Financial Education

Internet message boards offer a forum for professionals and amateurs to discuss the relative merits of various stocks. In the Journal of Technical Analysis, Issue 64, Manuel Amunategui creates a technical indicator based on the total traffic and moving average of traffic to the Yahoo! Finance message boards for 550 NASDAQ stocks.

In one test, the author finds that modifying a moving-average crossover strategy to enter the market only on days when the number of message board posts is declining results in fewer trades, lower transaction costs, and higher profit per trade. The premise behind the added condition is that declining message board traffic indicates the stable conditions under which trend-following systems flourish.

In another test, a strategy of trading for a bounce after four consecutive down days is modified to enter the market only when the message board posts have increased from the prior day. The logic in this case is that the increased attention may signal the opportunity for a reversal.

In order for a group of assets to be considered an asset class, they should meet the following criteria:

1. Homogeneous risk and return factors within the asset class
2. Mutual exclusivity with other asset classes
3. Low correlations (diversification) with other asset classes
4. Set of asset classes should incorporate most of the world’s investable assets
5. An asset class should be able to absorb a significant fraction of the investor’s portfolio without compromising liquidity

Working capital items such as inventory, accounts receivable and accounts payable represent the day-to-day financing requirements a company faces. Without inventory there can be no sales, etc. Most of the activity ratios focus on these working capital needs.

However, simply having working capital is not enough. Wal Mart could have all the inventory in the world, but without the store to put it in it would still have no business. Although the store does not constantly have to be replaced, it is essential to conducting business and requires ongoing support in the form of renovation, repairs, etc.

The final activity ratios measure how efficiently a company puts these longer-term assets to use. In other words, how much sales can the company generate given a certain amount of assets in place. The resulting ratio, asset turnover, can be expressed using solely long-term assets or by using total assets. The latter measure incorporates working capital efficiency as well. In either case, the numerator is sales and the denominator is the average asset value (long-term or total) during the period being measured.

Below is the data used to calculate both long-term asset turnover and total asset turnover for Plantronics, Inc.

The Sharpe ratio is often used for evaluating hedge fund performance. However, it has often been criticized for relying on the assumption that returns are normally distributed.

In the September 2007 Journal of Banking and Finance, Eling and Schuhmacher examine the Sharpe ratio and other performance measurement tools for evaluating hedge funds. By ranking hedge fund returns against 12 different performance measures, they find a high correlation between the different measures, suggesting that the choice of measure may not be a significant concern. The lowest correlations are between the Sharpe ratio, the Treynor ratio and Jensen’s alpha.

Given its practical advantages over other return measures, the Sharpe ratio’s popularity is now supported by empirical evidence. The authors find it to be an adequate measure of hedge fund performance.

Econometric modeling applies quantitative methods and analysis grounded in economic theory to analysis of economic data. It can combine historical data with estimated variables to forecast GDP, and is useful for simulating the impact of changes in variables.

Advantages of economic modeling include:

• Robust multi-factor models that can closely approximate reality
• Once built, they allow new data to be quickly and consistently collected and used
• They quantify the effect of changes in exogenous variables

Disadvantages include:

• They are complex and can be time consuming to formulate
• Data inputs and relationships are difficult to forecast and are not static
• Their output requires careful analysis
• They rarely do a good job of forecasting recessions

Many forecasts are prepared based on the past (ex-post) returns of similar assets. Using ex-post data tends to underestimate ex-ante risk and overestimate ex-ante returns.

At any given time, security prices reflect risk factors that may not materialize. When the risk fails to materialize, the security prices rise.

Since the risk did not materialize, historical data do not incorporate it (risk is understated.)

The rise in prices, however, did materialize and is incorporated in the data. Returns, therefore, are overestimated.

In order to function well, a securities market must have the following attributes:

• Information – timely, accurate information regarding volume, prices, bids and offers
• Liquidity – the ability to buy or sell quickly at a known price (near the most recent price). Continuity in prices means that the prices flow rather than gap. This requires depth – a large number of participants willing to buy and sell at prices above and below the current price.
• Low transaction costs, including the cost of reaching the market, brokerage costs, and transfer costs.
• Rapid adjustment of prices to reflect new information, which means the current price reflects all available information.

Foundations exist to support charitable activity. There are several types of foundations, each with different structures and requirements.

An independent (individual or family) foundation is established by an individual, family or group to provide grants for social, educational, religious or charitable activities. Decisions may be made by the donor, family members or an independent board of trustees. They must spend at least 5% of the foundation’s average assets each year.

Company sponsored foundations are legally independent from, but typically closely tied to, a for-profit corporation that provides funds in the form of an endowment or annual contributions. Decisions are made by a board of trustees, which in turn is typically controlled by company officers.  They must spend at least 5% of the foundation’s average assets each year.

Operating Foundations use their resources to provide services (operate a museum) or conduct research. The funds are provided by individuals, groups or families and decisions are made by an independent board of trustees. They must spend at least 85% of investment income in operations, and are sometimes subject to spending 3.3% of average assets.

Community foundations are public charities supported by the public or multiple donors. They provide grants or social, educational, religious or charitable activities and decisions are made by a board of directors. They are not subject to minimum spending requirements.

Taxes are faced by investors worldwide, but the various tax codes can be complex and confusing. Specific tax strategies are probably best executed by a tax attorney, but there are general considerations of which investors and investment advisers should be aware.

Common types of taxes include income taxes, taxes on the gains or profits from investments, property taxes and wealth transfer taxes. Each can play a role in investment planning.  Specific strategies include tax deferral, tax avoidance and tax reduction.

Tax deferral refers to delaying the time at which income is taxed. Periodic payments reduce the compounding effects of return, so the longer tax payment can be deferred the greater the terminal wealth will be. Longer holding periods can defer gains taxes. Loss harvesting strategies can also be used to mitigate gains.

Tax avoidance refers to legal strategies to avoid taxes (as opposed to illegal tax evasion.)  Typically such strategies come at the cost of lower returns (tax exempt bonds), lower liquidity (tax deferred accounts) or less control over the investments (trusts).

Tax reduction strategies consider differences in rates between different taxes (such as income versus gains) and seeks to maximize the most efficient type of return (i.e. favor gains over dividends.) Tax reduction strategies can also incorporate deferral and loss harvesting strategies.

In the May 2007 Review of Financial Studies, Duarte, Longstaff and Yu examine the risk/return characteristics of commonly used fixed-income arbitrage strategies. They find that the strategies that require high levels of modeling produce significant positive excess returns even after adjusting for risk, transaction costs and management fees.

Fixed income arbitrage strategies tend to exploit small differences between intrinsic value and market prices for securities. There has been some debate as to whether they are truly low risk arbitrage or whether the small positive returns most frequently earned are offset by infrequent but dramatic losses.

Of five strategies tested, the ones requiring the greatest intellectual capital – yield curve, mortgage and capital structure arbitrage – produced the highest excess returns after controlling for risk and costs. Swap spread arbitrage also produced positive risk adjusted returns.

Volatility arbitrage, or selling options on fixed income instruments and hedging the underlying asset exposure, produced positive excess returns but also had periods of significant losses.