Period of Global Credit Crunch - Example

Introduction The concept of efficiency has become central theme in finance especially as it is used to describe a market in which relevant information is impounded into the prices of financial assets. Simple microeconomic principles indicate that if capital markets are sufficiently competitive, then investors should not expect to make superior profits from their investments (Dimson and Massoud, 1998). According the Efficient Market Hypothesis (EMH) formulated by Fama (1970), an efficient market is one that at any given time, prices fully reflect all available information on a particular stock and/or market.1 This therefore means that no investor has an advantage in predicting a return on a stock price because no one has access to information not already available to everyone else. But increasingly, investors are using portfolio managers to find mispriced stocks in a bit to make a profit from such (so called active investors), whereas they are some (proponents of the EMH called passive investors) who believe that active management is a total waste of time and effort and are unlikely to justify the expenses they incur as fees to portfolio managers in trying to analyse the prices of stocks (Bodie, 2005). Active portfolio management Active portfolio managers attempt to achieve returns more than the commensurate risk or outperform the market by either forecasting broad market trends or simply identifying mispriced securities on the market. The rationale behind active portfolio management strategies is to beat particular benchmarks used to assessing the performance of an investment. The benchmarks among the dozens used by financial analysts include the S&P 500, the Dow Jones Industrial Average, the Russell 2000 Index and the Lehman Brothers Aggregate Bond Index. Many active portfolio managers have their own complex security selection and trading systems used in analysing market trends, the economy and the company-specific factor and methods such as fundamental analysis, technical analysis, quantitative analysis and macroeconomic (factors such as inflation, economic growth, etc) to implement their investment ideas. Active portfolio managers usually use the following strategies: Stock selection: To be up to date with every company’s situation, an active portfolio manager holds few companies in their portfolio for better management purposes. By analysing all publicly available information about the portfolio, the portfolio manager is able to come up with a stock that is undervalued, since this offers the greatest opportunity for growth above the market averages. Market timing: Managers at all times try to sell their stocks at peak periods, that is, when prices are up and buy them when prices are down. But it is extremely difficult to find managers who in the long run will get that right. But on the whole, they believe in their skills and experiences to be able to succeed. Bond swapping: Portfolio managers are well aware of the fact that long term bonds are very sensitive to interest rates and capital gains are linked to interest rate changes, portfolio managers attempts to guess periods when interest rates are expected to rise so as to sell long term bond and buy short term bonds and to pursue the opposite action when rate fall for capital gain. Ladder approach: Portfolio managers often buy different securities with different times of maturity just as to keep some fix income at all times. In all, active portfolio managers believe that capital markets are inefficient making it possible that anomalies and irregularities in the capital markets can be exploited by those with skill and insight especially as they believe that prices on the market react slowly to any major changes that may occur on the capital market. With all of this said, the main advantage for active portfolio managers is that, there is that possibility of managers to outperform the index due to their superior skills. This can be achieved because they have the skills to make informed investment decisions based on their experiences, insights, knowledge and ability to identify opportunities that can translate into superior performances. In cases where due to the experiences and skills, if the active portfolio managers believe that the market might face a turn downward, they take on defensive measures such as hedging or increasing their cash positions to reduce the impact on their portfolios. Active portfolio managers have as disadvantages: On the cost side, higher fees and expenses such as salaries to employees will certainly erode whatever profits they might have made in the long run. On the risk side, active portfolio managers run that exposure to firm’s specific risk as they seek to make huge profits. Another disadvantage for active portfolio manager is that, they tend to have a more concentrated portfolio with fewer securities as they attempt to beat the market. Another problem with active portfolio managers is that, when they are wrong, they may very significantly under-perform the market. Lagging performance of the portfolio on the market may also occur as a result of a manager’s management style that could be out of favour with the market for a period of time. Passive portfolio managers These are managers who make no attempts at outsmarting the market by neither trying to find out under valued or over valued stocks, but instead aim at establishing a well-diversified portfolio. These managers believe in the buy and hold strategy. They simply believe in the Weak form of EMH that states that stock prices already reflect all information available that can be derived by examining market trading data such as the history of past stock prices, volumes of stock traded on the markets, or the short term interest rates. Thus to them, there is just no need to frequently buy and sell stocks which generates large brokerage fees without increasing expected performance. In their line of thinking and following the EMH, Jensen (1968) in trying to assert the position that even corporate managers cannot make a profit by trading from insider information conducted a study on 115 mutual funds over the period 1955 – 1964. Using a risk-adjusted basis, he found that any advantage by the portfolio managers by trading on such insider information might be eroded by fees and expenses. This means that even if investment management fees and loads were added back to performance measures, and returns are measured gross of management expenses (ie, assuming research and other expenses were obtained free), this will result to them making zero profits. Jensen then concluded that “on average the funds apparently were not quite successful enough in their trading activities to recoup even their brokerage expenses”. The position of passive portfolio managers can be further shown by the Capital Market Line (CML) in the Capital Asset Pricing Model (CAPM). We know that CML is a capital allocation line provided by the market index portfolio to illustrate the rates of return for efficient portfolios depending on the risk-free rate of return and the level of risk (standard deviation) for a particular portfolio.2 The CML is considered to be superior to the efficient frontier since it takes into account the inclusion of a risk-free asset in the portfolio is derived by drawing a tangent line from the intercept point on the efficient frontier to the point where the expected return equals the risk-free rate of return. The capital asset pricing model (CAPM) demonstrates that the market portfolio is essentially the efficient frontier. According to the passive portfolio manager, it is worthwhile skipping all these analysis by holding a market portfolio, (which in the graph represents the point of intersection of the brown curve and the straight line passing through the risk free rate of return). They believe that this passive strategy is efficient and therefore, any investment opportunity should only deviate from the CML commensurate with the risk taken. Passive investment strategies have the following advantages: All investments closely matches the index through the investment has been benchmarked. This means that, the manager can at all times try to duplicate the chosen index and tracking it as efficiently as possible. If the CML theory if closely followed by the manager, this will require very little decision making on the part of the manager. The investor therefore will have to pay very low fees for transaction since the manager incurs little cost to come up with the efficient frontier. On the other hand, the passive portfolio manager faces the following disadvantages: A passively managed portfolio will never outperform the underlying index it is meant to track since the performance of the portfolio is dictated by the underlying index and the investor has no choice than to be satisfied with the performance of that index that has been used as benchmark. Managers are often faced with the problem of being unable to take action if they believe the overall market will decline or they believe individual securities should be sold unlike the active portfolio managers whom when faced with a market downward turn, can take on defensive measures such as hedging or increasing their cash positions to reduce the impact on their portfolios. Period of global credit crunch Financial markets have been very volatile of late with effects from credit crunch (sub prime loans) markets in November 2007 that all started from Cleveland in the USA, slowed down the US economy and forced banks to incur billions in losses. Banks were known to finance their mortgage lending using customer deposits which of course was a limit to the amount of mortgage lending they could do. But in recent years, banks in a bit to fund additional borrowing, moved to a new model where they sold mortgages on the bond markets which was widely seen as an easier means of funds. But this form of borrowing led to bank abusing that incentive to carefully check mortgages they issued.3 Banks saw the business to be extremely profitable since they could earn a fee for each mortgage they sold and went ahead to urge mortgage brokers to sell more and more of these mortgages. The market soon extended especially as the private sector dramatically expanded its role in the mortgage bond market that was previously dominated by government-sponsored agencies like Freddie Mac. Actions of the active portfolio manager in period of credit crunch: Active portfolio managers in periods of credit crunch should have been aware of what has to come especially as they carry out extensive market research. Therefore, they should have turned to buying of the mortgages rather than taking on the sell option. But as the EMH states, they failed given the fact that all available information was even there and they could not still strike a deal by foreseeing the down turn of the mortgage market. In every economic situation, just as in the technology bubble, the active portfolio manager should have realised that the bubble in the mortgage market was about to burst. This is because, they are people who operate on experiences and have those skills to forecast the market. Should they had forecasted that the bubble in the mortgage was about to burst, they should have instead restricted giving out loans without sufficient collaterals and at same time take on the buy option. Actions of the passive portfolio manager during credit crunch: The passive manager since he believes solely on the CML approach should have had not to recommend the further sale of mortgage bonds since they were almost not commensurate to the level of risk they were about taking. In conclusion, it is hard to take a stand point as whether the active or passive portfolio manager’s position should be best. This is because of the increasing uncertainty that surrounds our security markets. But in my opinion, the best option in managing any portfolio should be diversification. Through diversification, an investor is able to control the risks involved as it may not happen that all assets fall in value at the same time. References Bodie, Kane, Marcus (2005). Investments. McGraw Hill Elroy Dimson and Massoud Mussavian (1998): “A brief history of market efficiency”, European Financial Management, Volume 4, Number 1, March 1998, pp 91-193 Fama, Eugene (1970). "Efficient Capital Markets: A Review of Theory and Empirical Work", Journal of Finance, 25, pp. 383-417. Jensen, Michael (1968). "The Performance of Mutual Funds in the Period 1945-1964", Journal of Finance, 23, pp. 389-416. Web sites consulted http://www.investopedia.com/articles/02/101502.asp, retrieved on 25-11-2008 at 09:20 am http://www.investopedia.com/terms/c/cml.asp, retrieved on 25-11-2008 at 19,05pm http://news.bbc.co.uk/2/hi/business/7073131.stm, retrieved on 25-11-2008at 19.50pm Read More