Archive for April, 2008

The Efficient Market Hypothesis and Index Funds

The efficient market hypothesis implies that, on average, active managers will not be able to outperform the overall market on a risk-adjusted basis, after fees. The implication of this is that, unless the manager has access to superior research analysts, portfolios should be managed passively. Passive management should result in lower fees for the same average performance.

Index funds are designed to passively mirror the performance of a given index, thus providing passive management.

Posted on 30th April 2008
Under: Active Management, Investing in Stocks, Investment Returns, Passive Management | No Comments »

What is Behavioral Finance?

Traditional finance theory assumes that investors act rationally to maximize profit. Behavioral finance considers how psychological traits may affect how investors act individually or in groups.

Although there is no unified theory of behavioral finance, practitioners attempt to identify anomalies that can be explained by investor behavioral traits, and to identify opportunities to profit from exploiting the biases of other investors.

Posted on 29th April 2008
Under: Behavioral Finance | No Comments »

Value at Risk (VaR)

Value at Risk (VaR) has come to be regarded as the premier risk management technique for the financial industry. It measures the probability-based measure of potential loss that can be measured for specific transactions, business units or the total enterprise.

VaR estimates the loss in money terms that could be exceeded (i.e. it represents the minimum loss) at a given level of probability. For example, a $5 million one-day VaR at 5% indicates a 5% chance that losses could exceed $5 million on a given day.

All else equal, a higher loss has a lower probability of occurrence. Likewise, reducing the probability level from 5% to 1% (the two most common levels in use) would result in a higher VaR at the lower probability level.

Posted on 29th April 2008
Under: Asset Allocation, Governance, Portfolio Management, Risk Management | No Comments »

Are Markets Weak-Form Efficient?

If the weak form of the efficient market hypothesis holds, security market information should have no relationship with future returns. Technical analysis and trading rules should not allow investors to earn excess returns.

Researchers testing weak form market efficiency generally use one of two groups of tests when studying weak-form market efficiency.

  1. Statistical tests of independence measure either the significance of positive or negative correlation over time (autocorrelation) or by comparing the number of runs (consecutive moves in the same direction) with that expected in a normal sample. In general, statistical tests of independence have shown no relationship between current and future price movements.
  2. Tests of trading rules seek to mechanically simulate various trading strategies. For example, testing whether a strategy of buying when the stock price closes above the 50 day moving average and selling when the price closes below the moving average. In general, these tests have supported the weak-form efficient market hypothesis by showing no excess returns (after trading costs, compared to a buy-and-hold strategy) from following such rules. However, the results are not unanimous – some rules have been shown to offer superior returns.

Technical analysts criticize the existing tests as being too naive or simplistic to capture the

Posted on 28th April 2008
Under: Active Management, Behavioral Finance, Investing in Stocks, Investment Returns, Momentum Strategies, Portfolio Management, Research, Security Selection, Technical Analysis | No Comments »

The Structure of Hedge Funds

Like private equity funds, hedge funds are typically organized as either limited partnerships or limited liability corporations to protect investors from losses exceeding their initial investment and to avoid double taxation of corporate earnings.

Compensation for hedge fund managers typically is based on two components:

  • A management fee of 1-2% of assets under management
  • An incentive fee of 15-20% of the returns in excess of a pre-determined benchmark. Incentive fees are usually constrained by features such as high-water marks, claw-back provisions and other features.

The high fees earned by hedge fund managers has been widely criticized, particularly when the returns generated include some exposure to beta. Beta can be obtained very cheaply through passive investments such as index funds. However, to the extent that the hedge fund returns offer diversification the fees may simply represent a sort of insurance premium that investors are willing to pay  in exchange for risk reduction.

The investments made by hedge funds are often illiquid, and as such many funds require a lock-up period before investments can be withdrawn. In addition, most funds allow cash inflows and outflows only at specific times (usually quarterly.)

Posted on 28th April 2008
Under: Active Management, Alternative Assets, Asset Allocation, Hedge Funds, Investment Returns, Portfolio Management | No Comments »

Investments in Private Equity

Private equity investments are investments made in companies that are not publicly traded. They can take a number of forms:

  • Financing of private businesses by venture capitalists
  • Leveraged buyouts of public companies
  • Investments in distressed debt
  • Financing public infrastructure projects

Characteristics of private investments include:

  • Illiquidity (lack of a secondary market)
  • Requirement of long term commitments
  • Higher risk relative to public equities
  • Need for a high internal rate of return (25-30%)
  • Limited information availability, particularly for venture investments in novel technologies

Posted on 27th April 2008
Under: Active Management, Alternative Assets, Hedge Funds, Investing in Private Equity, Investing in Stocks, Portfolio Management | No Comments »

Selecting Equity Investment Managers

When selecting equity managers, it is important to verify that their stated practices are consistent with their actual results. Investors may wish to examine both qualitative and quantitative factors for this purpose.

Qualitative Factors

  • Investment personnel
  • Organizational structure
  • Investment philosophy
  • Investment decision-making process
  • Strength of equity research

Quantitative Factors

  • Performance relative to benchmarks and peers
  • Measures of style orientation and valuation characteristics of portfolios under management

Past performance should be taken with a grain of salt, as studies have indicated that few managers remain in the top quartile in repeated periods. As a result, managers are required to include a disclaimer that “past performance is no guarantee of future results.”

However, consistency of results can be important. In particular, a given level of performance will be highly valued if the philosophy, personnel and process behind it remained consistent over time.

Posted on 25th April 2008
Under: Investing in Stocks, Portfolio Management | No Comments »

Using Futures to Alter Risk in Fixed Income Portfolios

Compared to cash markets, futures offer a number of advantages for controlling duration in a fixed income portfolio. These include:

  • Cost effectiveness
  • Liquidity
  • Deep markets
  • Ability to shorten duration by shorting futures contracts

To alter the duration of a portfolio using futures contracts it is necessary to know how many contracts to buy or sell.

Target duration = Current dollar duration + Dollar duration of the futures contracts

Dollar duration of the futures contracts = Dollar duration per contract X the number of contracts

The number of contracts = the difference between the target duration and the initial duration, multiplied by the portfolio value, all divided by the dollar duration per futures contract.

Posted on 24th April 2008
Under: Active Management, Financial Statement Analysis, Investing in bonds, Investment Returns, Portfolio Management | No Comments »

Efficient Market Hypothesis: Weak Form

The weak form of the efficient market hypothesis assumes that current stock prices fully reflect all security market information. Security market information includes historical price and volume data, as well as other market-generated information such as odd-lot trades and short interest.

If the weak-form EMH holds, security market information should have no relationship with future returns. Technical analysis and trading rules should not allow investors to earn excess returns.

Posted on 23rd April 2008
Under: Active Management, Fundamental Analysis, Investing in Stocks, Investment Returns, Passive Management, Portfolio Management, Security Selection, Technical Analysis | No Comments »

Enhanced Indexing Risk Factors in Fixed Income Portfolios

Enhanced index strategies attempt to add modest additional return while minimizing tracking risk relative to a benchmark index. In fixed income portfolios, the following factors are the primary contributors to tracking risk.

  • Portfolio duration – exposure to parallel shifts in the yield curve
  • Key rate duration – exposure to nonparallel shifts in the yield curve
  • Sector and quality – the percentage of bonds in the portfolio with given credit ratings, yields or sector exposures
  • Sector duration – exposure to changes in sector spreads
  • Quality spread duration – exposure to changes in credit spreads
  • Sector/coupon/maturity cell weights – a matrix design to put sets of securities into cells that largely replicate various qualities
  • Issuer exposure – controls against issuer-specific event risks

Posted on 23rd April 2008
Under: Active Management, Fixed income investments, Investing in bonds, Passive Management, Portfolio Management | No Comments »