MSc Banking and Finance Lecture 1 PDF

MSc Banking and Finance Investments / Equity Portfolio Management Block I: Active vs passive / fundamental law of active management 2022/2023 Building Competence. Crossing Borders. Peter Schwendner / Frank Häusler Underlying question Can y...

MSc Banking and Finance Investments / Equity Portfolio Management Block I: Active vs passive / fundamental law of active management 2022/2023 Building Competence. Crossing Borders. Peter Schwendner / Frank Häusler Underlying question Can you really beat the market? 2 Efficient market hypothesis (EMH) Eugene Fama, 1970: Efficient Capital Markets: A Review of Theory and Empirical Work Securities markets are efficient in incorporating all information that determines the value of a security I.e. Asset prices fully reflect all available information It is impossible to “beat the market” consistently on a risk-adjusted basis Confirmed in a 2012 study by Fama and French: Distribution of fund returns very similar to as if no fund manager had any skill Makes it very hard to find an outperformer Assumptions Investors are always rational and are valuating securities in an unbiased fashion. 3  Efficient market hypothesis (EMH) Weak form of efficiency Asset prices fully reflect all past market price information Implications Technical analysis is useless (using stock market data, e.g. price trend) to produce excess returns Fundamental analysis (using company specific data, e.g. valuation multiples) might produce excess returns All price moves are random (if no change in fundamental data)  Studies show that prices tend to trend 4 Efficient market hypothesis (EMH) What should not exist (trend following, purely on price data) 5 Efficient market hypothesis (EMH) Semi-strong form Asset prices reflect all publicly available information Implications Neither technical analysis nor fundamental analysis can lead to profitable investment strategies, beat the market Strong form Asset prices reflect all information (non public too) Implications No one can earn any excess return Not even an insider Usually not supported by empirical research 6 Efficient market hypothesis (EMH) What should not exist (long-short fund on SPI companies, based on purely fundamental data) 7 Efficient market hypothesis (EMH) Are investors truly rational, all the time? Overconfidence Anchoring effect Confirmation bias Loss aversion Control illusion Etc. 8 Efficient market hypothesis (EMH) Underlying assumption for weak and semi-strong form Any inefficiency will be arbitraged away by smart market participants There are limits to trading, implementing in real life Information cost Transaction cost Noise trader risk Etc. 9 Answer Can you really beat the market? Fama: No, not on average. Empirical studies:Some managers can do it. The two answers are no contradiction! 10 Active versus passive management Passive management 1. Select an index (such as for example the SMI or the S&P500) 2. Then try to replicate the index as closely as possible (same constituents, same weights) Active management, relative 1. Select an index (such as for example the SMI or the S&P500) 2. Then try to beat the index performance (risk adjusted or absolute) by actively deviating (regarding weights and potentially investment universe) Active management, absolute Given a certain universe of stocks, try to build a portfolio with certain characteristics (index agnostic) to achieve a certain goal (for example: positive quarterly returns, high dividend payments, etc.) 11 Active versus passive management SPI versus SPI ETF versus SPI active manager (relative) Active manager (relative) Reference index (SPI) Passive manager (ETF) 12 Active versus passive management SPI versus SPI active manager (absolute) Active manager (absolute) Reference index 13 Passive investment What is an «ETF»? ETF = exchange-traded fund Traded on a stock exchange, much like a stock ETFs in general track an index (see the SPI ETF on previous slide) Combines Fair mark to market valuation at all points in time Tradability like a single equity At a reasonable price Index funds Mutual funds which track an index Only once a day liquidity Very reliable prices, no intraday pricing risk 14  Passive investment The natural enemy of replication and how to attack it COST of implementation (custody fees, fund structure fees, trading fees, salaries, etc.) Leads to a systematic underperformance of a passive investment (ETF or index fund) against its benchmark How to fight costs Lean organization, high degree of automation, scale, etc. Securities lending ETFs lend a pre-defined maximum of the stocks to other parties (to enable them to short sell) Guessing joiners/leavers Already include or exclude certain companies which will join/leave the index with high probability 15 Passive investment ETF implementation 16 Passive investment How to construct, trade an ETF Full replication Hold the exact same universe of stocks as the index with exactly the same weights as in the index Sampling Usually if an index has a very large universe (for example Barclays Global Agg Bond Index with > 5’000 single positions) Use mathematical/statistical techniques to replicate the behavior of the index with only a limited number of stocks Stupid example: The 10 largest SMI titles are approx. 85% of the SMI (which has 20 titles) Synthetic Derivative structure to replicate the return Usually a total return swap that swaps the return of the index into the portfolio 17  Passive investment Pros Cons Transparency Certain Low cost underperformance Liquidity Hidden cost Diversification True liquidity Low turnover Counterparty risk (swap investment strategy implementation) 18 Active investment Fama (and what he never said in these words): «Only fools pursue active portfolio management because you cannot beat the index because markets are efficient» Let’s meet the fools! 19 Active investment - Wall Street Journal 2016 20 Active and Passive Investing — The Long-Run Evidence (AQR, 2018) 21 Active and Passive Investing — The Long-Run Evidence (AQR, 2018) 22  Active investment Traditional approach Active management, relative 1. Select an index (such as for example the SMI or the S&P500) 2. Then try to beat the index performance (risk adjusted or absolute) by actively deviating (regarding weights and potentially investment universe) “Try to beat the index” Use information (macro, micro, market, sentiment) to build an opinion why certain stocks are over- or underpriced Invest accordingly 23  Active investment Absolute Active management, absolute Given a certain universe of stocks, try to build a portfolio with certain characteristics (index agnostic) to achieve a certain goal (for example: positive quarterly returns, high dividend payments, etc.) Two camps Traditional absolute long-only, no leverage portfolio Equity hedge fund strategies 24  Active investment Hedge fund strategies Difference to traditional strategies Leverage Short-selling Investment horizon (trading frequency) Event driven Betting on specific events (for example merger) Long/short Betting on both direction (gaining and falling) Market neutral Have no net exposure but only relative trades Equity hedge Specifically try to hedge long-only equity 25  Active investment Pros Cons Potential to outperform Transparency (?) the market Cost (?) “Buy” certain portfolio Outperformers are few tilts and far between 26  Factor investing 1. Create an index 2. Track that index in a transparent fashion as closely as possible What is new: Traditionally, indices are «market cap indices» Can be any type of index Value index Equal weighted index Trend following index Active managers and factor investing Usually, factor offerings have lower fees Certain active styles can be replicated by factor offerings 27 Fundamental law of active management If you are an active manager, what determines the outcome? 28  Fundamental law of active management Some preliminaries I Information ratio (IR) = (active return) / (tracking error) 𝐸 𝑅𝑝 −𝑅𝑏 𝛼 𝐸 𝑅𝑝 −𝑅𝑏 𝐼𝑅 = = = 𝜎 𝜛 𝑣𝑎𝑟 𝑅𝑝 −𝑅𝑏 Information coefficient (IC) = correlation (prediction, actual outcome) Breadth = number of independent forecasts = N 29 Fundamental law of active management In its basic form 𝑚𝑎𝑥𝑖𝑚𝑢𝑚 𝑖𝑛𝑓𝑜𝑟𝑚𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑖𝑜 = 𝑖𝑛𝑓𝑜𝑟𝑚𝑎𝑡𝑖𝑜𝑛 𝑐𝑜𝑒𝑓𝑓𝑖𝑐𝑖𝑒𝑛𝑡 × 𝑏𝑟𝑒𝑎𝑑𝑡ℎ 𝐼𝑅 = 𝐼𝐶 × 𝑁 What does it tell us The better the forecasts the higher the risk adjusted outperformance (at equal breath) The more independent “bets” the higher the risk adjusted outperformance (at equal IC) Many small bets are better than a few large bets Beware The number of “bets” is substantially smaller than the number of independent forecasts (common factors problem) 30  Fundamental law of active management Some preliminaries II Transfer coefficient (TC) = efficiency of implementation Market impact costs (TCost) = average market impact per transaction in % of market value Turnover rate (TR) = annual portfolio turnover rate Tracking error (TE) = portfolio tracking error 31  Fundamental law of active management Extended version 2 𝐼𝑅 = 𝐼𝐶 × 𝑁 × 𝑇𝐶 − 𝑇𝐶𝑜𝑠𝑡 × 𝑇𝑅 × Derivation: see JPM paper p.10ff 𝑇𝐸 What does it tell us The higher the transfer coefficient, the higher the IR (all else equal; for example from long-only to long/short) The lower the turnover the better The lower the market impact the better Beware TC not necessarily observable but only possible to determine indirectly (solve for TC) The second part of the equation can put you in negative territory (even if you are good at IC, N and TC) 32 Fundamental law of active management Dependencies 1/2 2 𝐼𝑅 = 𝐼𝐶 × 𝑁 × 𝑇𝐶 − 𝑇𝐶𝑜𝑠𝑡 × 𝑇𝑅 × 𝑇𝐸 Extending the Fundamental Law of Investment Management (Or How I Learned to Stop Worrying and Love Shorting Stocks*) JPMorgan Asset Management 33 Fundamental law of active management Dependencies 2/2 2 𝐼𝑅 = 𝐼𝐶 × 𝑁 × 𝑇𝐶 − 𝑇𝐶𝑜𝑠𝑡 × 𝑇𝑅 × 𝑇𝐸 Extending the Fundamental Law of Investment Management (Or How I Learned to Stop Worrying and Love Shorting Stocks*) JPMorgan Asset Management 34 Answer If you are an active manager, what determines the outcome? Prediction: You need very good predictions (IC) Instruments: As many independent bets as possible (N) Implementation: Minimize the “loss” between pure signals and implementation (the other terms) 35 Conclusion and outlook Theoretical background Fama tells you, only fools are selecting active managers and markets are highly efficient Empirical research Does not fully support any form of market efficiency But shows that it is very difficult to find a consistently outperforming manager Conclusions Where do you want to be passive (S&P 500 long-only)? Where might you think about being active (small/mid caps Switzerland long/short)? Costs, etc. can be the main reason why you underperform, although you have a very good IC, N and TC If you are active It is all about the fundamental law in the extended version Outlook: when are stocks attractive? 36