Archive for June, 2008

Biases in Detecting Efficient Market Anomalies

A mispricing occurs when the price of a security predictably deviates from its normal or expected return. Persistent mispricings are called anomalies. However, the methods for determining expected return, and of finding anomalies, can introduce bias.

Expected Return

In order to constitute a mispricing, a security must predictably earn a higher or lower return than expected. However, the expected return itself is subjective. If it is improperly measured, an apparent anomaly may be nothing of the sort.

Data Mining

Studying hundreds or thousands of relationships is likely to result in a few that appear significant only due to random chance.

Survivorship Bias

When results are based on existing entities, they may ignore entities that have failed. While the existing fund managers, on average, have outperformed their benchmarks this is because if they had not investors would have withdrawn their funds. Only an examination of all managers, whether failures or successes, can give a true reading.

Small Sample Bias

Patterns observed over a short time period may not repeat in other time periods.

Selection Bias

Some anomalies are affected by a portion of the sample. For example, a certain anomaly may pertain only to small cap stocks. Attempts to exploit the anomaly could fail if not applied to the correct sample.

Nonsynchronous Trading

Stocks that trade less frequently will have price changes that reflect all information since the prior trade. Large swings in the overall market between trades will be masked. The stock may appear less volatile than it actually is.

Risk

Riskier investments should generate higher returns. If the risk estimate is incorrect, an apparent anomaly may simply reflect the correct risk.

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

The Historical Method for Estimating Value at Risk (VaR)

One way to estimate VaR is to use the historical method, which graphs the actual daily returns over a user-specified past period into a histogram. For a two-year observation period (500 trading days) the 1% VaR would be the loss on the fifth-worst day, and the 5% VaR would be the loss on the 25th-worst day.

The results reflect past results, not necessarily those that will be encountered in the future. It is also important to adjust for a moving investment horizon. For example, calculating the VaR for bonds expiring in 2020 from historical results of the prior year would be best done using bonds expiring in 2019.

An advantage of the historical method is that it is non-parametric, which means it does not require assumptions for probability distribution. The disadvantage is that the past may have very different risk characteristics from the future.

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

Overconfidence and Confirmation Bias

Overconfidence, in behavioral finance, causes analysts to overestimate the growth potential of growth companies. As a result, they tend to overemphasize good news and underemphasize bad news related to such firms, possibly in the belief that growth companies must also be good stocks.

The emphasis of news that confirms a pre-existing opinion is also called confirmation bias.

Posted on 29th June 2008
Under: Uncategorized | No Comments »

Due Diligence for Hedge Fund Managers

Since reported hedge fund performance is of doubtful significance and risk monitoring is difficult, due diligence takes on special significance when investments in hedge funds are being considered. Some of the things investors must determine include:

  1. The structure of the fund
    • Legal entity
    • Identity of manager
    • Domicile
    • Regulatory regime
  2. Strategy
    • Style
    • Instruments used
    • Benchmark
    • Niche
    • Current holdings
  3. Performance data since inception for all funds under management
  4. Risk management
    • What risks are measured
    • How are they measured
    • How are they controlled
    • How is leverage employed
  5. Research
    • Has the firm’s research led to changes in strategy
    • Strength of research efforts
    • Research budget
    • Personnel
  6. Administration
    • Lawsuits
    • Employee turnover
    • Disaster recovery plans
  7. Legal and Regulatory
    • Fee structure
    • Lock-up period
    • Minimum and maximum subscription amounts
    • Drawback provisions
  8. References
    • Professional
    • Other investors in the fund

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

Are Markets Strong Form Efficient?

In a strong-form efficient market no group of investors should be able to generate excess risk-adjusted returns. Technical analysis, fundamental analysis, and even inside information will provide little value once the information is known.

Tests of the strong form efficient market hypothesis have generally examined the performance of four groups of investors.

  1. Corporate insiders
  2. Stock exchange specialists
  3. Security analysts
  4. Professional money managers

Studies of insider buying and selling have provided mixed support for the EMH. At one time, insiders and public investors following insider trades experienced excess risk adjusted returns. However, more recent studies have indicated that public traders can no longer profit after adjusting for transaction costs.

Stock exchange specialists have monopolistic access to certain market data such as unfilled limit orders. Data suggests that specialists are able to earn excess risk-adjusted returns due to their access to this data.

There is some evidence that certain analysts may possess superior information, and that following the recommendations of these analysts may permit excess returns. Often these anomalies appear to be incorporated, which would support the EMH. For example, the Value Line timeliness rating was considered enigmatic as it appeared to consistently predict returns. However, changes in rating are now incorporated in stock prices within a day or two, and transaction costs may limit any usefulness of the anomaly.

In general, tests of professional investors have supported the EMH. On average, such investors do not enjoy superior risk-adjusted returns.

Posted on 28th June 2008
Under: Active Management, Fundamental Analysis, Institutional Investing, Investing in Stocks, Investment Returns, Passive Management, Research | No Comments »

Why Eliminating Rivals is a Risky Strategy

In the January 2008 Harvard Business Review Michael Porter updates his five forces model and discusses merger and acquisition strategies merely designed to eliminate rivals (rather than improve cost or quality) are risky.

Based on the five forces model, the reduced competition should increase industry profitability in the short term. However, the additional profits often attracts new competitors and a backlash from customers and suppliers.

Posted on 27th June 2008
Under: Industry Analysis | No Comments »

Buyout Funds

Buyout funds represent a significantly larger market segment within private equity compared to venture capital. Mega-cap buyout funds typically will take public companies private through a leveraged buyout. Mid-market funds will purchase private companies or divisions of larger companies.

Buyout funds add value by restructuring operations, by buying opportunistically when companies are selling at less than their intrinsic value, or by capturing gains by adding to or restructuring existing debt. They can realize these gains through a later public offering, selling the company to another buyer or by recapitalizing (borrowing and using the proceeds to pay a special dividend).

Buyout funds differ from venture capital funds in a number of ways:

  • They are usually highly leveraged
  • Cash flows to investors are typically more stable and start sooner
  • Returns are not as subject to measurement error

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

Market Movements and the Business Cycle

Major movements in interest rates, equities and commodity prices are related to changes in the business cycle.

Typically, the bond market is the first to signal business cycle turning points. Bonds will begin a bull phase after economic growth has slowed considerably, and often during the early stages of a recession. Bond prices are inversely related to interest rates, so falling interest rates result in higher bond prices.

As the recession deepens, equity investors begin to “look past” the trough in corporate profits. As a general rule, the longer bonds have been rallying prior to the bottom in the stock market, the better the chances of a rally in stocks.

Once the recovery begins, resource utilization begins to tighten and commodity prices bottom.

Posted on 25th June 2008
Under: Economic Analysis, Technical Analysis | No Comments »

Using Derivatives to Hedge Different Types of Credit Risk

There are three primary types of credit risk:

  • Default risk is the chance the issuer will fail to meet its obligations
  • Credit spread risk is the chance the spread between the risky bond and risk-free securities will vary after purchase
  • Downgrade risk is the chance a rating agency will lower its rating on the issuer

These risks can be hedged using option contracts.

A binary credit option pays off only if a specified negative event occurs. These can be used to hedge default risk or downgrade risk.

Credit spread options pay off based on the spread over a benchmark rate. They can be used to hedge credit spread risk.

Posted on 24th June 2008
Under: Derivatives, Fixed income investments, Futures, Investing in bonds, Portfolio Management | No Comments »

Portfolio Leverage and Repo Rates in Fixed Income Portfolios

Using leverage magnifies the return in a portfolio. If a portfolio can earn 7% and can borrow funds at 5%, the additional 2% accrues to the fund investors. Instead of earning 7,000 on a 100,000 investment, the manager borrows an additional 100,000 and can earn 14,000, but must pay 5,000 in interest. The 9,000 remaining equates to a 9% return for the investors.

If the fund fails to earn the cost of borrowing, the leverage will work in the opposite direction as a drag on returns.

Given the liquidity of certain types of bonds, many managers seeking leverage make use of repurchase agreements (repos). These are agreements to sell a set of securities and to buy them back at a later agreed-upon date and price. The price difference is called the repo interest.

Repos offer the borrower lower rates (due to the liquid collateral) and the lender higher returns than Treasury bonds. Several factors contribute to the final repo rate that will be charged:

  • Quality of collateral – higher quality bonds result in a lower repo rate
  • Term of the repo – a longer term equates to a higher repo rate
  • Delivery requirement – if the lender takes physical delivery of the collateral there is no default risk and the repo rate will be lower. Escrow accounts will reduce the rate to a lesser extent relative to no delivery.
  • Availability of the collateral – if the bonds being offered as collateral are difficult to buy, the lender may accept a lower rate for the repo
  • Prevailing interest rates – repos are generally tied to short-term interest rates
  • Seasonal factors – certain market participants may have seasonal factors that affect their supply and demand for capital

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