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1 Alpha, the Capital Markets, and the Efficient Markets Hypothesis ( Chapter 6) Adapted from Portfolio Construction, Management, & Protection, 4e, Robert.

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Presentation on theme: "1 Alpha, the Capital Markets, and the Efficient Markets Hypothesis ( Chapter 6) Adapted from Portfolio Construction, Management, & Protection, 4e, Robert."— Presentation transcript:

1 1 Alpha, the Capital Markets, and the Efficient Markets Hypothesis ( Chapter 6) Adapted from Portfolio Construction, Management, & Protection, 4e, Robert A. Strong Copyright ©2006 by South-Western, a division of Thomson Business & Economics. All rights reserved.

2 2 No matter how many winners you’ve got, if you either leverage too much or do anything that gives you the chance of having a zero in there, it’ll all turn into pumpkins and mice. Warren Buffett

3 3 Outline  Introduction  Alpha and Portfolio Management  Role of the Capital Markets  Efficient Market Hypothesis  Anomalies

4 4 What is “alpha”?  Alpha = the amount by which the market is beaten, after adjusting for risk  What is alpha for the market as a whole?  Alpha for market as a whole is zero –So, on average, portfolios are ON the SML  Provides conceptual value of CAPM –Regardless of whether market is efficient, it is still a zero-sum game  Burden of active manager –In order to win (i.e., beat the market), someone else has to lose  Key question = what is special about you (and about your knowledge) that will allow you to be the one that wins?

5 5 Generating alpha  Are there ways to consistently generate alpha?  See portfolio manager performance example:

6 6 Portfolio Manager’s Performance: Past Three Years Previous Three Years:S&P 500 Fund Manager Compound Annual Return-4.98%-22.01% Total Return-14.20%-52.56%

7 7 Portfolio Manager’s Performance: Past Four Years Previous Four Years:S&P 500 Fund Manager Compound Annual Return0.50%-14.19% Total Return2.02%-45.77%

8 8 Portfolio Manager’s Performance: Past Five Years Previous Five Years:S&P 500 Fund Manager Compound Annual Return3.17%-0.54% Total Return16.91%-2.67%

9 9 Portfolio Manager’s Performance: Past Six Years Previous Six Years:S&P 500 Fund Manager No. of Down Years2 of 64 of 6 Compound Annual Return3.29%-1.66% Total Return21.47%-9.58%

10 10 Generating alpha  Would you have invested with this manager?  Who is this manager with this horrible record?  Warren Buffett, of course!!!  Portfolio = investment in Berkshire-Hathaway, over the period of 1970 – 1975  Note: while stock price lagged market substantially, book value per share grew faster than market each year except 1975; this is a metric with which Buffett is more concerned

11 11 Generating alpha  As we have seen previously in discussing the EMH, value stocks tend to outperform growth stocks  Concomitantly, Warren Buffett has the best investment record in history, becoming the 2 nd richest man in the world in the process  However, as we have just now seen, although value wins on average, over the long run, it does not win perfectly consistently!  Instead, the markets tend to cycle, with different styles of investment performing well at different times

12 12 Book to Market as a Predictor of Return: Value (positive  ) tends to outperform Growth (negative  ) Value Growth 0% 5% 10% 15% 20% 25 % Annualized Rate of Return High Book/Market Low Book/Market

13 13 Rolling Annualized Average 5-year Difference Between the Returns to Value and Growth Composites: The Market cycles between Value and Growth, But Value Wins on Average -20% -10% 0% 10% 20% 30% 40% 50% Year Relative Difference

14 14 Empirical Regularities: Sources of alpha  Three categories that tend to outperform over the long run: –Value stocks vs. Growth stocks –Size: Small caps tend to outperform large caps –Momentum: stocks with momentum (earnings or price) tend to beat stocks without momentum  However, the payoffs to all of these tend to cycle! –A typical portfolio manager, being judged on a quarter-by-quarter basis, would have been fired long before if he had the same record as Buffett for 1970 – 1975! –(In fact, he fired himself during this period!)  None of these beats the market perfectly consistently –A typical portfolio manager would need to try to cycle along with the market, in order to keep from ever lagging too far behind it

15 15 Empirical Regularities: Sources of alpha  Beating the market consistently would require some sort of rotation strategy in order to profit from the type of securities that are performing well in the given type of market  But - combination of “fat tails” and “volatility clustering” (discussed previously) can cause problems! –Best performance for a given style is likely to follow closely on the heels of its worst performance, and much of the movement for the style is likely to come in a relatively short burst (thus, if you miss it, it’s gone) –E.g.: 40% of the stock market gains for the entire decade of the 1980’s occurred during a mere 10 trading days ! –So efforts to cycle with the market and keep from falling too far behind it also make it much more difficult to beat the market!

16 16 Capital Market Theory  Capital market theory springs from the notion that: –People like return –People do not like risk –Dispersion around expected return is a reasonable measure of risk

17 17 Role of the Capital Markets  Definition  Economic Function  Continuous Pricing Function  Fair Price Function

18 18 Definition  Capital markets trade securities with lives of more than one year  Examples of capital markets –New York Stock Exchange (NYSE) –American Stock Exchange (AMEX) –Chicago Board of Trade –Chicago Board Options Exchange (CBOE)

19 19 Economic Function  The economic function of capital markets facilitates the transfer of money from savers to borrowers –e.g., mortgages, Treasury bonds, corporate stocks and bonds

20 20 Continuous Pricing Function  The continuous pricing function of capital markets means prices are available moment by moment –Continuous prices are an advantage to investors –Investors are less confident in their ability to get a quick quotation for securities that do not trade often

21 21 Fair Price Function  The fair price function of capital markets means that an investor can trust the financial system –The function removes the fear of buying or selling at an unreasonable price –The more participants and the more formal the marketplace, the greater the likelihood that the buyer is getting a fair price

22 22 Efficient Market Hypothesis  Definition  Types of Efficiency  Forms of Efficiency –Weak Form –Semi-Strong Form –Strong Form  Semi-Efficient Market Hypothesis  Security Prices and Random Walks

23 23 Definition  The efficient market hypothesis (EMH) is the theory supporting the notion that market prices are in fact fair –Under the EMH, security prices fully and fairly (i.e., without bias) reflect all available information about the security –Since the 1960’s, the EMH has been perhaps the most important paradigm in finance –Whether markets are efficient has been extensively researched and remains controversial

24 24 Types of Efficiency  Operational efficiency measures how well things function in terms of speed of execution and accuracy –It is a function of the number of orders that are lost or filled incorrectly –It is a function of the elapsed time between the receipt of an order and its execution

25 25 Types of Efficiency (cont’d)  Informational efficiency is a measure of how quickly and accurately the market reacts to new information –This is the type of efficiency with which the EMH is concerned –The market is informationally very efficient  Security prices adjust rapidly and fairly accurately to new information  However, as we’ve already seen, the market is still not completely efficient

26 26 Forms of Market Efficiency  Eugene Fama’s original formulation of the Efficient Market Hypothesis established three forms of market efficiency, based on the level of information reflected in security prices: 1.Weak form = prices reflect all past market level (price and volume) information 2.Semi-strong form = prices also reflect all publicly available fundamental company and economic information 3.Strong form = prices also reflect all privately held information that would affect the value of the company and its securities

27 27 Weak Form  Definition  Charting  Runs Test

28 28 Definition  The weak form of the EMH states that it is impossible to predict future stock prices by analyzing prices from the past –The current price is a fair one that considers any information contained in the past price data –Charting techniques are of no use in predicting stock prices

29 29 Definition (cont’d) Example Which stock is a better buy? Stock A Stock B Current Stock Price

30 30 Definition (cont’d) Example (cont’d) Solution: According to the weak form of the EMH, neither stock is a better buy, since the current price already reflects all past information.

31 31 Charting  People who study charts are technical analysts or chartists –Chartists look for patterns in a sequence of stock prices –Many chartists have a behavioral element

32 32 Runs Test  A runs test is a nonparametric statistical technique to test the likelihood that a series of price movements occurred by chance –A run is an uninterrupted sequence of the same observation –A runs test calculates the number of ways an observed number of runs could occur given the relative number of different observations and the probability of this number –These tests have provided evidence in favor of weak form efficiency

33 33 Conducting A Runs Test Conducting A Runs Test

34 34 Semi-Strong Form  The semi-strong form of the EMH states that security prices fully reflect all publicly available information –e.g., past stock prices, economic reports, brokerage firm recommendations, investment advisory letters, etc.

35 35 Semi-Strong Form (cont’d)  Academic research supports the semi- strong form of the EMH by investigating various corporate announcements, such as: –Stock splits –Cash dividends –Stock dividends –Examined through “event studies”  This means investors are seldom going to beat the market by analyzing public news

36 36  Market seems to do a relatively good job at adjusting a stock’s valuation for certain types of new information Determining how much the new info. will change the stock’s value and then adjusting the price by an equivalent amountDetermining how much the new info. will change the stock’s value and then adjusting the price by an equivalent amount  This is what event studies examine But it does seem to have problems developing an overall valuation for a stock in the first placeBut it does seem to have problems developing an overall valuation for a stock in the first place E.g., What is the correct value for IBM as a whole is a very difficult question to answer, but how much IBM’s value should change if it is awarded a specific new contract is much easier to determineE.g., What is the correct value for IBM as a whole is a very difficult question to answer, but how much IBM’s value should change if it is awarded a specific new contract is much easier to determine Semi-Strong Form (cont’d)

37 37 Semi-Strong Form (cont’d)  Burton Malkiel points out that two-thirds of professionally managed portfolios are consistently beaten by a low-cost index fund –Suggests that securities are accurately priced and that in the long run returns will be consistent with the level of systematic risk taken  Supports semi-strong form of the EMH –Also would suggest that portfolio managers do not possess any private information that is not already reflected in security prices  Supports the strong form of the EMH

38 38 Strong Form  The strong form of the EMH states that security prices fully reflect all relevant public and private information  This would mean even corporate insiders cannot make abnormal profits by using inside information about their company –Inside information is information not available to the general public

39 39 Semi-Efficient Market Hypothesis  The semi-efficient market hypothesis (SEMH) states that the market prices some stocks more efficiently than others –Less well-known companies are less efficiently priced –The market may be tiered –A security pecking order may exist –Lynch prefers stocks that “the analysts don’t follow … and the institutions don’t own …” –See the Small Firm and Neglected Firm Effects discussed later

40 40 Security Prices and Random Walks  The unexpected portion of news follows a random walk –News arrives randomly and security prices adjust to the arrival of the news  We cannot forecast specifics of the news very accurately

41 41 Anomalies  Definition  Low PE Effect  Low-Priced Stocks  Small Firm and Neglected Firm Effect  Market Overreaction  Value Line Enigma  January Effect

42 42 Anomalies (cont’d)  Day-of-the-Week Effect  Turn-of-the Calendar Effect  Persistence of Technical Analysis  Behavioral Finance  Joint Hypothesis Problem  Chaos Theory

43 43 Definition  A financial anomaly refers to unexplained results that deviate from those expected under finance theory –Especially those related to the efficient market hypothesis

44 44 Low PE Effect  Stocks with low PE ratios provide higher returns than stocks with higher PEs –And similarly for high P/B (hence lower Book/Market) stocks  Supported by several academic studies  Conflicts directly with the CAPM, since study returns were risk-adjusted (Basu)  Related to both semi-strong form and weak form efficiency

45 45 Low-Priced Stocks  Stocks with a “low” stock price earn higher returns than stocks with a “high” stock price  There is an optimum trading range

46 46 Small Firm and Neglected Firm Effects  Small Firm Effect  Neglected Firm Effect

47 47 Small Firm Effect  Investing in firms with low market capitalization will provide superior risk- adjusted returns  Supported by academic studies  Implies that portfolio managers should give small firms particular attention

48 48 Neglected Firm Effect  Security analysts do not pay as much attention to firms that are unlikely portfolio candidates  Implies that neglected firms may offer superior risk-adjusted returns

49 49 Market Overreaction  The tendency for the market to overreact to extreme news –Investors may be able to predict systematic price reversals  Results because people often rely too heavily on recent data at the expense of the more extensive set of prior data

50 50 The Value Line Enigma  Value Line (VL) publishes financial information on about 1,700 stocks  The report includes a timing rank from 1 down to 5  Firms ranked 1 substantially outperform the market  Firms ranked 5 substantially underperform the market  Victor Niederhoffer refers to Value Line’s ratings as “the periodic table of investing”

51 51 The Value Line Enigma  Changes in rankings result in a fast price adjustment  Some contend that the Value Line effect is merely the unexpected earnings anomaly due to changes in rankings from unexpected earnings  Nonetheless, Value Line’s successful record is evidence in support of the existence of superior analysts who apparently possess private information

52 52 January Effect  Stock returns are inexplicably high in January  Small firms do better than large firms early in the year  Especially pronounced for the first five trading days in January

53 53 January Effect (cont’d)  Possible explanations: –Tax-loss trading late in December (Branch) –The risk of small stocks is higher early in the year (Rogalski and Tinic)

54 54 January Returns by Type of Firm 7.71%10.72%11.32%Neglected Non-S&P 500 Companies 5.03%6.87%7.62%Neglected 1.69%4.19%4.95% Moderately Researched -1.44%1.63%2.48% Highly Researched S&P 500 Companies Average January return after adjusting for systematic risk Average January return minus average monthly return in rest of year Average January return Source: Avner Arbel, “Generic Stocks: The Key to Market Anomalies,” Journal of Portfolio Management, Summer 1985, 4–13.

55 55 Day-of-the-Week Effect  Mondays are historically bad days for the stock market  Wednesday and Fridays are consistently good  Tuesdays and Thursdays are a mixed bag

56 56 Day-of-the-Week Effect (cont’d)  Should not occur in an efficient market –Once a profitable trading opportunity is identified, it should disappear  The day-of-the-week effect continues to persist  However – there are confounding effects between the levels and the volatilities of returns across different days

57 57 Turn-of-the-Calendar Effect  The bulk of the return comes from the last trading day of the month and the first few days of the following month  For the rest of the month, the ups and downs approximately cancel out

58 58 Persistence of Technical Analysis  Technical analysis refers to any technique in which past security prices or other publicly available information are employed to predict future prices  Studies show the markets are efficient in the weak form  Literature based on technical techniques continues to appear but should be useless

59 59 Behavioral Finance  Concerned with the analysis of various psychological traits of individuals and how these traits affect the manner in which they act as investors, analysts, and portfolio managers  Growth companies will usually not be growth stocks due to the overconfidence of analysts regarding future growth rates and valuations  Notion of “herd mentality” of analysts in stock recommendations or quarterly earnings estimates is confirmed

60 60 Chaos Theory  Chaos theory refers to instances in which apparently random behavior is systematic or even deterministic –under Mauboussin’s theory of the market as a complex adaptive system, then we would expect to see chaotic dynamics  Econophysics refers to the application of physics principles in the analysis of stock market behavior –e.g., an investment strategy based on studies of turbulence in wind tunnels –Includes use of multifractal models

61 61 Are Markets Rational?  This question always faces a joint hypothesis problem: –Tests of EMH are always dual tests of both market efficiency and the specific asset-pricing model assumed –Market efficiency  Is the stock’s price equal to its true value? –Asset pricing model used (CAPM, APT, etc.)  What is the stock’s true value?  Never known for sure  “The question of value presupposes an answer to the question, of value to whom, and for what?” – Ayn Rand  E.g., the value of Apple stock would be different to Steve Jobs than to any other investor

62 62 Are Markets Rational?  Related issue – what is information? –“Information is that which causes changes” – Claude Shannon (father of information theory) –So, if something causes the markets to move, then by definition, it must be information, and vice versa –From this perspective, the market is neither efficient nor inefficient, it just is  So, are the markets efficient or rational? –Ultimately, difficult to answer categorically –Key question is not whether or not the markets are efficient – this is a side issue – but how investors should act, given how the markets work


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