Financial Education

Investors must use data to form investment outlooks. It is important to understand some of the measurement errors and biases that can be introduced to the process.

Transcription errors are errors made in gathering and recording data. They are most serious when they reflect a bias – for example, survey respondents are often those most interested in a particular subject.

Surviorship bias occurs when a study includes only those entities that have been viable during the entire time period studied. Since many other entities may have failed, such methods tend to paint an overly optimistic picture.

Appraisal-based data is sometimes used for illiquid assets that trade infrequently. Infrequent measurements tend to produce smoothed data, understating the volatility and potential correlations with other assets.

In the November/December 2007 Financial Analysts Jounal Fama and French break down the returns historically delivered by growth and value stocks into dividends and three components of capital gain: growth in book value, primarily through retained earnings; convergence in price/book ratios due to mean reversion in profitability and expected returns; and the general upward drift in P/B ratios experienced over the last century.

For value stocks, the capital gains arise primarily from convergence. P/B reverts to the mean (increases) and many of the companies that were cheap due to lack of profitability become more profitable.

For growth stocks, the growth in book value is the primary positive factor for returns and convergence is a negative one.

Drift has had a negligible effect on average returns, regardless of the growth or value profile.

Property and casualty insurers face significant and unpredictable policy liabilities. The nature of the business has a substantial effect on investment policy.

Risk Objectives

Sufficient funds are needed to cover unpredictable liabilities, which restricts the ability to accept risk. As a result, such insurers have very low risk tolerance.

Return Objective

Given the low ability to accept risk, non-life insurers have limited ability to earn significant returns. However, higher returns do allow for more competitive policy pricing and improved profitability. Furthermore, growth in the surplus allows the company to underwrite more business, improving the overall firm condition. As a result of the conflicting objectives, risk and return policies vary widely among non-life insurers.

Constraints

Liquidity is a great concern. The time horizon is influenced by a short duration of liabilities, offset by the ability to earn higher return by investing in longer-duration assets. Taxes are a significant concern, but there are minimal legal or regulatory restrictions on investment choices.

In a defined contribution retirement plan, the sponsor provides participants with a specific contribution in the present, and the participant is responsible for investing the assets in order to meet future objectives. As such, each participant is responsible for defining individual investment objectives and constraints.

The principal responsibilities for the plan sponsor are to ensure diversification by offering a menu of plan options. Ideally the sponsor will also limit holdings in the sponsor’s company stock as a further step to ensure that participants have a diversified portfolio.

Investment policy statements for the sponsor typically outline the fiduciary responsibility to offer plan options, and procedures to ensure that diverse individual objectives and constraints can be met within the confines of plan options.

Investors can be categorized (on an ad-hoc basis or by the responses to a questionnaire) into one of four categories: methodical, cautious, individualist and spontaneous.

Methodical investors rely on hard facts. They tend to be more conservative, and less emotionally attached to their investments. They are more risk averse and make decisions based on thinking.
Cautious investors are loss averse, and may miss opportunities due to indecision and overanalysis. Although uncomfortable making decisions, they also tend to be uncomfortable taking advice from others. They are more risk averse and make decisions based on feeling.

Individualist investors are self-assured, and put faith in hard work and insight. They work to gain information from multiple sources, and will take the time to reconcile any differences in information between the sources. They tend to be confident that the results of these efforts will be achieved. They are less risk averse and make decisions based on thinking.

Spontaneous investors are less risk averse and make decisions based on feeling. They tend to be adjusting their portfolios constantly, resulting in overmanaged portfolios with high turnover. Profits are often eroded by trading costs. They tend to be more concerned with missing an opportunity than with risk, and doubt the advice of others even though they may not have expertise themselves.

One form of statistical arbitrage is a strategy used to exploit short-term volatility in securities. Such techniques resemble market-making. In an article in the September/October 2007 Financial Analysts Journal, Fernholz and Maguire show that these strategies can achieve remarkably high information ratios.

In the Fall/Winter 2006 Journal of Applied Finance, Jiraporn and Ning investigate the relationship between shareholder rights and dividend policy to determine the role of agency costs in dividend policy.

Under the free cash flow theory, higher dividends reduce the cash available to management. This theory suggests that companies with weak shareholder protection will offer lower payouts in order to provide more perks to management. This management opportunism hypothesis suggests a direct relationship between dividends and shareholder rights.

The substitution hypothesis says dividends are a substitute for shareholder rights, and that an inverse relationship exists.

Using the Governance Index as a proxy for shareholder rights, the authors find an inverse relationship between dividends and shareholder rights, supporting the substitution hypothesis that high dividend payments are a method companies use to compensate for having weak shareholder rights.

GIPS requires portfolio returns to be calculated using time-weighted total return, adjusted for external cash flows. Portfolios must be valued for return calculations at least monthly (beginning in January 2010 valuation must occur at least monthly on the last business day of the month and also whenever large external cash flows occur.)

The definition of a “large” external cash flow must be applied consistently. Firms can formulate and document composite-specific policies as long as the policies are consistently applied. The policy must describe the methodology for computing time-weighted return (beginning in January 2010 only true time-weighted return will be permitted) and the assumptions made regarding capital inflows and outflows.

Macro attribution analysis is conducted at the level of the fund sponsor rather than the portfolio manager. The distinction relates not to who conducts the analysis, but to the factors considered.

Macro attribution can be expressed either as a rate of return or as a value. It expresses total return in terms of:

• The policy allocation to each asset class
• The benchmark portfolio return for each asset class
• The returns, valuations and external cash flows related to each manager hired

Macro performance attribution decomposes the change in portfolio value into a variety of components, which can include:

• Net contributions – how much of the change in value was due to additions and withdrawals from the portfolio
• Risk-free asset – the return that would be generated if the fund and all contributions were invested at the risk free rate
• Asset categories – the return that would be earned on passive investments at the policy weight for each asset class
• Benchmarks – the difference between the sum of the weighted returns of manager benchmarks and the asset category return
• Investment managers – the difference between the weighted average sum of manager returns and that of their benchmarks
• Allocation effects – this category reconciles the difference between the fund’s actual return and the separate analyses conducted above, in order to account for any differences resulting from deviation from policy weights

Time weighted rate of return measures the compound rate of return over a given period for one unit of money.  Money-weighted rate of return, by contrast, measures the compound growth rate in the value of all funds invested in the account over the evaluation period.

Money-weighted rate of return is equivalent to a portfolio’s internal rate of return (IRR). It is the growth rate that solves the equation:

MV1 = MV0(1+R)^m + CF(1+R)^m-L(1) + … + CFn(1+R)^m-L(n)

where:

• m is the number of time units in a given subperiod
• L(i) is the number of time units by which the ith cash flow is separated from the beginning of the evaluation period