Archive for May, 2008

Liquidity Constraints to Investment Portfolio Management

Liquidity requirements are any need for cash in excess of the amount being saved (or contributed in the case of endowments or pension plans) in a given year. Liquidity requirements usually stem from liquidity events.

Liquidity events may be planned for, such as a child’s education. They may also be unplanned, such as a medical emergency. In either case they require a portfolio allocation to assets that can be readily converted into cash without impacting their value.

In some cases, liquidity requirements can also be met by using derivatives or insurance products.

Posted on 31st May 2008
Under: FInancial Planning, Portfolio Management | No Comments »

Limitations to Achieving Fully Efficient Markets

There are three significant limitations to achieving fully efficient markets: the cost of information, the cost of trading, and limits of arbitrage.

Cost of Information

A fully efficient market requires that all new information be processed instantaneously and fully reflected in the share price. However, if all information is fully priced instantaneously there is no incentive for any market participant to process the information. The time and effort expended would not earn a return. In order for markets to become efficient, there must be just enough inefficiency to make the efforts worthwhile.

Cost of Trading

Trading costs include brokerage fees, taxes, and research time. High trading costs reduce the incentive to trade, and small inefficiencies may not be priced away.

Limitations to Arbitrage

Ideally, if two securities are mispriced relative to their risk one can be sold short and the other purchased. The sale of one and purchase of the other will drive both toward their efficient price. In practice, there are four problems associated with this.

  1. It is uncertain when, if ever, prices will return to equilibrium. The mispricing could become even more pronounced in the meantime, potentially forcing the arbitrageur to close the position.
  2. Two assets rarely have identical risks. If there are no close substitutes for a given security, no arbitrage may be possible.
  3. Arbitrageurs have limited access to capital. Only the most egregious mispricings can be exploited.
  4. Arbitrageurs may face restrictions on trading by the owners of the capital they employ.

Posted on 30th May 2008
Under: Uncategorized | No Comments »

The Analytical (Variance-Covariance) Method for Estimating Value at Risk (VaR)

One way to estimate VaR is the analytical method, also called the variance-covariance method.

This method assumes a normal distribution of portfolio returns, which requires estimating the expected return and standard deviation of returns for each asset. As the number of securities in a portfolio increases, these calculations can become unwieldy. As a result, a simplifying assumption of zero expected return is sometimes made. This assumption has little effect on the outcome for short-term (daily) VaR calculations but is inappropriate for longer-term measures of VaR.

The advantage of this method is its simplicity. The disadvantage is that the assumption of a normal return distribution can be unrealistic.

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

Prospect Theory

Prospect theory is a branch of behavioral finance that contends that an investor’s utility depends on deviations from moving reference points rather than absolute wealth.

An example of prospect theory is the general bias among investors to hold on too long to stocks that have declined, and to sell stocks too quickly when they have risen. The fear of realizing a loss, apparently, is stronger than the value assigned to unrealized gains.

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

Are Markets Semistrong Form Efficient?

If the semistrong form of the efficient market hypothesis holds, investors should not be able to earn excess risk-adjusted returns if their decisions are based on information that has already been made public. Neither technical analysis nor fundamental analysis would provide a predictable edge.

There are two types of studies frequently used to test the semistrong form of the EMH:

  1. Return prediction studies attempt to predict the future rates of returns for the market or individual stocks using public information such as valuation, dividend yield, or risk premium. Another type of return prediction study is event studies, which examine abnormal returns immediately following a major announcement to determine whether returns predictably persist or reverse.
  2. Cross-sectional return prediction studies test whether variables such as valuation to predict the relative returns of all stocks in a sample.

Return prediction studies have generally shown little success in predicting short-term returns. However, they have successfully been used to predict long-term returns. For example, high dividend yields, high default spreads and high term structure spreads all tend to predict higher long-term returns for stocks.

Studies have also demonstrated that markets do not rapidly process the information related to earnings surprise, or unanticipated changes in earnings. If markets are semistrong efficient such information should be reflected on the day of the earnings announcement. However, as much as half of the total change in stock price can occur in the 90 days following the day of the announcement.

Cross-sectional studies have demonstrated several anomalies that appear to contradict the efficient market hypothesis. On a risk adjusted basis: low P/E stocks tend to outperform high P/E stocks; small stocks tend to outperform large stocks; stocks with low price/book ratios outperform stocks with high price/book ratios.

Event studies of stock splits, IPOs (after issuance), accounting changes and corporate finance events generally support the efficient market hypothesis in that the news of such items is quickly and fully incorporated into the market price.

Posted on 28th May 2008
Under: Active Management, Behavioral Finance, Fundamental Analysis, Investing in Stocks, Investment Returns, Passive Management, Portfolio Management, Research, Security Selection | No Comments »

Hedge Fund Benchmarks

There are a number of benchmarks available for hedge funds, distinguished primarily by the frequency of data reporting (monthly or daily), whether they are investable or not, and whether they list the actual funds from which they are comprised.

Principle differences among the indices include:

  • Selection criteria – what kind of track record or level of assets must a fund attain in order to qualify for inclusion?
  • Style classification
  • Weighting scheme – usually either equal weights or based on assets under management
  • How frequently the weights of the constituent funds are rebalanced
  • Investability

Since hedge funds often promote themselves as absolute return vehicles (and thus do not have a direct benchmark) that absolute return nonetheless must be measured in terms of some benchmark. Important questions to consider are whether any alpha reported is sensitive to the benchmark in use and whether the alpha takes into account the true systematic risks faced by the portfolio.

There are also a number of limitations to most of the available hedge fund indices, including:

  • Results are self-reported by the managers and may not be completely neutral or accurate
  • Databases reflect survivorship bias as poorly performing managers exit leaving only the best included. This results in an upward bias to reported returns.
  • The frequency of data reporting may lead to stale prices and distort correlation measures.
  • Missing data can be filled at the manager’s convenience, leading to a backfill bias.

Studies to determine whether hedge fund returns can be mimicked using passive strategies have shown mixed results but do show that returns are influenced largely by the trading strategy employed. Market neutral strategies may offer better diversification to traditional asset classes.

Hedge fund returns have been shown to exhibit low skewness and high kurtosis, which are undesirable features. Mean-variance optimizations are sensitive to errors in the return estimates, and historical data (as discussed above) can be unreliable.

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

Investments in Venture Capital

Formative stage companies and privately held companies often have limited access to capital. Start-ups often need capital to fund research or obtain office space before they have generated any revenue. Other companies may need capital in order to expand operations.

Venture capital can be supplied by Angel investors (accredited investors who supply small amounts of seed or early-stage capital), venture capitalists (who manage pooled capital and also offer companies financial and management support) or large companies who want to become strategic partners.

Financial needs for private companies typically go through several stages:

  1. Early stage financing
    • Seed capital – small amounts of money used to form the company and prove the idea
    • Start-up – pre-revenue commercialization of a product
    • First stage – additional funds that may be needed, and which are typically supplied only when conditions warrant
  2. Later-stage financing offers funds to promising companies that need to expand their operations
  3. Exit stage
    • Acquisition by a larger company
    • Merger with another company
    • Initial public offering (IPO)

Posted on 27th May 2008
Under: Active Management, Alternative Assets, Asset Allocation, Institutional Investing, Investing in Private Equity, Portfolio Management | No Comments »

Questionnaire for Equity Investment Managers

Investment consultants hired to evaluate equity investment managers typically employ questionnaires to formally compare managers. Typically the questionnaires cover five key areas:

  1. Organization, structure and personnel
  2. Investment philosophy, policy and process
  3. Research capabilities and resources
  4. Historical performance and risk factors
  5. Fee structure

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

Immunizing a Fixed Income Portfolio Using Futures

The difference between the cash price of a bond and the futures price is called its basis. Basis risk is the chance that basis will change between unpredictably between the time the hedge is initiated and the time the hedge is lifted.

If the bond underlying the futures contract differs from the portfolio bond (a situation known as a cross hedge) the basis risk can be substantial. In essence the hedge substitutes basis risk for price risk.

The hedge ratio equals the factor exposure on the portfolio divided by the factor exposure on the hedging instrument.

If the factor is limited to interest rate exposure and one assumes a fixed yield spread between the bond being hedged and the cheapest-to-deliver (CTD) bond on the futures contract, the hedge ratio equals the product of the duration and price of the hedged bond, divided by the product of the duration and price of the CTD bond.

Posted on 24th May 2008
Under: Asset Allocation, Fixed income investments, Investing in bonds, Investment Returns, Portfolio Management | No Comments »

Efficient Market Hypothesis: Semi-Strong Form

The semistrong form of the efficient market hypothesis assumes that security prices adjust rapidly to all publicly available information. Such information includes market based information and thus the semistrong EMH encompasses the weak form EMH (if markets are semistrong efficient, they are also weak form efficient.)

In addition to market information, other public information includes earnings and dividend announcements, financial ratios, accounting practices, stock splits, and economic and political news. If markets are semistrong efficient, investors should not be able to earn excess risk-adjusted returns if their decisions are based on information that has already been made public. Neither technical analysis nor fundamental analysis would provide a predictable edge.

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