Investing

Investing

Investing 1 We define investment as the process of putting disposable funds to work as productive assets with the intent that they will produce addi...

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Investing

1

We define investment as the process of putting disposable funds to work as productive assets with the intent that they will produce additional income for the individual or entity that invests the funds (see Figure 1.1). In Book 1, An Introduction to Trading in the Financial Markets: Market Basics, we saw that in value terms the majority of investment in the world today takes place under the management of professional institutional investors. The process we detail in this chapter occurs both for individuals and institutional investors, but we describe the more formal process usually employed by institutions.

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Investor Figure 1.1  Investing includes a wide spectrum of approaches to managing financial assets that we group into four major categories for individuals and entities.

Investing Concepts

Before we examine the approaches to investing, we address a few concepts ­common to all types of investment and terms that participants assume others understand when they hold conversations about investment. We examine these concepts briefly before we investigate investment strategies (see Figure 1.1.1).

Investing Concepts

Concepts Return

Gain

Loss

Portfolios

Diversification

al

ent Go

Investm

Initial Issue

…OR…

Secondary Market Sale

Secondary Market Purchase

In ve

st

Time

Time

m

en

tH

or

Initial Issue

Maturity

…OR…

…OR…

Secondary Market Purchase

Secondary Market Sale

iz

Now

Investor

Holding Period

Investment Horizon

Initial Issue

Maturity

…OR…

t2



tn-1 tn

t0

…OR…

Secondary Market Purchase

Investing

Periodic Income Payments t1

on

Secondary Market Sale

t0

tn

Holding Period Holding Period

Capital Gains

Income TIC

= IP1*(1+iTR)

t1

+ IP2*(1+iTR)

t2

+



+ IP1*(1+iTR)

tn

+ CG*(1+iTR)

tn

= ∑IPt*(1+iTR)

t

+ CG*(1+iTR)

tn

Total Return

Figure 1.1.1  Investing depends on seven major concepts that support different variations of styles and approaches.

Portfolios A portfolio is a collection of instruments including cash that is held with a common investment goal or purpose (see Figure 1.1.1.1). It is usually the case that the concept of a portfolio is viewed from the perspective of the entity or individual making portfolio decisions about the portfolio. For example, a firm that manages the assets

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We agree

FUTURE

Securities

We agree

¥

Contract Instruments

Cash Positions

OPTION We agree

(home currency)

FORWARD We agree

¥

ForEx

Portfolio COMPLEX DERIVATIVE



£

Commodities

Packaged Instruments

(other portfolios)

Figure 1.1.1.1  Portfolios are collections of instruments managed for a single investment purpose.

in a packaged instrument (see Book 1 for a description of packaged investments) views all the assets in the package as a portfolio. In contrast, an investor that purchases shares or units of the package views those holdings as a part of the investor's own portfolio that likely also includes other types of holdings. We distinguish between holdings in a portfolio and an account. Although an account can be a portfolio, it also can include other assets and possibly liabilities. We discuss accounts in more detail in Part 4 and in Book 3, An Introduction to Trading in the Financial Markets: Technology—Systems, Data, and Networks.

Investing Concepts

Diversification We mentioned diversification in passing in Book 1, but diversification is the general concept that as an investor holds more instruments, the probability that one asset doing poorly will adversely affect the investor is reduced (see Figure 1.1.1.2). (The converse is true as well. If a single investment does extremely well, its benefits are diluted by other holdings.) We look at diversification in a more systematic way when we describe Modern Portfolio Theory later.

Date of purchase

Return

+

Gain

Time Any time after purchase

Loss

-

Figure 1.1.1.2  Diversification is the concept that the risk of losses in a portfolio from market events can be reduced by owning an array of instruments with different reactions to those market events.

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Holding Period A holding period is the length of time a given investment is held in a portfolio (see Figure 1.1.1.3). For a fixed-income instrument, the holding period could be from the time when the asset is acquired to when it matures. For an equity, the holding period is the length of time the stock remains in the portfolio. Maturity forces the end of the holding period. The sale of an instrument results in the voluntary end of a holding period.

Equity

Initial Issue …OR…

Secondary Market Purchase

Secondary Market Sale

Investor Time

Fixed Income

Initial Issue …OR…

Maturity …OR…

Secondary Market Purchase

Secondary Market Sale Holding Period

Figure 1.1.1.3  Holding period describes the time period over which an investor remains invested in an instrument or group of instruments.

Investing Concepts

Investment Horizon An investment horizon is the time frame over which an investor evaluates various potential investments (see Figure 1.1.1.4). An investment horizon permits an investor to consider the risks and benefits of different possible holdings to achieve the goals for investments during the time frame. Typical investment horizons for ­individuals might be the remaining time before retirement or a child's need for funds for education. For institutions, a known future event such as a pension beneficiary's retirement or a life insurance customer's expected life could be or at least could ­influence the investment horizon for portfolios under management. An investor might choose instruments such that the holding period corresponds to the ­investment ­horizon, but in many cases the horizon simply affects how patient an investor can be with an investment strategy.

nt

e Investm Goal

In ve

Time

st

m

en

tH

or

iz

on

Now

Investor

Figure 1.1.1.4  Investment horizon defines the timespan over which an investment is managed to achieve planned results from that investment.

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Income Income is usually the cash generated by an instrument or a portfolio (see Figure 1.1.1.5).1 Many instruments such as equities and fixed income may generate income. The need for cash, tax treatment of income, and other investment alternatives affect an investor's preference for cash income as an alternative for increases in market value of an instrument.



Initial Issue

…OR…





Secondary Market Purchase £

Maturity



…OR…

£

£

£

£

£

£

£

Secondary Market Sale

Investor £

£

Periodic Income Payments £

£

£

£

£

£

£

£

£

£

£

£

£

£

£

£

£

£

£

t1 t2 …

tn-1 tn

t0

MP xU PP + TF TIC

Market Price t0 Units Purchased Purchase Price Transaction Fees Total Initial Cost

Holding Period

MP xU SP - TF NFR - TIF CG

Market Price tn* Units Sold Sale Price Transaction Fees Net Final Receipt Total Initial Cost** Capital Gain (Loss)

* If fixed income matures = Face value ** Assumes all units purchased at t0 are sold at tn

Figure 1.1.1.5  Income includes cash payments from dividends and interest received for instruments held in a portfolio. 1  There are multiple definitions for income. For tax purposes, it includes both income as we describe it as well as capital gains after it is realized (i.e., after an investment that has increased or decreased in value is converted to cash). Capital gains (realized or unrealized) are excluded because we treat changes in market value separately.

Investing Concepts

Capital Gains In addition to income, investors can benefit from the increasing value of instrument ­holdings resulting from changes in the market price. The benefit from the increasing value of instruments is known as capital gains but also as price appreciation or ­market appreciation (refer to Figure 1.1.1.5). Capital gains are changes in the value of an instrument or ­portfolio due primarily to changes in market prices. Unlike income, market value can be ­negative resulting in possible losses. Also, unlike income, capital gains do not happen automatically. The change in value of an instrument holding is only ­theoretical until it is sold. Most investors can bias their portfolios to favor either income or ­capital appreciation. Many packaged investment portfolios explicitly choose one or the other. In addition, the immediate need for cash versus longer-term goals can affect the choice between income and capital appreciation, but differences in tax treatment can also influence an investor's preference. (Sometimes tax rates are lower on capital appreciation than on current income.) Total Return The concept of total return incorporates the idea of combining both income and ­capital gains into a single measure or estimate of the profitability of an investment in a single instrument or a total portfolio (see Equation 1.1.1). Generally, returns are reduced to a percentage figure analogous to the interest earned on a fixedincome instrument. The difference is that the return incorporates not only the income, as in the case of interest on fixed income, but also any capital gains. Because ­capital gains are earned only when an instrument matures or is sold, computed returns are ­estimates prior to the termination of a holding. Total return is computed for an ­investment by ­combining income and capital gains into a single measure that is ­usually expressed as a percentage rate:2 TIC = IP1 (1+iTR )t1 +IP2 (1+iTR )t2 +…+IPn (1+iTR )tn +CGm (1+iTR )tm =

∑ IP (1+i

0→ m

n

TR

)tn +CGm (1+iTR )tm (1.1.1)

where TIC = Total Initial Cost iTR = Rate of Total Return CG = Capital Gain (Loss) IPt = Income Payment at Any Time t

2  Although total return is conceptually simple, the actual calculations can be very complex mathematically, particularly when a portfolio with many different components is involved. We suggest a good book on investment theory for a basic understanding or a more detailed analysis of calculations for different types of assets. Several alternatives are presented in the References at the end of this book.

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The computed rate of return most commonly used is specified by the CFA Institute (formerly the Association for Investment Management and Research) headquartered in Charlottesville, Virginia.3 Total return can be most easily thought of as a time-weighted rate of return that equates subsequent cash flows for income and other transactions as well as capital gains to an initial investment. Investment Styles

Appreciating investment styles is important to understanding the way in which ­individuals and institutional investors make trading decisions,4 the tools they use, and the services they demand from the rest of the marketplace. Although there are many ways to classify the style of investing, we employ the following four broad ­categories (see Figure 1.1.2): 1. Instrument selection 2. Portfolio-oriented investing (Modern Portfolio Theory) 3. Behavioral finance 4. Quantitative investing We describe these styles and the substyles within them briefly. You should remember that these categories are wide ranging, and many substrategies lie within each category. Also, many investors that would classify themselves in one way also pay attention to other styles of investing in formulating strategy. For example, a value investor may view technical research and commentary in formulating his or her ­strategy and as a basis for timing decisions. Instrument Selection The earliest investment styles focused on the methods investors employed to select specific securities to buy or sell. Many investment managers and individuals still engage in instrument selection, including different methods for selecting individual instruments, each deemed to have superior performance potential for the investor's specific investment goals. Although there are many variations, four primary substyles typify the different approaches to instrument selection. Value Investing

The most famous and respected form of instrument selection is value investing, best described by Benjamin Graham and David Dodd in the book Security Analysis 3  The AIMR has established Global Investment Performance Standards (GIPS) and Performance Presentation Standards for the way information on performance must be presented for member funds on a country-by-country basis if the funds want to claim conformance with the standards. AIMR Performance Presentation Standards (AIMR-PPS), 2001, Association for Investment Management and Research. 4  The general description of investing styles depends heavily on the following: Peter L. Bernstein. Capital Ideas: The Improbable Origins of Modern Wall Street. (Hoboken: John Wiley & Sons, Inc., 2005); Capital Ideas Evolving. (Hoboken: John Wiley & Sons, Inc., 2007); Benjamin Graham and David L. Dodd. Security Analysis, 6th ed. (New York: McGraw-Hill, 2009); and Burton G. Malkiel. A Random Walk Down Wall Street, 8th ed. (New York: W.W. Norton, 2003).

Investment Styles

+ i =α

ßi

m

p

Modern Portfolio Theory

Instrument Selection

Investing

Behavioral Finance

Quantitative Investing

Figure 1.1.2  Investment styles are grouped into four major categories, including instrument selection, MPT, behavioral finance, and quantitative investing.

(1934) and again by Graham in his 1949 book The Intelligent Investor (see References), and most famously employed by Warren Buffett. Reduced to its most fundamental description, value investors believe that each security has a true “worth” or “value” that can be found by careful analysis of the fundamentals of the security, such as earnings, assets, and leverage. If an investor finds a security with a market price lower than its true worth, the ­security should be bought. Any security with a price in the market higher than its value should be sold. Technical Investing

Technical investing holds that securities prices and the market, as the sum of the actions of all its participants, tend to operate in repetitive patterns. Technical traders look for these patterns most simply deduced by graphics of the price history of securities and purchase or sell based on these patterns. Because technical investing often makes use of graphical representations of prices—price charts—technical traders are often referred to as chartists, although technical investing is more than the simple analysis of charts.

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Today sophisticated technical investors depend more on computers and sophisticated statistics to analyze historical price patterns than on handwritten charts. Technicians believe that repeated priced patterns reveal the underlying supply and demand for securities as described in classical economic pricing theory. A critical ­distinction between technical investing and Modern Portfolio Theory that we consider later is whether historical prices contain information about future price behavior that can result in profits for an investor. Momentum Investing

Some investors believe that other investors tend to behave like a “herd” or mob. When the market as a whole sees a security rise or fall, there is a tendency for investors to “pile on” to the trend. This behavior pushes prices up or down, often to a greater extent than the fundamentals would suggest. Momentum investors tend to look for these trends and ride with them. Obviously, the key to this style of investing is to be able to distinguish between a sustained trend and a short-run price movement to know when to enter the market. Also, the momentum investor needs to know when a trend is exhausted to be able to get out of the market or the security. There are two primary types of momentum investing. Price momentum f­ollows the fluctuations in the price of securities. Earnings momentum holds that companies tend to move in cycles. A security with positive earnings momentum is a good investment, and those with negative momentum are poor investments. The common tendency for investors to get caught up in euphoria during bull markets or gloom during bear markets is akin to that in momentum investing but usually does not reflect either conscious or even rational investment decision making. Matching Assets and Liabilities (Contributions and Payments)

Life insurance, pensions, and annuities, which are products often offered by ­insurance companies, have inflows of contributions and outflows of payments that can be ­anticipated with considerable precision many years in advance. Life insurance depends on actuarial tables that have been in use and constant revision for ­several hundred years. Actuaries can make relatively accurate predictions of life ­expectancies provided the universe of participants is large. Annuities are often sold with explicit promised payout streams, maturity dates, and/or predictable expected payouts based on life expectancies. Pensions also have predictable inflows and outflows based on the promises of the plan and the characteristics of the participants. The nature of the cash flows into insurance, pensions, and annuities has created an investment approach in which assets are selected to meet conservative investment objectives. For these types of investment products, more effort is

Investment Styles

expended in matching investment assets' cash flows to known or anticipated future payments than on other elements of investment analysis. This technique is known as matching assets and liabilities or liability-driven investing. Other Strategies

If you review the investment section of a library or bookstore, you might find ­hundreds of different books on how to pick instruments. Many of these books are variations of major strategies we have mentioned, but others are unique. Among the more ­interesting methods of instrument selection is a strategy known as a contrarian. Contrarians hold that the majority of the market is always wrong, so if you do the opposite of what the majority in the market is doing, you will find good investments. Other strategies look for instruments that are out of favor. (One variation of this ­strategy is colorfully known as the “Dogs of the Dow.”) Still other strategies range from plausible observations of security behavior to curious ideas that employ horoscopes, analysis based on which NFL conference wins the Super Bowl, or what party wins an election. Modern Portfolio Theory In 1952 Harry Markowitz wrote his Ph.D. thesis on portfolio selection, which began a revolution in investment theory. By the early 1970s, several important academic studies had been conducted on portfolios as the focal point of investment strategy that have collectively come to be known as Modern Portfolio Theory (refer to Figure 1.1.2). The term describes a set of interrelated theories of investing that holds that a portfolio is more important than any component instrument, and risk is inextricably intertwined with expectations of investment returns. Modern Portfolio Theory (MPT) has a number of key insights, but the two significant, overarching points that proponents of MPT assert are first that a portfolio— a group of instruments—is more important to investment strategy than any individual component instrument. Second, risk and return on investments and portfolios are inextricably intertwined. Even before Markowitz and the development of MPT, it was widely understood that having a portfolio meant that if one security did poorly, other securities might mitigate the loss. This phenomenon is known as diversification. MPT took the general idea of diversification and applied a “scientific” approach to portfolio ­construction to maximize the benefits of diversification.

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Concepts

Before we describe the investment styles that grow out of Modern Portfolio Theory, it is useful to ­understand some of the more important component ideas in MPT (see Figure 1.1.2.1).

Concepts

Infeasible Portfolios

Efficient Frontier

Efficient Frontier

Return

Return

Feasible Portfolios

Feasible Portfolios

Risk-free Rate of Return

Risk

Risk

Efficient Portfolios

Holdings Cash

CAPM

Instruments Return on an Instrument

16

+ bi a =

m

i

XXX

p

Modern Portfolio Theory

Efficient Market Hypothesis

RT = RD + RND Risk

β

α

Return on Market

Alpha (a) and Beta (b)

t

TIC = ∑ IPt*(1+iTR) + CG*(1+iTR)

tn

Return

Figure 1.1.2.1  MPT concepts include six different underlying principles relating risk and return for investment portfolios.

Investment Styles

Portfolio Selection

Portfolio selection is the unifying process in Modern Portfolio Theory, but the best way to select portfolios is a matter of intense debate. Most of MPT evolved from Markowitz, who hypothesized that the best way to select securities in each ­portfolio was to construct a set of efficient portfolios by using a technique known as q ­ uadratic programming (see Figure 1.1.2.2). Markowitz defined an efficient

Infeasible Portfolios Portfolio C = Not possible

X

Efficient Frontier

Return

Portfolio B = Efficient

(all possible efficient portfolios)

X Higher return same risk

X

Lower risk same return

Portfolio A = Inefficient

Feasible Portfolios (risky assets only)

Risk

Figure 1.1.2.2  An efficient portfolio frontier implies assembling instruments into a set of portfolios such that for any given portfolio in the set, it is not possible to increase return without increasing risk or to decrease risk without decreasing return.

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­ ortfolio as the group of securities with the highest possible return for a given p amount of risk. He argued that the optimum sets of portfolios produced by the ­programming model were those for which it is not possible to get a higher reward or return on the portfolio without accepting more risk. Conversely, if a portfolio is efficient, it is not possible to reduce risk without reducing the return. Prior to Markowitz's insight, investment strategy did not pay much attention to risk in an organized way. Efficient Market Hypothesis

Eugene Fama of the University of Chicago is credited with a paper defining the idea that markets are efficient, which came to be known as the efficient market ­hypothesis.5 That markets are “efficient” implies that information about the values of securities is rapidly incorporated into prices. Information is incorporated into prices as competing securities analysts project values for most all commonly traded instruments and look for even the smallest differences between current prices and their perceptions of securities' true values. Investors and traders quickly act on the information from analysts taking advantage of small opportunities, thus removing the opportunities. In short, in an efficient market, the prices reflect all that is known about the instruments in the markets. Proponents of the strictest definition of efficient markets believe there is little value in trying to pick individual instruments.

Of Drunks under Street Lamps

MPT has caused the development of very colorful lore as researchers have attempted to explain concepts that were at least initially radical or counterintuitive. The idea that it is not possible to increase returns without accepting more risk evolved into “There is no such thing as a free lunch.” The ­efficient market hypothesis spawned the “random walk” (see figure that ­follows). A ­random walk comes from the statistical metaphor that suggests if you leave a drunk under a street lamp in the evening and want to look for him or her the next morning, the best place to begin the search is under the same street lamp. The drunk will walk randomly all night and end up very near the ­starting point.

5  Actually, M.F.M. Osborne, a researcher at the Naval Defense Laboratory, presented a paper several years earlier than Fama (Operations Research, March–April 1959) suggesting that the behavior of stock prices resembled the random patterns known as Brownian motion. Brownian motion is the random vibrating motion exhibited by smoke particles when magnified. Around 1900, a French student named Louis Bachelier wrote a dissertation titled “The Theory of Speculation” at the University of Paris in which he noted that bond prices on the Paris Bourse resembled a random walk. The paper was not translated into English until about the same time in the 1950s.

Investment Styles

Random Walk

Efficient markets also created the often-used metaphor for instrument ­selection that suggests throwing darts at stock tables is just as effective as ­careful security analysis. The Wall Street Journal has run variations on an ­investment dartboard contest for both retail customers and professionals. The idea is to compare the results of portfolios that are carefully selected with ­portfolios ­created by throwing darts at the Journal's stock tables.

Risk and Return

As we have noted, one pillar of MPT is the relationship between risk and return (see Figure 1.1.2.3). MPT defines risk as the variability of a security's expected return or a portfolio's expected return over a defined investment time horizon. Most ­models

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RiskT = RiskD + RiskND Risk t

TIC = ∑ IPt*(1+iTR) + CG*(1+iTR)

tn

Return

Figure 1.1.2.3  Risk and return are central concepts in MPT and subject to constant trade-offs in the construction of an efficient portfolio.

use a statistical measure known as variance of historical returns as an ­estimate of risk.6 Return is a measure that computes the current value (present value) of ­earnings and/or income on an instrument or portfolio over the investment time ­horizon using a discounting formula. The return is expressed as a percentage or interest rate that discounts the future stream of earnings.

6  These types of analyses can become complex. Although one can argue that historical variance of a single instrument may be a reasonable estimate of future variance, the same is not true of a portfolio. Unless the portfolio has not changed, analyzing the variance of historical returns does not produce a reasonable measure of future variance. Even measuring the historical variance of returns on a model portfolio using returns on the instruments currently in the portfolio creates concerns about future changes in composition. These kinds of issues cause academics and investment analysts to debate continually and reevaluate theories.

Investment Styles

We introduced this type of measure in the total return calculation in Equation 1.1.1. If markets are efficient, the present value of future earnings and income should equal the current market price. One of the important points that MPT helped to ­clarify and quantify was that investing is a process of balancing risk and returns. As we noted, to earn higher returns, an investor must accept higher risk. Risk has two separate components. Each instrument is unique, and some instruments behave in ways unrelated to the market. This is an attractive attribute for an instrument to have because it suggest that the less an instrument moves with other instruments in the market, the higher its value in offsetting undesirable ­movements of other instruments in a portfolio. In effect, this attribute makes diversification more effective. This is known as diversifiable risk (see Equation 1.1.2). In other words, in a portfolio of assets with significant diversifiable risk, the price movements of the component assets tend to cancel one another. Note that both good and bad movements cancel. Just as assets that perform better cancel the negative results of assets that perform poorly, so average and poor assets negate the positive results of portfolio components that do well. The other component of risk results from the fact that an instrument is part of the total market and therefore moves with other instruments in the market is known as nondiversifiable risk. RiskT = Risk D + Risk ND

(1.1.2)

where RiskT = Total Risk RiskD = Diversifiable Risk RiskND = Non-diversifiable Risk Risk is most often defined as the variability of the returns and is the ­ ombination of risk that can be removed by a diversified portfolio and risk resulting c from the ­movement of instruments in the portfolio with the market because the instruments are themselves part of the market. Return is computed from the Total Return ­calculation in Equation 1.1.1 presented earlier. Capital Asset Pricing Model

William Sharpe of Stanford and Jack Treynor, who was the editor of the Financial Analysts Journal, independently developed a theory that prices of different securities moved in a predictable relationship to the market as a whole; they called this theory the Capital Asset Pricing Model, or CAPM (see Figure 1.1.2.4). They selected returns computed on broad market indexes such as the DAX, FTSE, the S&P 500, or TOPIX as surrogates for the return on their respective markets. They further chose the variability in returns over time as a measure of risk. One method for relating individual securities to the market is to employ a statistical technique known as regression analysis to determine the correlation of individual securities' returns to returns on the index. Relating security prices to the index uncovered several important insights. These insights are described in the sidebar that follows.

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Portfolio B with leverage

Efficient Frontier

Portfolio B + cash

Return

22

(all possible efficient portfolios)

X

Portfolio B

(efficient portfolio with risky assets only)

Feasible Portfolios (risky assets only)

Risk-free rate of return

Risk (standard deviation of returns)

Figure 1.1.2.4  The Capital Asset Pricing Model extends the idea of an efficient portfolio by showing that risk can be reduced by holding some portion of a portfolio as cash, and that return can be increased by borrowing to invest.

Sharpe and Treynor's critical insight of an instrument moving in concert with the market is critical to how effectively risk can be diversified. The tendency for instruments to move with the market, and therefore with each other, is what economists call covariance (after all instruments are part of the market, so it is reasonable for the components of the market to move together). However, the more instruments move together (i.e., the more they are correlated), the less effective diversification is at reducing market risk. (In Book 4, An Introduction to Trading in the Financial Markets:

Investment Styles

Global Markets, Risk, Compliance, and Regulation, we see that market risk is only one of a group of different kinds of risk associated with investing.)

Alpha (a) and Beta (b)

Return on an Instrument

CAPM is an underlying concept used in many portfolio strategies—that is, that a security bears a stable relationship to the market, as shown in the following ­figure. For practitioners, the market is usually represented by an index, and a portfolio is chosen to behave in a specific way with respect to the index and therefore to the market it represents.

a= Return on asset (portfolio) when market return = 0

Linear Correlation b = Correlation of returns on asset (portfolio) to returns on market = Slope of correlation line β < 1 Asset less volatile than market β > 1 Asset more volatile than market β = 1 Asset same volatility as market β = 0 Asset uncorrelated with market β < 0 Asset negatively correlated with market

Return on Market

(Continued)

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You may remember that the formula for a straight line is ra = a + bri. In this formula, ra is the return of the security a (or for a portfolio) at any moment; ri is the return on the index (representing the market) at that same moment; a is the anticipated return on the security a when the line intersects the y-axis (i.e., when the return on the market is zero); and b is the slope of the line. The meanings of these elements are as follows: Alpha (a) is the y-axis intercept and suggests that the security may have a return (either positive or negative) even when the return on the ­m arket is zero. A number of strategies attempt to find securities that “capture” a ­p ositive a. Beta (b ) is the slope of the line and indicates the extent to which the ­security moves in response to a movement of the market. b is a measure of price ­volatility. If b is greater than one, the security is more volatile than the market. If it is less than one, the security is less volatile than the market as represented by the index. A b of exactly one implies that the volatility of the security equals that of the market. The problem for practitioners, and an issue we return to in Book 3, is how to choose the data to put into the formulas and what commonly presented statistics really mean. Most market data services regularly present values for a and b in their basic displays. Implicit in these and other statistics are assumptions about the time period used for the regression, the index representing the market, the assumptions within the data used for the rates of return or prices, and the degree to which data gathered from the past reflects the possible outcomes of the future.

There are two important categories of investment styles that grow out of Modern Portfolio Theory, the discussion of which continues next. MPT has generated many approaches to investing. Here we describe two signature approaches and some variations. Index Funds (Passive Investing)

Proponents of the strongest form of the efficient market hypothesis maintain that it is futile to try to “beat the market.”7 They believe the best way to earn returns is to construct a portfolio that exactly mimics the market. To do this, they pick a broad-based

7  Malkiel's book presents a sharp attack on most forms of instrument selection and active investing.

Investment Styles

index and construct a portfolio that replicates the returns on the index as closely as possible. The benefit of this strategy is that a portfolio of equity instruments has been shown to have a long-term positive return of just under 10%. Different index funds, as they are known, use different indexes and construction techniques. Most funds do not try to exactly duplicate the index but use statistical sampling to construct a smaller number of securities that track the index closely. This reduces the number of securities involved and lessens the number of trades required to keep the fund in balance. With better technology supporting them and large quantities of funds to invest, most index funds these days are able to run full samples of the universe, unless the universe is really, really large, like the Wilshire 5000. Especially since the advent of the electronic funds transfer (ETF), trading a ­basket of all stocks in the index is necessary. A secondary benefit of this type of investing is that transaction costs can be minimized. A capitalization-weighted fund tracking a capitalization-weighted index automatically stays in balance if stock prices move. Thus, trading levels for index funds are extremely low, accounting for only index composition changes and issuance or buyback of individual stocks. Furthermore, academic research has shown that portfolios lose money when they trade. There are several components of trading costs (discussed later) that together reduce the returns on a portfolio and in some cases may exceed the ­benefits created by the trade. A creative strategy can take advantage of trading ­methods that keep total transaction costs low. An index fund trades only when the holdings of the fund become out of balance with the index the fund is tracking. The fund usually has a target amount by which it is allowed to vary from its theoretical balance before the fund has to be rebalanced. Trading to rebalance the fund costs money in fees and other transaction costs, so the goal is to trade as little as possible to keep the fund balanced. The allowable difference between the goal for holdings of replicating the target index as closely as possible and the actual holdings in the fund is sometimes known as ­tracking error. Models define how large the tracking error is permitted to be before the fund must be rebalanced. Asset Allocation and Alpha Capture

If you accept the stronger statements of the efficient market hypothesis, it is futile to try to pick individual securities as a means to achieve higher returns. A number of funds seek to intentionally vary from an index. These funds may use the process of asset allocation to systematically bias a portfolio to achieve either higher returns or lower risk than a given index. A second approach attempts to take advantage of the concepts shown graphically in the figure in the preceding sidebar, Alpha and Beta. If α is the return on a portfolio or an asset when the return on the market is zero, by definition, finding portfolios with positive α or assembling portfolios from instruments with positive α

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would seem to create portfolios with returns higher than the market. The techniques that attempt to select portfolios with a positive α to achieve higher returns are loosely termed alpha capture.8 Some strategies actually split portfolios into two components: One component replicates the market as an index fund would, and the other component is designed to achieve higher returns with more risk. The components are then offered to investors with different goals. Other Portfolio-Oriented Strategies

Many other strategies depend on MPT but do not accept the principle that markets are completely efficient. These strategies suppose that, although generally true, the efficient market hypothesis does not apply to those with access to superior ­information and/or to those who construct portfolios designed to incorporate unique assets with superior returns. Moreover, even those investors who believe they can pick securities better than the average may take advantage of some of the elements of MPT. Behavioral Finance One of the assumptions of MPT is that investors are rational and always behave in a way that takes advantage of available knowledge and they are not influenced by extraneous (to the portfolio decisions) factors. A number of academic theorists have developed investment models predicated on the fact that actual investment behavior often varies from what pure rationality would suggest. This insight can lead to many different approaches to investing. In particular, those who subscribe to the validity of behavioral finance suppose that they can develop strategies that take advantage of behaviors that are less than purely rational to achieve better investment results. Even those who support MPT may incorporate concepts of behavioral finance into their strategies. Behavioral finance holds that when humans are investors, they often act in ways that are not purely rational as presupposed by MPT, and that smart investors can take ­advantage of this non-­rational behavior to earn better returns than predicted by the efficient ­market hypothesis. Quantitative Investing The final investment style is not so much a separate style as an approach. The use of computer technology has increasingly been applied to all facets of investing. Although most investors use computers to some extent to implement the strategies described previously, we are interested in a few unique techniques in which the computer is ­actually making the investment decisions. (See Book 3 for more information on how computers are used in regular investing.) We also describe the use of computers in the process of managing executions in the following sections on the sell side and exchanges. 8  Bernstein's most recent book, Capital Ideas Evolving, describes a number of different real-world investment strategies (several created by some of the same academics who helped to create MPT) that take advantage of either perceived limitations of Modern Portfolio Theory or nuances of MPT assumed to offer returns that exceed those of passive investment.

Investment Styles

A very common use of computers for investing is through the development of a multi-factor regression model to identify instruments that are underperforming and overperforming expectations. (Note that this statement presumes a ­philosophy about what is “expected.”) These models constantly evaluate a target universe and develop investment ideas when they find an overperforming or an underperforming asset. Quantitative investing includes a wide range of investment approaches that employ mathematical models and computer algorithms to effect investment ­strategies for a portfolio. Arbitrage

Arbitrage is the process of simultaneously buying one instrument and selling another security short (also known as shorting a security) where the two instruments are perceived to be either perfect substitutes for each other, or where the two securities have a strong pricing relationship with one another (see Figure 1.1.2.5).9 If you buy the underpriced security and sell the overpriced security, the difference in prices is locked in and should be the profit on the transaction less any transaction costs. The security that is sold is usually borrowed in a process known as a short sale. When the securities' prices come back into line, the borrowed security or an equivalent must be repaid. There are three primary types of arbitrage. Risk Arbitrage

Risk arbitrage involves simultaneously buying and selling securities that are potential substitutes, most often as the result of a takeover, a merger, or a company ­choosing to purchase a portion of its own outstanding securities, a scenario known as a ­buyback. In these situations, the firm initiating the activity offers a combination of cash and/or its own ­securities in exchange for the securities it is trying to accumulate. For example, a ­common arbitrage situation involves a takeover where the shares of the acquiring company are offered in exchange for the shares of the company being acquired (the target).





Figure 1.1.2.5  Arbitrage is the process of simultaneously buying and selling related instruments or the same instrument in different markets to take advantage of a perceived anomaly in the relative prices of the instruments, thus capturing a profit for the arbitrageur. 9  The question arises as to whether arbitrage is an investment style or a trading technique. We are at the point in the continuum between trading and investing presented in Figure 1 where the two begin to merge. We include arbitrage at this point because there are hedge funds and private equity firms using arbitrage as their primary funds-management strategy.

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In this situation, there is usually a fixed ratio between the number of shares of the acquiring company and the number of shares in the target company that will be accepted in the exchange. This ratio usually results in a higher price for the shares of the target company than the market price of the target in the period just prior to the offer. This premium is an incentive for the target's stockholders to go along with the takeover. However, because the conversion is not certain, the prices of the two securities are not exactly equivalent, and there is a “risk” that the deal will not be completed. This is the reason for the term “risk arbitrage.” An arbitrageur would ­typically purchase the acquiring company's stock and short the shares of the target ­(assuming the target's price is higher) in proportion to the conversion ratio. In principle, this position is perfectly balanced, or hedged, because the shares of both companies are equivalent after the conversion is complete. This transaction locks in the ­differences in price as the arbitrageur's profit. Statistical Arbitrage

Like risk arbitrage, statistical arbitrage involves simultaneously buying and selling two securities. With statistical arbitrage, however, there is not an eventual replacement of one side of the transaction, known as a leg, with the equivalent other leg. Instead, when some expected pricing relationship between two securities is out of balance, the overpriced security is shorted and the underpriced security is purchased. The profit is achieved when the pricing relationship returns to normal. As an example, bonds tend to trade with an observed difference, or spread, with highly liquid, low-risk securities known as a benchmark. (Gilts and U.S. Treasury securities are widely used as benchmarks in many markets.) An arbitrageur might construct a hedge based on a difference between a target security and the benchmark. Derivatives Arbitrage

A final type of arbitrage can occur with a simultaneous purchase of a security, or pool of securities, and the sale of an equal but opposite derivatives contract on the ­security or pool. Typically, a derivatives strategy is to lock in a pricing difference between the market price of the security and the derivative. The derivative introduces anticipated future prices into the arbitrage. In a related strategy, an investor may purchase securities in anticipation of some market movement and then write an option against the security. If the price movement occurs as anticipated, the option becomes worthless, and the appreciation is achieved in the security. However, by writing a contract as opposed to buying an option (or future), the investor also profits from the sale of the contract. This ­strategy is known as a buy/write. (Writing options against existing holdings is a way

Investment Styles

to earn extra returns from the holdings that an investor might be willing to sell at a specific price. The writer earns the premium from writing the option. If called, the writer sells at the target price. If not, the premium is added income.) Other Quantitative Strategies

A number of investment managers have quantitative models used to generate buy and sell recommendations. In these quantitative strategies, portfolio managers are not required to intervene to initiate orders submitted to the buy-side trading ­process in real time. Of the firms we have seen, there are two primary approaches. The first type of firm employs one of the portfolio-based solutions that periodically ­compares the returns and allocation of assets in the whole portfolio and then ­generates orders to rebalance with a series of orders to the in-house trading department. Another approach uses models to evaluate individual instruments using the model to ­compute the instrument's theoretical value and compare that value to momentary prices in the market. When the model finds overvalued instruments, they are sold, and ­undervalued assets are purchased. There are many other variations of the use of quantitative models in investing. No doubt there are many other automated ­investment strategies.

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