Financial Education

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.

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.

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.

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.

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.

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.

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.

Part of the responsibility of any investment manager is to seek the best possible execution for clients. Best execution is the trading strategy that maximizes the value of the client’s portfolio, subject to the investor’s objectives and constraints.

Some characteristics of best execution include:

• A tie to the investment decision (obtaining the right price or capitalizing on the information)
• Inability to know what the best execution will be prior to the actual execution, but an ability to measure and analyze the execution afterward
• A component of complex practices and relationships that are undergoing continuous refinement

To help achieve best execution, firms should establish processes around maximizing the asset value of client portfolios, and establish guidelines for measuring and managing execution. The compliance with these procedures should be documented and disclosed to clients.

Firms should also disclose general information about their trading techniques, venues and agents and also any potential conflicts of interest that may result.

A value weighted security index is calculated by summing the market capitalization of each stock in the index. A derivation of a value weighted index is the float weighted index, which uses only the freely trading shares to calculate market capitalization. Today, most capitalization weighted indexes are actually float-weighted.

A major advantage of value weighted indexes is that they automatically adjust for corporate actions such as stock splits. The decline in value per share following a split is exactly offset by the increase in the total shares outstanding. Stocks with higher market capitalization receive relatively more weight in the index.

The efficient market hypothesis implies that, on average, active managers will not be able to outperform the overall market on a risk-adjusted basis, after fees. The implication of this is that, unless the manager has access to superior research analysts, portfolios should be managed passively. Passive management should result in lower fees for the same average performance.

Index funds are designed to passively mirror the performance of a given index, thus providing passive management.