Financial Education

A total return analysis is a tool used to determine how a particular trade will affect the return in a portfolio. Given a specific interest rate forecast, the manager can determine how the transaction’s reaction will affect the return and risk of the overall portfolio.

Since any single interest rate forecast is subject to considerable error, most managers will not rely on one. Scenario analysis runs several total return analyses using a wide range of reasonable assumptions. Benefits of scenario analysis include:

• The ability to assess the distribution of possible returns
• The ability to reverse the calculation and find the range of interest rate movements that would result in the desired outcome
• The ability to evaluate components of total return
• Applicability to entire trading strategies rather than merely single trades

In the United States, capital gains on stocks held for less than one year are taxed as ordinary income, while gains on securities held longer than one year receive a preferential tax rate. Many investors and advisors hold stocks past the magic one year in order to maximize the after tax gain. In the Journal of Technical Analysis, Issue 64, Jerome Harti examines whether this tendency results in predictable (and thus exploitable) stock price patterns.

The author proposes that a sharp, downward, high-volume trading day and subsequent recovery should be followed one year later by a corresponding period of underperformance as those investors who have delayed realization of capital gains close their long positions.

Based on a sample of Russell 2000 stocks from the 2004-2005 period, the author finds that during the 10-day “anniversary window” beginning one year after the initial event the experimental group underperformed a control group by 4.36%.

Assets should be considered for portfolio addition if their inclusion would improve the portfolio’s mean-variance efficient frontier. This occurs when the asset class’s Sharpe ratio is higher than the product of the existing portfolio’s Sharpe ratio and the correlation between the asset class return and the portfolio return.

For example, a manager may be considering whether to add an asset class with a Sharpe ratio of 0.18 to a portfolio with a Sharpe ratio of 0.20. The correlation between the asset class and the portfolio is 0.5. Since 0.18 > 0.20 * 0.5 = 0.10, the asset class should be added.

Economic indicators can be leading, lagging or coincident with changes in economic growth. Diffusion indexes can combine multiple indicators.

Advantages to leading indicator approaches to economic forecasting include:

• Intuitive, simple-to-construct models
• Availability from third parties
• Can be tailored to fit individual needs
• Effective use is well documented in economic literature

Disadvantages include:

• They have not historically worked consistently because the relationships between inputs are not static
• They can provide false signals

The methods analysts use to estimate future returns tend to be influenced by data mining and time period biases.

Data mining refers to the fact that given enough data, certain relationships may appear due to randomness yet have no real relationship that will apply in future periods. Such relationships are not meaningful. One way to identify potential spurious correlations is to question why such a relationship would exist. “No story, no future.”

Time period bias reflects the fact that many research findings are sensitive to the start and end dates of the period measured. If a certain asset had fifty poor years followed by two very good ones, the inclusion or exclusion of those two years could have a significant impact on the results of the study.

The primary market refers to trading in new issues of securities. This could be bond issues by corporations or governments, stock issues by corporations or other types of securities in which the initial trade is being made by transferring funds from investors to the security issuer.

Consider, for example, the initial public offering of a stock. The company sells shares to investors, increasing the total number of shares outstanding. Proceeds from the sale increase the company’s cash position, which enables it to invest in new opportunities.

Selecting the most appropriate asset allocation for a given investor consists of four steps.

1. Determine all possible asset allocations that meet the investor’s return requirement on the basis of total return after tax.
2. Eliminate any allocations that fail to meet the investor’s risk objective, whether through quantitative risk factors or inconsistency with subjective measures of risk tolerance.
3. Eliminate any allocations that fail to meet the investor’s other constraints (liquidity, legal, tax, unique circumstances).
4. Select, from allocations that remain, that which offers the best risk-adjusted performance and diversification.

Firms complying to Global Investment Performance Standards (GIPS(R)) must disclose whether the returns are being presented gross of fees (return on assets less direct trading expenses) or net of fees (gross return less management fees). Any other fees deducted should also be disclosed, along with the fee schedule appropriate to a given presentation.

Firms must also disclose:

• Their use of leverage or derivatives in sufficient detail to allow investors to identify the related risk
• Conformity with local laws that conflict with GIPS
• Any non-compliant performance records

Firms must show 10 years of GIPS compliant returns (or as many as are available if fewer than 10). This includes the annual return in each year, the number of portfolios and dispersion of returns in the composite (if 6 or more portfolios), the amount of assets in the composite, the total firm assets (or percentage represented by the composite), and the benchmark return.

The Treynor measure relates excess returns to the systematic risks assumed by a manager. In this regard, it provides the same assessment of manager’s skill as does Jensen’s alpha.

The numerator for the Treynor ratio is the difference between the return on the portfolio and the risk free rate. The denominator is the manager’s beta.

The Treynor ratio can be conceived as the slope of a line connecting the risk free rate to the point representing the portfolio’s average return and beta.

In order to determine the success of an investment strategy it must be compared to a benchmark. A valid benchmark should possess the following qualities:

• Unambiguous – the identities and weights of securities or factor exposures should be clearly defined
• Investable – could the investment be placed in the benchmark itself rather than being managed actively
• Measurable – the return should be readily available or calculable
• Appropriate – the benchmark should reflect the manager’s style or expertise
• Reflective of current investment opinions – an equity manager has opinions (positive or negative) on equities but may have no opinions on fixed income securities. The latter should not be included in a valid benchmark.
• Specified in advance – all interested parties should know the benchmark and its constituents before an evaluation period begins
• Owned – the manager is willing to accept responsibility for performance relative to the benchmark