Financial Education

The value premium refers to the well-documented outperformance of value stocks (those with high book value relative to market value) over gorwth stocks (those with high market-book ratios.) This outperformance is not explained by systematic Beta as defined in the CAPM, though it does represent one of the three/four factors used in the Fama-French model.

In the March/April 2008 Financial Analysts Journal, Phalippou finds that the value premium is driven by stocks with low institutional ownership - a group that represents just 7% of the total stock market capitalization. Since individual investors may be less sophisticated than institutional investors, such stocks may have a higher tendency to be mispriced. The low institutional ownership may also signal that the mispricing opportunities are difficult to arbitrage.

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fund managers, on average, have outperformed their benchmarks this is because if they had not investors would have withdrawn their funds.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.

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.

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

The strong-form efficient market hypothesis assumes that stock prices reflect all information, whether public or private. As such, it encompasses both the weak-form EMH and the semistrong-form EMH. If a market is strong form efficient, it is also weak- and semistrong-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.

In essence, the strong form efficient market assumes a perfect market in which all information is cost-free and universally available to all market participants simultaneously.

When investing or considering investments in International assets, investors should consider the following special issues:

Currency risk: This affects both return and volatility. Investors must decide whether to hedge this risk.

Correlations with other assets: Although international assets frequently have low correlations with domestic assets, the correlations increase during times of stress. Times of stress are exactly the times in which a low correlation (higher diversification benefit) is most needed.

Emerging markets: Emerging markets tend to be less liquid and less transparent than developed markets. Their investment return distributions tend to be non-normal, which is significant for investors employing mean-variance optimization strategies.

Cash

Cash managers can earn higher returns by accepting longer-dated maturities or credit risk. The yield curve reflects the consensus expectation for future interest rates. Managers must distinguish between future events that are reflected in the yield curve adn those that will surprise the market.

Nominal Default Free Bonds

Conventional government bonds of developed countries have little or no default risk. Return can be disaggregated into real return and an inflation premium. The investor must compare his own forecast for inflation with that imbedded in the yield. If the investor believes inflation will be lower than expected, the bonds are a good buy.

Defaultable Debt

Default risk in commercial bonds is reflected in a premium yield relative to Treasuries. This spread tends to widen in recessions as economic stresses increase the likelihood of default. Understanding when a bond is pricing in greater default risk than is necessary can help determine whether securities are attractively priced.

Emerging Market Bonds

The sovereign debt of non-developed countries is often priced in foreign currencies. Since the issuer cannot print the money needed to cover repayment such bonds are subject to default risk, similar to corporate debt of similar ratings. A country risk analysis often involves an understanding of local politics.

Inflation Indexed Bonds

Inflation indexed bonds allow investors to directly observe the consensus inflation forecast by comparison with the yield of conventional bonds. The yield curve will still vary with the real economy and according to supply and demand. However, higher volatility of inflation will increase their hedging value and can result in lower real yields.

Common Stock

The economy affects earnings (cash flows) and interest rates in opposite directions. Trend growth depends on labor growth, investment and productivity while the business cycle affects profitability. In emerging economies, ex-post risk premia have been higher and more volatile than in developed countries.

Real Estate

Returns are affected by growth in consumption, real interest rates, the term structure of interest rates and unexpected inflation. Economic cycles can also affect the cost of building materials and construction labor, but the net effect of lower interest rates is positive for real estate valuations.

Currencies

Exchange rates reflect the balance between supply and demand. Imports increase currency supply, usually reducing its value. Capital flows for investment purposes, however, may outweigh the effect of trade imbalances. Differences between local interest rates can also affect exchange rates, as the higher yielding currencies attract capital and thus the currency value.

Historical averages incorporate many different types of economic environments, only some of which may be relevant to current conditions. One of the most important areas for investors to apply subjective judgment and insights is in “conditioning” historical data or choosing the periods that best reflect current conditions.

Even when using conditioned data, it is important for the analysis to incorporate any new facts that may be relevant to the decisions being made.

Over time, small capitalization stocks have been shown to outperform large-capitalization stocks. However, timing changes in the relative performance between the two groups could lead to still-better performance. In the Fall 2007 Journal of Portfolio Management, L’Her, Mouakhar and Roberge test three nonparametric techniques derived from artificial intelligence and using 20 macroeconomic and financial variables as inputs.

The three approaches are recursive partitioning, a neural network and a genetic algorithm.

Each of the three techniques outperforms a naive small-minus-big strategy, but the best results are derived from taking the consensus of the three techniques.

Behavioral finance theory has pointed to research that shows short-term momentum and long-term reversals in pricing as signs that markets are not fully efficient. In the December 2007 Journal of Finance George and Hwang show that the trends may be at least partially attributable to the differential tax rates applied to short-term and long-term capital gains.

The authors first note an asymmetry between the reversals of stocks with capital gains and stocks with capital losses. In the latter case, there is no tax incentive for holding over longer periods. They then test the capital gains hypothesis by comparing U.S. results to Hong Kong, where there are no capital gains taxes. They find no evidence of reversals in Hong Kong, supporting the thesis that short term momentum may be a means of compensating holders for additional taxes, while long-term reversals result as the tax effects subside.

The study is reminiscent of Harti’s study showing underperformance around the anniversary dates of large price swings, which would also appear to be tax-driven.