Financial Education

Many studies have questioned the ability of mutual funds and pension funds to time the market. In an article published in the December 2007 Journal of Financial and Quantitative Analysis, Chen and Liang examine the returns of 221 hedge funds self-identified as market timers. They find that, for the 1994-2005 period, evidence supports timing ability - especially in volatile or bear markets.

The results are robust to model specification and volatility timing. They do not appear to result primarily from option-like trading or luck.

The authors conclude that the flexible strategies associated with hedge funds are useful for professional market timers, and that funds promising market-timing results are likely to deliver them.

Various studies have documented that the four-day period starting with the last trading day of a month and ending on the third trading day of the subsequent month accounts for the bulk of stock market returns. In the March/April 2008 Financial Analysts Journal McConnell and Xu show that this effect has persisted, and is not confined to small capitalization or low priced stocks. It occurs in 31 of the 35 countries they examined and does not appear to be caused by month-end buying pressure as measured by trading volume or equity fund money flows.

Portfolio monitoring includes monitoring changes in the characteristics of individual securities or asset classes. Over time, underlying average returns, volatility and correlations with other asset classes can change. Such changes alter the appropriate mix of assets for meeting an investor’s objectives and constraints. If the changes are perceived as temporary, they may also present opportunities to make tactical changes.

The market and economic environment also require monitoring. Of particular importance can be the yield curve, market risk premia, central bank policy, and unusual deviations from normal relationships between securities or asset classes.

High quality securities markets are those that supply liquidity, transparency and assured completion.

Liquidity can be defined a number of ways:

• Tightness (low bid/ask spread)
• Depth (limited price impact from large trades)
• Resiliency (rapid adjustments for discrepancies between market price and intrinsic value)

Transparency means access to quotes is quick, easy and inexpensive. It also requires that trade details (size and price) are rapidly disseminated to the public.

Assurity of completion simply means that the counterparties of a trade can be trusted to honor the trade.

Persistent mispricings should attract profit-seeking investors to exploit them. This, in turn, should eventually cause the anomaly to disappear. There are several potential reasons for anomalies to persist.

Misunderstood Mispricings

Certain anomalies may not have a logical explanation, causing investors to be wary of trying to exploit them.

Costly Arbitrage

Particularly for less liquid securities, there may be significant costs involved in trading them. The higher the costs, the greater a mispricing must be in order for arbitrageurs to try to exploit it.

Insufficient Profit

Large investors, in particular, may find that certain mispricings do not offer a significant return for the time involved in identifying and exploiting them.

Trading Restrictions

Many investors have limits imposed on their activity, such as a prohibition on short selling. Such prohibitions can prevent investors from exploiting opportunities when identified.

A number of factors affect performance evaluation for hedge funds, particularly with respect to using the Sharpe ratio to measure risk-adjusted return.

Starting with return, typically monthly returns are compounded to an annualized rate of return. However, entry and exit opportunities may be permitted only quarterly or even less frequently. In addition, some measures of downside risk such as the maximum drawdown are not compounded. Measures comparing return (compounded) and drawdown (not compounded) may not fully reflect the risk/return profile.

The Sharpe ratio is defined as:

• Numerator is the difference between annualized return and the annualized risk-free rate
• Denominator is the annualized standard deviation of returns

The Sharpe ratio increases proportionately with the square root of time, and is not appropriate when returns are asymmetrical. In particular, the Sharpe ratio tends to be overestimated when returns are serially correlated or assets are illiquid. Furthermore, the correlations between the fund and an investor’s other portfolio assets are not considered.

There are a number of ways managers can “game” the Sharpe ratio, including:

• Lengthening the measurement interval
• Compounding monthly returns but calculating standard deviations without compounding
• Writing out of money put or call options to produce asymmetric returns
• Smoothing returns
• Using swaps to eliminate extreme outlying returns

In part because of these deficiencies, the Sharpe ratio has not been found to be a good predictor of hedge fund returns.

Venture capital investors typically receive convertible preferred stock when funding companies. If the company is forced to liquidate, the preferred shares will have precedence in receiving funds. The company founders will hold a residual stake of common shares. If subsequent funding rounds are provided, each round is typically senior to the previous.

Typically the preferred investors must see a return of capital and also some investment return (often a total of 2x the capital contributed) before any cash can be returned to common shareholders. This provides the founders with an incentive to earn the return required by their investors so they can reap their own rewards.

The preferred shares are also convertible to common shares, which is typically done when a corporate action (merger or IPO) creates liquidity for the common shares and an opportunity to cash out.

International bond managers can seek excess return from a variety of sources:

1. Bond market selection - choosing the best country in which to invest
2. Currency selection - deciding whether to hedge or retain currency risk
3. Duration/yield curve management - getting the most favorable returns within the selected market
4. Sector selection - choosing among government, corporate, local currency or dollar-denominated bonds
5. Issuer credit analysis - being able to identify improvement or deterioration in advance of changes in rating
6. Benchmark mismatches - investing in markets that are not included in the benchmark index

Changes in interest rates affect both the reinvestment rate earned on portfolio income (directly) and the value of the portfolio (inversely.) An immunization strategy is designed to lock in total return over a specified time horizon by creating a portfolio in which the two total return factors exactly offset each other.

To immunize a portfolio over a single period, the portfolio must have duration equal to the investment horizon and an initial present value of cash flows equal to the present value of the future liability.

Since yield changes over time will result in duration changes other than those caused solely by the passage of time, it is necessary to periodically rebalance an immunized portfolio. This must be done only if the benefits outweigh the costs. Some transaction costs must be borne in order to avoid duration mismatch, but some duration mismatch is needed to avoid transaction costs.

Typically the rebalancing will restore the dollar duration equivalency to the time horizon. Dollar duration is the product of Duration X Portfolio Value X 0.01.

To rebalance the dollar duration requires three steps:

1. Calculate present dollar duration based on the prevailing yield curve and time to maturity
2. Calculate the rebalancing ratio by dividing the original dollar duration by the new dollar duration. This can be expressed as the percentage change for each position by subtracting one and converting the result into percentage terms.
3. The new market value of the portfolio multiplied by the percentage change is the amount of cash that will be needed for rebalancing.

Portfolio management theory asserts, based on the variance between a given asset and the rest of the portfolio, that as few as 8-20 stocks are sufficient to provide most of the benefits of diversification.

In the November 2007 Financial Review Domian, Louton and Racine challenge this assumption by proposing that long-term investors are likely to be more concerned with shortfall risk (failure to reach a target ending wealth) than with return variance.

Based on the returns of 1,000 stocks and a safety first criterion, they find that at least 164 stocks are necessary to reduce shortfall risk to no more than a 1% chance of underperforming Treasury bonds. Although smaller portfolios can be enhanced by diversifying across industries, the benefit is not as powerful as that provided by simply adding more stocks to the portfolio.