BM410: Investments

1. BM410: Investments Portfolio Construction 2: Market Anomalies and Portfolio Tilts

2. Objectives • A. Understand different market anomalies • B. Review active versus passive investing • C. Understand portfolio tilts

3. A. Understand Market Anomalies • What is a market anomaly? • A market anomaly refers to price behavior that differs from the behavior predicted by the efficient market hypothesis. • An anomaly discussed means it is known • It is less like to do the same next time because others will be watching for it as well. • Are there known anomalies?

4. Anomalies (continued) • Price Earnings Effect • Portfolio’s of low P/E stocks have exhibited higher average risk-adjusted returns than higher P/E Stocks • Investors prefer cheaper stocks to more expensive stocks even if risk levels are the same. • Small Firm Effect • Smaller firms generally earn higher returns • May be tied to fact that ownership of smaller firms is left to smaller investors who require a higher return to invest.

5. Small Firm Effect Source: Ibbotson Associates 2000

6. Anomalies (continued) • January Effect • Stocks tend to exhibit a higher return in January than any other month (higher for smaller stocks) • May be tied to tax-loss selling or window dressing at year-end • Neglected Firm Effect • Firms not followed by analysts tend to perform better than those followed • Because costs are higher to analyze smaller firms, investors require a higher rate of return to invest in less liquid stocks

7. Anomalies (continued) • Liquidity Effect • Less liquid stocks sometimes perform better than more liquid stocks • Investors may require a higher return premium to compensate for lower liquidity • Market to Book Ratios • Stocks with lower price to book ratios (or higher book to market ratios) perform better • Investors prefer to invest in cheaper stocks (in reference to their assets) than more expensive stocks

8. Book to Market Ratios

9. Anomalies (continued) • Reversals • Extreme stock market performance tends to reverse itself, i.e. reversion to the mean. • Losers rebound and winners fall • Value Line Enigma • Stocks rated highly by Value Line perform better • Investors may actually read Value Line

10. Anomalies (continued) • Post-Earnings Announcement Drift • The effect of earnings announcements continue for many days after the announcement • May be due to trading costs, particularly for smaller companies • In addition, this drift shows consistency • If a company consistently has above market expectations, the market learns it

11. Anomalies (continued) • Market Anomalies are due to: • Risk Premia • Are we accounting for all the appropriate risk factors, such as in an multifactor framework? (there may be more factors than just market portfolio) • Behavior - Irrational or rational • Investors prefer to purchase large and growth stocks and neglect small and value stocks. • Data Mining • By chance, some criteria will appear to predict returns. Is it logical? If not, don’t bet on it!

12. Anomalies (continued) Over-fitting the S&P 500: Butter Production in Bangladesh and the United States, United States Cheese Production, and Sheep Population in Bangladesh and the United States. R2=.99 Source for all the S&P 500 data mining graphs is: David Leinweber’s “Data-Snooping Biases in Tests of Financial Asset Pricing Models.”

13. Questions • Do you understand the market anomalies?

14. B. Review Active versus Passive Investing • What is Active Portfolio Management? • Trading to earn more than a “market” return for time and risk • It is using publicly available data to actively manage a portfolio in an effort to consistently beat the benchmark after all costs, taxes, management, and other fees (not just from luck) • What is passive management? • Not trading to earn a market return for time and risk. • The process of buying a diversified portfolio which represents a broad market index (or benchmark) without any attempt to outperform the market

15. Active versus Passive (continued) • What does active management require? • Active management requires a competitive advantage in at least one of three categories: • 1. Information. You should have information not widely available and not already reflected in stock prices • 2. Trading costs. You should have a lower cost to trade, possibly helped by being a dealer or floor trader • 3. Analysis. You should have the ability to convert public data into private knowledge about value that is not fully reflected in current prices.

16. Active versus Passive (continued) • Does it have to be one or the other? • Why not use a combined approach • Index when that is perceived to add value • Actively manage when you can add value there • What about in-between? • What about enhanced-indexing? • It is often called risk-controlled active funds or hybrid active-passive strategies • For example, you could have a bond and equity index funds, and you could dynamically market time by varying your allocations in each fund (i.e. asset allocation)

17. C. Understand Index-tilt Strategies • What is an index-tilt strategy? • It is the process of using an index as a performance benchmark and departing from the exact index weighting in order to overweight assets or sectors you expect to outperform • Are their different types of “tilts?” • There are a number of them • Interestingly, most are bets on the persistence of so-called long run market anomalies discussed earlier

18. Index-tilt Strategies (continued) • What is the key question for anomaly-tilt strategy? • Will the market anomaly continue? • Can the excess returns from the tilt cover the additional costs in research, trading costs and fees, and taxes? • Is the additional return sufficient to justify the increase in fees for the active strategy?

19. Index-tilt Strategies (continued) • What are some variations on index-tilting? • Suppose you want excess returns from your U.S. portfolio. You decide on an 80% passively managed portfolio with a 20% actively managed portfolio. • This strategy would give you the stability of the index fund (i.e. risk reduction and close to benchmark returns) • In addition, it would give the opportunity to earn higher than benchmark returns if you do well on your actively managed portion of your portfolio

20. Index-tilt Strategies (continued) • The 20% might include: • Stocks not in the index • Purchase assets from other asset classes that have higher than the expected returns from your benchmark • Industry tilts • Overweighting more attractive industries that you expect to add value above the benchmark • Size tilts • Overweight (underweight) smaller companies if you expect their returns to be higher (lower)

21. Index-tilt Strategies (continued) • Anomaly tilts • Invest in market anomalies that you expect to continue, i.e., low PE or high book to market stocks • Risk tilts • Increase (decrease) the beta if you expect is market forecast is for higher (lower) returns • Tax tilts • Increase (decrease) investments in high dividend (taxed at 15%) stock companies versus bonds (taxed at marginal tax rates) if your forecast for market returns is higher (lower)

22. Index-tilt Strategies (continued) • What is the key to portfolio construction? • The key is to build that optimal portfolio to help you achieve your goals the quickest • There are distinct advantages for active, passive, and hybrid strategies • Understand your goals • Understand what you want to accomplish, and • Understand the tools that can help you achieve them

23. Review of Objectives • A. Do you understand different market anomalies? • B. Do you understand active versus passive investing? • C. Do you understand portfolio tilts?