Archive for the 'Passive Management' Category

Portfolio Rebalancing: Cost/Benefit Analysis

Portfolio rebalancing requires a trade-off between the cost of rebalancing and the cost of not rebalancing. Costs of rebalancing include trading costs and taxes, which must be weighed against:

  • the reduction in expected portfolio value resulting from suboptimal asset allocation
  • exposure to greater risk as the riskier assets typically earn more and become a larger percentage of the portfolio
  • shifting risk factors as asset weights change
  • using rebalancing to reduce exposure to the assets that have risen most and may be overvalued

To reflect this trade-off, rebalancing is typically performed in a disciplined fashion, based either on the calendar or on tolerance corridors.

Calendar rebalancing takes place at specific times, and as such does not require constant monitoring. However, it is insensitive to market conditions and may allow weights to drift substantially between rebalancings.

Tolerance corridors call for rebalancing whenever an asset class drifts out of proportion to a pre-specified range around the target weight. It allows tighter control as it is directly related to market performance, but also requires continuous monitoring.

Posted on 4th September 2008
Under: Active Management, Asset Allocation, FInancial Planning, Investment Returns, Passive Management, Portfolio Management, Risk Management | No Comments »

Why Apparent Efficient Market Anomalies May Persist

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.

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

How Many Stocks are Needed for Diversification?

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.

Posted on 9th July 2008
Under: Active Management, Asset Allocation, FInancial Planning, Institutional Investing, Investing in Stocks, Investment Returns, Passive Management, Performance Measurement, Portfolio Management, Research, Risk Management, Security Selection | No Comments »

Risk Based Theories and the Value Premium

The value premium refers to the fact that stocks with priced at a low multiple of book value tend to perform better than would be explained by the Capital Asset Pricing Model. Proponents of the Efficient Market Hypothesis (EMH) argue that the value premium results from a risk factor not captured by Beta. Opponents argue that the value premium is evidence that the EMH is not valid.

Fama and French, among others, have developed models that attribute the value premium to risk factors. Typically these studies use company size as a proxy for liquidity risk. In the Review of Finance, Phalippou replicates these studies in their original form, and then using institutional ownership as an alternative liquidity proxy. In this second iteration, the value premium persists and cannot be explained by the risk factor models.

Phalippou concludes that if the value premium is attributable to risk factors, the risk factors are not the ones identified in previous research.

Posted on 3rd July 2008
Under: Behavioral Finance, Investing in Stocks, Passive Management, Portfolio Management, Research, Valuation | 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 »

Secondary Capital Markets

Secondary markets are those in which securities that have already been issued trade. Transactions occur between investors, and the proceeds do not affect the issuer. Instead, one investor gives another investor cash in exchange for the securities.

Secondary markets provide liquidity to the investors who initially buy the securities. Investors value liquidity because changes in their circumstances may require them to sell the security in order to use the cash for other purposes. By having a liquid secondary market, investors are willing to pay more (accept a lower return) when buying primary issues. This helps issuers raise money at more favorable rates.

Secondary markets also offer issuers price discovery – new issues can be priced according to the value of other similar securities.

Posted on 17th June 2008
Under: Investing in Stocks, Investing in bonds, Passive Management, Portfolio Management, Trading Execution | No Comments »

Alternative Routes to Hedge Fund Return Replication

With the growth in the hedge fund industry has come a decline in the value added by hedge fund managers. Given the high fees typically charged by hedge funds, some have questioned whether passive approaches can be constructed that would provide returns similar to those of hedge funds while offering greater transparency and liquidity.

In the Winter 2007 Journal of Wealth Management Harry Kat discusses three general approaches to hedge fund replication:

  • Factor Models
  • Mechanical Trading Rules
  • The author’s FundCreator product

In a factor model, linear regressions determine the market exposures experienced by a hedge fund or hedge fund index. Factors may include stock, bond, commodity and currency returns, or changes in credit spreads and market volatility. These exposures can then be taken via index products or derivative instruments.

In the case of funds that add value by timing short-term changes in market exposure, the investor’s trading behavior can be compared to mechanical trading rules.

The FundCreator product is a risk management tool that allows the investor to target the risk and correlation properties desired in order to maximize diversification potential.

Posted on 6th June 2008
Under: Active Management, Alternative Assets, Asset Allocation, Hedge Funds, Institutional Investing, Investment Returns, Passive Management, Research, Risk Management | No Comments »

Unweighted Securities Indexes

An unweighted securities index assigns equal value to each index component regardless of its relative price or market capitalization. It is equivalent to investing the same dollar amount in each index component.

Smaller cap stocks will receive a higher weighting in an unweighted index than they would in a value-weighted index. This can lead to a bias toward small cap stocks over time.

Posted on 2nd June 2008
Under: Investing in Stocks, Investment Returns, Passive Management, Performance Measurement, Risk Management | 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 »

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 »