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Lecture 1 - INTRODUCTION AND OVERVIEW OF THE FUND MANAGEMENT INDUSTRY
The 4 main ASSET CLASSES:
1) CASH - notes, coins, banks deposits, short-term government bonds under 1-year because they are the most liquid)
Advantages: liquid, safe (less uncertainty)
Disadvantages: low return, may not be as safe as we think (because of the banking crisis for e.g.)
2) EQUITY/SHARES can be classified into 3 types:
Domestic (UK) = underlying shares risk (uncertainty of return)
Developed nation (France, Germany) = underlying shares risk + exchange rate risk
Emerging market (India, Ecuador) = underlying shares risk + exchange rate risk + political risk
Advantages: offers higher return than bond and cash
Disadvantages: has greater risk than bond and cash 3) FIXED INCOME/BONDS/DEBT can be classified into 3 types:
Domestic (UK) = interest rate risk + credit risk + rating risk (depending whether the bond will be hold till maturity or not)
Developed nation (France, Germany)
Emerging market (India, China)
Advantages: offers higher return than cash
Disadvantages: has greater risk than cash 4) ALTERNATIVES - derivatives, private equity, real-estate, commodities and art
Advantages: low correlation with other asset classes, well diversified,
reduced volatility of overall portfolio
Disadvantages: illiquidity (higher transaction/trading costs but with ETFs it is less difficult to trade)
ASSET ALLOCATION - the choice of allocating money across different asset classes
SECURITY SELECTION - the choices within asset classes
SERVICES provided by INVESTMENT COMPANIES:
1. Record keeping of what is going on in terms of assets in their fund and administration
2. Access to diversification and divisibility
3. Professional management (professional managers who know what to do with their investors' money)
1 4. Lower transaction costs because of bulk trading
NAV (Net Asset Value) - the value of underlying assets that each share has claim to.
NAV = [ASSETS - LIABILITIES] x Number of SHARES
Suppose there is a fund.
It has got 3 BT shares, each worth $5. Also, it has got 2 BA shares, each worth $10.
Then the value of this fund is $35, in total.
Now, suppose this fund issues 35 fund shares, in total. Then each of this fund shares should worth $1. This $1 is the claim of each fund share on the assets of the fund. That is the NAV!
The 6 types of INVESTMENT COMPANIES:
1) MUTUAL FUNDS (or OPEN-END FUNDS) - the number of shares in the fund responds to fund inflows and outflows. So, the price is equal to NAV (investors trade shares with the fund management company)
2) CLOSED-END FUNDS - fixed number of shares traded at market determined prices which are typically below NAV (investors trade shares on a stock exchange through a broker)
3) EXCHANGE-TRADED FUNDS - index tracking open-end funds traded on exchanges like closed-end funds (it typically tracks stocks, bonds and commodity indices). As the number of shares in the ETF is not fixed, the shares are typically traded at NAV
4) HEDGE FUNDS - open only to high-net-worth and institutional investors. Its investors are subject to "lock-up" periods during which investors cannot take out their investments, so that hedge funds can invest in less liquid assets. Hedge funds are usually less regulated than mutual funds, hence they pursue complex investment strategies such as short-selling and derivatives 5) SOVEREIGN WEALTH FUNDS - country-level investment vehicles owned by the government. They invest state savings, often driven from commodity exports or export surpluses. Large pools of money managed by the government seeking favorable returns for its citizens 6) PRIVATE EQUITY FUNDS - any type of equity investment in which the stock is not freely tradable on a public stock market. They either buy private equity in companies
OR raise sufficient funds to buy all the equity in a publicly traded companies and make it private. The majority of investors are institutional 7)
2 Lecture 2 - THE MARKET EFFICIENCY
Due to the competitiveness of financial market, securities' prices fully and instantaneously reflect all available relevant information.
Should prices reflect all information? Not necessarily, for 2 reasons:
1) Yes, only if the cost of getting the information is 0.
2) BUT, if the cost of getting the information is positive, it will only pay its costs if it has a value. "PRICES REFLECT INFORMATION UNTIL THE marginal COST NO LONGER
EXCEEDS THE marginal BENEFIT."
The 3 FORMS of EMH (different degrees to which information is incorporated into prices) :
1) WEAK - prices reflect all information contained in historic data. If historical data conveyed signals about future performance, investors would have already learnt how to exploit signals already 2) SEMI-STRONG - prices reflect all publicly available information regarding the firm concerned, including the data from firm's prospectus, production lines, quality of management, etc. which may affect the value of the firm 3) STRONG - prices reflect all available information (both the public and private information that are available only to company insiders) regarding the firm concerned. This requires insiders engage in trading, which is illegal
TECHNICAL ANALYSIS - using historic prices and trading volume information to predict future prices. This analysis is inconsistent with WEAK form of efficiency since that historic information is already incorporated in prices
FUNDAMENTAL ANALYSIS - using economic and accounting information to predict the stocks' prices. This analysis is inconsistent with SEMI-STRONG form of efficiency since that information is already incorporated in prices
If EMH holds, active management (picking stocks) is largely a waste of time for small investors, hence the best thing for small investors is to buy and hold well-diversified portfolios without trying to find over/under-valued stocks - this is known as the PASSIVE
STRATEGY. One common strategy of passive management is to create an index fund which tries to mimic the performance of target indices (S&P 500). This type of stock index funds have lower expenses as they don't have to pay analysts to pick stocks nor they incur high costs associated with portfolio turnover.
The 2 types of MARKET EFFICIENCY TESTS:
1) RETURN PREDICTABLITY TESTS - Can stock returns be predicted using the publicly available information? NO if markets are efficient, BUT we will see the cases where returns are predictable (there are patterns in returns):
SEASONAL PATTERNS - Calendar anomalies (January effect for small stocks,
Time of the day, End month, Holidays) - stocks earn higher returns at certain times of the year.
January effect - people trading on this information, buy stocks just before the period and sell them afterwards, this drives up prices at the start of January, and drives down the prices at the end of
January, hence January returns will be reduced and January effect must be eliminated. But this is not eliminated because of taxes. Still,
there are countries with non-December account-end year and there is still January effect in those countries. So, overall this is puzzling.
PAST RETURNS - measuring the serial correlation of stock returns:
Momentum property (over SHORT HORIZON like 3-12 months):
'+' serial correlation means that positive returns tend to be followed by positive returns in t+1, t+2, and so on
Reversal property (over LONG HORIZON like 3-5 years):
'-' serial correlation means that positive returns tend to be followed by negative returns in t+1, t+2, and so on
FIRM CHARACTERISTICS - certain easily accessible company information may be useful to predict future abnormal returns (e.g. firm size, P/E ratio,
book-to-market ratio). The below firms are risky but the risk is not captured by CAPM:
P/E ratio - returns are higher for LOW P/E stocks
SIZE - returns are higher for SMALL stocks of small firms
BOOK-TO-MARKET - returns are higher for HIGH book-to-market ratio firms (VALUE FIRMS)
MARKET RETURNS - certain easily observable market information to predict aggregate market returns
HIGH DIVIDENT YILED implies high stock market returns
EARNINGS YIELD can predict market returns
YIELD SPREAD between high and low-grade corporate bonds can predict market returns
2) SPEED TESTS - How quickly are information announcements reflected in prices?
IMMEDIATELY if markets are efficient, BUT there is an exception creating an opportunity for abnormal returns - POST EARNINGS ANNOUNCEMENT DRIFT
EVENT STUDIES - are financial studies that allow us to test the impact of announcements (like M&A) on firm's returns. There should be no drift in prices up or down after the initial announcement.
Most event studies conclude that information announcements are immediately incorporated into prices. BUT there is an exception - POST
EARNINGS ANNOUNCEMENT DRIFT. Earnings announcements are good news if the announced returns exceed market expectations/predictions.
Firms that make the most earnings surprise announcements have the largest DRIFT in returns afterwards, implying that the information is absorbed into prices SLOWLY!!! This is inconsistent with the EMH. The
4 abnormal return continues to rise even the earnings information becomes public. The market adjusts to the earnings announcements only gradually,
resulting in a sustained period of abnormal return.
JOINT HYPOTHESIS PROBLEM says testing the market efficiency is problematic. This is because any attempts to test the market efficiency must involve some models such as the CAPM model. If we find that abnormal returns can be earned after an announcement it could be that market is inefficient. But could ALSO be that we are using incorrect CAPM model for generating expected returns. Any test of whether abnormal returns can be earned from exploiting information relies on the quality of CAPM model.
5 Lecture 3 - Testing CAPM
Testing the idea that, "STOCKS WITH HIGHER BETA EARN HIGHER EXCESS RETURNS"
CAPM tells us that beta is what explains the security returns
BETA - tells us how sensitive is the security's expected excess return to the market's excess return
In order to test the CAPM model, we need to decide on:
1) the relevant time period, and 2) which securities - excess return on a security
- beta of a security (in order to estimate the beta of a certain stock,
we regress the stock's excess return on market's excess return and the slope of that regression corresponds to the beta of a stock)
We then plot stock's excess returns against the stock's betas to get the SML (Security Market
6 Lecture 4 - Beyond CAPM (SIZE, VALUE AND MOMENTUM FACTORS)
Since the returns on stocks of SMALL and HIGH BOOK-TO-MARKET firms are higher (meaning these firms are riskier but this is not captured by CAPM), SIZE and BOOK-TO-MARKET ratios also can be used to determine/explain returns, which are not captured by CAPM.
The FAMA-FRENCH (FF) 3-FACTOR model:
1) SIZE = SMB size factor (small - big)
2) BOOK-TO-MARKET RATIO = HML value factor (high - low)
3) MARKET INDEX = (rm - rf) market factor
Therefore, the FAMA-FRENCH 3-FACTOR model is:
(rt - rf) = α + β (rm - rf) +s(SMB) + h(HML)
To test the FF 3 factor model, DFF formed 9 portfolios, and for each portfolio they estimated the FF model. The size and value factor coefficients were gradually all significant. How can we explain this? 1. Size and value firms are risky;
2. Behavioral explanation - investor irrationality
CAHART's 4-FACTOR model is:
(rt - rf) = α + β (rm - rf) +s(SMB) + h(HML) + m(MOM) + e
Momentum factor cannot be explained by the FF model.
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