Developing and Evaluating an Investment Analysis - Assignment Example

Investment Analysis Q. You are an investment advisor and your client is not sure whether to invest in actively or passively managed fund. Explain the pros and cons of each approach. Relate your discussion to the efficient market hypothesis (EMH) and its implications. Efficient Market Hypothesis (EMH) assumes that security prices, at any given time, fully reflect all available information. Obviously, it all depends upon how fast information is integrated in prices. When there is a time gap in reflecting the price to the information available, the discerning investors or active fund managers take advantage of the situation to make profit out of it either buying or selling the stocks. In actively managed portfolios, fund managers do not believe that market is always efficient and they are always eager to make use of such mismatch in pricing that does not discount the information completely. If active fund manager remains successful in identifying such opportunities, it is possible to make above average returns without exposing to higher systematic risk and thus, it is possible to outperform the market through actively managed portfolios. Information always continues to flow in the market and prices keep on fluctuating. Sometimes the information is stock specific and sometimes, some macroeconomic factors may provide direction to the market. Disadvantage of actively managed fund is that these funds have higher expense ratios. They also pay higher taxes as they frequently enter and exit in the market. Due to their modus-operandi, these funds may give higher returns; however, they carry higher risks too. It is also true that prices fluctuate in response to available information widely as per the perceptions of the players involved and they are mostly unpredictable. Usually, it is not possible to use information to predict future price. Contrasting actively managed funds, passively managed funds take a long term view and do not frequently enter or exit the market. The advantage is that they are less risky and pay lesser taxes in comparison to active funds. Owing to limited number of transactions, passively managed funds spend less on transaction costs. They usually provide risk free average returns. Passively managed funds are highly diversified to minimize market risks. Another advantage is that they are not information dependent while reshuffling their portfolios, which usually happen at much lesser frequency. The only disadvantage that can be said against passively managed funds is that they do not provide fancy returns; however, they are much safer as they distribute the risks systematically without noticing any short-term news. Investors choose active or passive managed funds depending upon their own risk-reward profiles. It can be said that passively managed funds usually move in line with the index while actively managed funds attempt to overshoot any popular index-based returns; however, any failure in gauging the trend of market may swiftly put the fund into a negative return. Q. You are an investment advisor and your client is not sure whether the CAPM or multifactor APT model is a better investment bench mark. Explain the pros and cons of each approach. Capital Asset Pricing Model (CAPM) Model It is well understood that every financial investment carries some amount of financial risk. Usual expression of the risk is the discount rate and that varies in line with the risks associated with the investment. The Capital Asset Pricing Model is widely accepted to calculate discount rate based on a specific risk. That means CAPM is a tool to find desired return based on the risk anticipated. It is obvious that the higher the risk the higher will be the expected return on the investment to be made. Thus, the CAPM is a tool to find the risk-adjusted rate based on the risk-free rate already available. Mathematically, it can be denoted as: Risk-adjusted rate (Ra) = Risk-free rate (Rf) + beta * market risk premium Here, Beta is the stock specific risk. Advantage of CAPM The model is simple to apply as it calculates return over and above risk-free rate of investment. The model is good to apply for established companies and traditional assets because beta is known in such cases. It serves as a useful bottom-line benchmark. Disadvantages or Shortcomings of CAPM The model fails to explain the variability in stock returns. The model does not take into account the transaction costs and any taxes applicable. As a risk-free rate, it takes into account 3-month treasury bills. Usually, the treasury bills are risk-free but cannot be called completely risk-free; moreover, interest rates on the 3-month Treasury bills vary significantly. For example, between 2004 and 2014, the returns on treasury bills have moved from 7% to 0%. That means any significant change in risk-free rate in short period will alter the risk-adjusted rate too considerably. It is difficult to apply CAPM for new stocks as beta is not known. Moreover, it is important to notice that the market risk premium is a subjective decision and may vary between 5% and 8%. They not only vary country to country but also vary in line with the state of economy. Multifactor APT Model Arbitrage Pricing Theory Multi-factor APT models are employed to build portfolios that have certain characteristics such as book-to-market values, size of firms. It takes into account multiple factors while calculating and explaining equilibrium asset prices. It can be used for performance evaluation, pricing assets, and risk management purposes. Pros The APT functions on fewer assumptions. Moreover, it provides appropriate description of risk and return. Cons It does not inform about the systematic factors that provides returns. Also it does not say what the right factors are! Arbitrage has cost implications because in order to exploit overpricing, short selling needs to be done. Mutual funds and Pension funds face certain limits on their discretion to short securities so in that sense Arbitrage has limitations. An arbitrageur looks for mispricing in a stock but one does not know how long it will remain that way. Market can remain irrational longer than one can remain solvent. Q. Discuss the strengths and limitations of the behaviorists approach to investment analysis, in comparison with conventional theories assuming full investor rationality. According to the conventional wisdom or investment theory, investors are rational in their investment decisions; however, many a times, they go irrational while taking an investment decision. Sometimes, investors behave strangely with emotion and psychology takes over to influence their investment decisions discarding rational behavior. Behaviorists approach contradicts traditional investing views and theories. It has its own strengths as well as limitations. Behaviorists argue that investors are mostly overconfident in their abilities to forecast future prices. It is not surprising that active funds dominate passive funds; however, there is no evidence that active funds outperform markets. Investors are slow in refining their beliefs based on the fresh evidence. There is no evidence that price always reflects immediately on new information. That is also true that excessive trading results into negative or poor performance. Efficient market theory and investor rationality is pretty hard to swallow if the past investment bubbles in certain asset class including stocks are observed. It is the herd instinct that makes people to imitate others. When the market is on upward trend, often investors have a feeling of ‘missing the bus for good’. The instinct prompts investors to enter the market even at a much higher price. It is never possible to predict how long the euphoria will last; it may last for a few weeks or months. While several pricing anomalies exist in the market, behaviorists assume that it occurs mostly due to investor irrationality. People infer based on small occurrence and make long-term investment decisions. Due to herd mentality, during upward trend, buying spree intensifies causing significant price run-up. Again, it is the investor psychology that makes them to keep losing stocks for a long time while disposing off winners too quickly. Thus, according to behaviorists, common investors have some typical traits that cause market to either overshoot fair market price or undershoot than its true valuation. Those who follow behaviorists approach tend to take advantage of this overshooting and overreacting of valuation in short-terms. In fact, that is the reason why prices keep on fluctuating continuously and those who study such patterns, also known as technical analyst, try to take advantage by entering into short-term trades. Those who are experts in technical analysis can exploit numerous opportunities to make profits in short-terms and that is perhaps the biggest strength of behaviorist approach; however, the limitation of this approach is that it entails transaction costs every time when one enters into a trade. Also, one needs to book profit before the trend reverses. The approach requires mastery and clear understanding over trends and price movements and that is indeed a difficult task for any investor. Q. Suppose you are an investment advisor. You suggest your clients to buy stocks of small firms and stock with high ratios of book equity to market. (1) Explain the rationale of your suggested investment strategy (Suppose the CAPM is your benchmark model). (2) Explain the multifactor APT model that incorporates size and book-to-market equity as proxies for systematic risk exposures and provide risk- and behavioral based interpretations of these two additional risk exposures. A. Those stocks that have high ratios of book value to market value are defined as value stocks. Usually, value stocks have low prices when compared with their book value. Fama and French have already demonstrated in their paper "value versus Growth: The International Evidence" that value stocks offer higher returns than growth stocks across the world. Growth stocks are good but usually, their prices are high. It is obvious that any investment done at higher price tend to give lower returns. Value stocks by virtue of having low market prices relative to their book value tend to provide higher returns with time. While growth stocks having high market prices relative to their book value will appreciate at slower rates providing lower returns. As an investment advisor, thus, it is perfectly logical to advise clients to invest in value stocks so that higher return can be obtained. As per Fama and French, size and book-to-market equity picks up most of the variations in returns that is possible to explain. That is why small firms with high ratios of book equity to market have been chosen for investment. While incorporating size and book-to-market Market equity as proxies for systematic risk exposures in the multifactor APT model, the risk proportion is balanced by choosing growth stocks and large stocks. When the expected return is not commensurate with the amount of systematic risk the asset bears, the APT model can balance the risk. It is possible to construct a new portfolio mimicking the risk of portfolio that includes small firms and stocks with high book equity to market. While selling short in one portfolio and buying long in another portfolio, risk exposure is brought to zero. Q. Comment on the following statement:"Stock-picking and active portfolio management must yield profits, or else the market would not be efficient!" Active portfolio management, in contrast to passive portfolio management, attempts to takes advantage of the price discrepancies that exist in the market time to time. Often, the active portfolio management techniques aim at short-term trading with the time horizon of a few weeks or a few days or it could be for a day only. Significant change in quarterly earnings or changes in economic policy including macroeconomic changes leading to changes in future earnings keep on creating price discrepancies on a continuous basis. Active portfolio keeps on harnessing such opportunities. The moot question is whether such active portfolio management can outsmart passive portfolio management in long-term by significant margin. Light (2014) quotes Russ Wermers, a finance professor in the Wall Street Journal, "Its hard to find an active manager to consistently give good performance," In 1989, around 15% of active managers were successful in adding value to their portfolios but by 2006, only 0.6% of the total 2076 active fund managers were successful in true sense. It has been further argued that active fund managers may outperform market over short periods but fail to do so in long-terms. These findings are significant to arrive at the conclusion that active fund management is not a winning proposition but why is it so? Behavioral critics argue, "Efficient Market Hypothesis (EMH) makes many predictions that do not hold up empirically". According to them, many pricing anomalies prevail in short term either due to investor irrationality, or behavioral biases such as false beliefs or even due to information processing errors. As per Standard and Poor’s, "One of the most enduring investment myths is the belief that active management has a distinct advantage in bear markets due to the ability to shift rapidly into cash or defensive securities" (Evanson Asset Management). The case studies of the US stock market during 2000-2002 and then bear market of 2008 provide no evidence that active funds beat indexes. On the contrary, passive managers outperform active managers by about 2% per year after all costs taken into account. Thus, several studies suggest that active funds do not yield profits that surpass passive funds. The fact remains that all active fund management strategies focus on short-term trading to make big profits but eventually, most of them fail in their endeavors. This simply means that the efficient market hypothesis (EMH) does not hold ground. What behavioral scientists argue about EMH based on empirical evidence is certainly true in short-term, at least. The only conclusion that can be made is that while active portfolio management does not yield profits that surpass returns achieved through passive portfolio management strategies, the market functioning on asset valuation is certainly not efficient. References Evanson Asset Management. A Comparison of Active and Passive Investment Strategies. Retrieved May 17, 2014 from http://www.evansonasset.com/index.cfm?Page=2 Light, J. (2014). And the Next Star Fund Manager Is …Retrieved May 17, 2014 from http://online.wsj.com/news/articles/SB10001424052702304419104579324871451038920 Read More