocks are underpriced due to neglect.  Efficient market believers usually ascribe the cheaper price to risk factors that investors are accurately pricing into the stocks.

Anyone can see that a stock is cheap. Successful value investors need to understand why a stock is cheap. Is it simply due to neglect, or is there a good reason for the low value? Are other investors missing something, or is the value investor failing to interpret the market’s reason for the low valuation? Is there a catalyst to make the stock rise to its proper value, and if not how long must one wait for the market to recognize the mispricing?

The main subsets of value investors are those who look for a low P/E ratio (usually in hopes of mean reversion), those who seek high dividend yields (and accepting most of the return potential as dividends), and contrarians. Contrarians seek companies that often have little or no earnings and are trading near or below book value. Often this is due to cyclical weakness that can be reversed during the cyclical recovery. Other times the contrarian investor may expect management to turn the performance around.

Source: Managing Investment Portfolios: A Dynamic Process (CFA Institute Investment Series)

In the November 2006 Journal of Financial Economics Cooper, McConnell and Ovtchinnikov examine whether investment returns in January have predictive power over returns for the subsequent 11 months. Between 1940 and 2003, when the market-weighted portfolio is positive in January returns for the remainder of the year have averaged 14.8% and when January returns were negative the remaining 11 months returned an average of just 2.92%.

The authors find no explanatory value from business cycle variables, presidential party affiliation, or consumer sentiment. Further, the results occur independently of other recognized factors such as portfolio weighting, market capitalization or valuation.

Behavioral Finance suggests that overconfidence will cause investors to attribute market-related returns to their own skill level and trade more frequently when markets are rising than when they are falling. In the Winter 2006 Review of Financial Studies Statman, Thorley and Vorkink examine the relationship between past returns and stock turnover in portfolios. This is related to the disposition effect, in which investors will realize gains but delay realizing losses.

The authors find a statistically and economically significant positive relationship between market turnover and lagged market returns, consistent with the overconfidence hypothesis. They also find that individual security turnover is related to both market and security specific returns, supportive of both overconfidence and the disposition effect. Finally, they find that the effect was smaller after 1982 and in large cap stocks, which may be explained by larger institutional (rather than individual) participation in those subsets.

Many have argued that the presence of high-performing portfolio managers could be due simply to random variations in a large sample. In the December 2006 Journal of Finance, Kosowski, Timmerman, Wermers and White challenge this argument.

Using a bootstrap analysis that can account for return distributions, they find that there are more top-performing managers than would be expected from the inherent variation in fund returns. They also find that the performance of these managers persists in subsequent periods. Consequently, they conclude that such managers do have skill rather than luck on their side.

In the Winter 2006 Journal of Investing, Amenc and Vaissie found that funds of hedge funds offered advantages over direct investment in hedge funds due to better diversity, liquidity and disclosure. However, few of the funds added value through active management. Instead, the value add was in terms of style selection. The authors conclude that investors should focus on funds of funds that sought diversification among strategies rather than active management.

Skilled managers are likely to be able to identify stocks that are priced too high as well as those that are underpriced. Theoretically, this skill should be maximized by using a market-neutral (long-short) portfolio in which each long position is matched by a corresponding short sale. However, over the long term stock prices generally rise, and investors may wish to capture this general market exposure (beta).

One way to capture Beta while maximizing manager skill (alpha) is to equitize the market neutral portfolio by holding index futures contracts.

Rather than buying the stocks in an index individually, a fund can gain exposure to all of the stocks at once using either basket (program) trades or stock index futures. A single S&P 500 futures contract provides exposure to 250 times the value of the S&P 500, while the e-mini futures contract provides 50x exposure. These contracts are very liquid, so a fund can gain exposure with minimal transaction costs.

Furthermore, by using an exchange of futures for physicals, the fund can use the futures as a low-cost way to gain access to a fully replicated portfolio. This can be useful because an all-futures portfolio must be rolled over periodically as futures expire in order to maintain appropriate exposure.