Documente Academic
Documente Profesional
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PORTFOLIO
INVESTMENT
MANAGEMNET
Dr Lau Wee Yeap
Project Directors:
Module Writer:
Moderator:
Nuradli Ridzwan
Universiti Sains Islam Malaysia
Developed by:
Printed by:
Table of Content
Course Guide
xi-xiv
Topic 1
1
3
4
6
10
11
12
14
14
14
15
17
18
18
19
19
Topic 2
20
22
23
23
25
25
26
27
28
28
29
30
30
31
31
34
34
36
36
iv
TABLE OF CONTENT
37
38
39
39
39
Topic 3
41
42
43
44
45
45
46
47
50
53
55
56
56
57
Topic 4
58
59
60
62
66
67
69
70
70
72
72
72
74
75
79
79
79
81
TABLE OF CONTENT
Topic 5
81
82
83
85
86
87
88
89
89
90
92
93
96
96
98
98
101
101
101
102
Topic 6
105
105
107
108
108
109
109
110
111
111
111
Topic 7
112
113
114
115
117
117
120
120
121
121
vi
Topic 8
Topic 9
TABLE OF CONTENT
Summary
Key Terms
Self-Test 1
Self-Test 2
122
123
123
124
125
127
128
130
130
132
133
136
138
139
140
140
141
143
144
144
145
146
147
147
148
149
150
151
151
152
153
153
153
154
154
156
161
162
TABLE OF CONTENT
Topic 10
vii
162
164
164
166
166
168
168
168
169
169
170
171
175
175
176
177
179
179
179
180
180
185
185
186
186
187
188
189
189
189
190
191
192
192
192
Answers
194
References
225
COURSE GUIDE
PANDUAN KURSUS
COURSE GUIDE
xi
INTRODUCTION
BBPM4103 Portfolio Investment Management is one of the courses offered by
Faculty of Business and Management at Open University Malaysia (OUM). This
course is worth 3 credit hours and should be covered over 15 weeks.
COURSE AUDIENCE
This is a core course for students pursuing the degree in Bachelor of Accounting
program.
As an open and distance learner, you should be acquainted with learning
independently and being able to optimise the learning modes and environment
available to you. Before you begin this course, please confirm the course material,
the course requirements and how the course is conducted.
STUDY SCHEDULE
It is a standard OUM practice that learners accumulate 40 study hours for every
credit hour. As such, for a three-credit hour course, you are expected to spend
120 study hours. Table 1 gives an estimation of how the 120 study hours could be
accumulated.
xii
COURSE GUIDE
STUDY
HOURS
60
10
Online participation
12
Revision
15
20
120
COURSE OBJECTIVES
By the end of this course, you should be able to:
1.
Explain the basic concepts used in financial market and securities markets;
2.
3.
4.
5.
Apply capital asset pricing model to any given security, single-index, multiindex and APT model to estimate portfolio return;
6.
7.
8.
9.
COURSE GUIDE
xiii
COURSE SYNOPSIS
This course is divided into 10 topics. The synopsis for each topic can be listed as
follows:
Topic 1 explains the economics of the financial market. It also describes the types
of investing and financing, and the types of financial markets and assets. It also
explains the concept of unit trust funds and investment risk. Lastly it touches on
Capital Market Plan and the type of career this field offers.
Topic 2 explains the underlying concept of risk and return. It also states the
methods on how to measure risk and return. It goes further by discussing the
investors behaviour and utility function. Concepts such as covariance and
correlation and mean-variance analysis are also introduced and explained.
Topic 3 examines the concept of portfolio formation. It explores the idea of
diversification. It touches on the method on how to formulate portfolio return
and risk. It discusses the role of correlation and covariance in portfolio
diversification. It examines the role of correlation and covariance in portfolio
diversification. Minimum variance portfolio is introduced. In addition, the
differences between diversifiable risk and non-diversifiable risk are discussed.
Topic 4 explains the concept of efficient frontier and Markowitz portfolio theory.
It also applies the concept of capital allocation line (CAL). Furthermore, it derives
capital market line (CML). Lastly, this topic applies asset allocation strategies in
forming optimal portfolios and evaluates the usefulness of market indices.
Topic 5 explains the concepts of Capital Asset Pricing Model (CAPM) and its
assumptions. It derives from the Security Market Line (SML). It also applies SML
for investment decision making. It analyses empirical evidence of CAPM. It
appraises the implications that CAPM has for investors and evaluates the
limitations of CAPM.
Topic 6 explains the concept of single-index model. It also discusses the concept
of Arbitrage Pricing Theory Model (APT), factor sensitivities, usage and
empirical issues in APT. This topic also compares between CAPM and APT.
Lastly, it discusses the concept of behavioural finance.
Topic 7 explains the concept of efficient markets, the degrees of efficiency and the
empirical tests of EMH. This topic also discusses the implication of EMH to
investment strategies. Lastly, it touches on market rationality in relation to EMH.
xiv
COURSE GUIDE
COURSE GUIDE
xv
PRIOR KNOWLEDGE
Learners of this course are required to pass BBPW3103 Financial Management I
and BBPW3203 Financial Management II course.
xvi
COURSE GUIDE
ASSESSMENT METHOD
The assessment method and evaluation distribution for this course can be listed
as follows:
OLP
5%
Assignment
30%
Mid Term
26%
Final Examination
39%
Total
100%
REFERENCES
Elton, E.J., Gruber M. J., Brown S. J., & W.N. Goetzmann. (2007). Modern
portfolio theory and investment analysis. (7th ed.). USA: John Wiley &
Sons, Inc.
Reilly, F. K., & K. C. Brown. (2006). Investment analysis and portfolio
management. (8th ed.)., Thomson South-Western.
Bodie, Z., Kane, A., & Marcus, A. J. (2005). Investments, (6th ed.). USA: Irwin
McGraw-Hill.
Sivalingam A. (1990), Modern portfolio management. Longman Publication.
Sharpe, W.F., Alexander, G. J., & J. V. Bailey. (1999). Investments. (6th ed.).,
New Jersey: Prentice Hall.
Topic
Introductionto
Financial
Marketand
Securities
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1.
Explain the economics of financial market;
2.
Discuss the two main types of investors;
3.
Assess the four types of financial markets and assets;
4.
Examine the concept of unit trust fund;
5.
Describe the Capital Market Plan; and
6.
Analyse the types of career in capital market.
INTRODUCTION
that the fund managers use the knowledge acquired from Portfolio Management
in managing your funds. You can also be a good investor if you master this
subject. Therefore, you need to have the required patience and passion to learn
this subject.
We will begin this subject by introducing some background knowledge such as
the economics of financial market, types of investors and financing, as well as the
concepts of financial instruments and asset classes. We will also discuss in quite
details on unit trust fund investment and the risks related to this type of
investment. There will be also an introduction to Capital Market Plan. Lastly, we
will talk on the types of career available in capital market.
Harry Markowitz is awarded the Nobel Prize in Economics (1990) for having
developed the theory of portfolio choice.
The contribution for which Harry Markowitz now receives his award was first
published in an essay entitled "Portfolio Selection" (1952), and later, more
extensively, in his book, Portfolio Selection: Efficient Diversification (1959). The socalled theory of portfolio selection that was developed in this early work was
originally a normative theory for investment managers, i.e., a theory for optimal
investment of wealth in assets which differ in regard to their expected return and
risk. On a general level, of course, investment managers and academic economists
have long been aware of the necessity of taking returns as well as risk into account:
"all the eggs should not be placed in the same basket". Markowitz's primary
contribution consisted of developing a rigorously formulated, operational theory
for portfolio selection under uncertainty - a theory which evolved into a foundation
for further research in financial economics.
Markowitz showed that under certain given conditions, an investor's portfolio
choice can be reduced to balancing two dimensions, i.e., the expected return on the
portfolio and its variance. Due to the possibility of reducing risk through
diversification, the risk of the portfolio, measured as its variance, will depend not
only on the individual variances of the return on different assets, but also on the
pairwise covariances of all assets.
Hence, the essential aspect pertaining to the risk of an asset is not the risk of each
asset in isolation, but the contribution of each asset to the risk of the aggregate
portfolio. However, the "law of large numbers" is not wholly applicable to the
diversification of risks in portfolio choice because the returns on different assets are
correlated in practice. Thus, in general, risk cannot be totally eliminated, regardless
of how many types of securities are represented in a portfolio.
In this way, the complicated and multidimensional problem of portfolio choice with
respect to a large number of different assets, each with varying properties, is
reduced to a conceptually simple two-dimensional problem - known as meanvariance analysis. In an essay in 1956, Markowitz also showed how the problem of
actually calculating the optimal portfolio could be solved. (In technical terms, this
means that the analysis is formulated as a quadratic programming problem; the
building blocks are a quadratic utility function, expected returns on the different
assets, the variance and covariance of the assets and the investor's budget
restrictions.) The model has won wide acclaim due to its algebraic simplicity and
suitability for empirical applications.
Generally speaking, Markowitz's work on portfolio theory may be regarded as
having established financial micro analysis as a respectable research area in
economic analysis.
Source: www.nobelprize.org (Retrieved 7 August 2007)
www.wsecurities.com/image9.gif(Retrieved 7 August 2007)
www.ifa.com/.../12steps/Step2/harrymarkowitz.jpg(Retrieved 7 August 2007)
1.1
The surplus units will lend their funds to financial markets, while the deficit
units will borrow their funds from the markets. The demand and supply of funds
through various financial instruments are the fundamental reasons for the
existence of financial markets.
ACTIVITY 1.1
Discuss the following question in myLMS.
1.2
1.
2.
We assume typical economic agent is rational and it means he or she will always
choose to maximise his or her utility. This is an important assumption regarding
the behaviour of an economic agent.
It is important to have a clear understanding of the types of investors that exist in
the market. On a broad basis, investors are divided into retail investors and
institutional investors. Figure 1.2 below summarises the main types of investors
and its examples.
SELF-CHECK 1.1
1.3
1.
2.
In general, there are four types of financial market as shown in Figure 1.3. They are
money market, capital market, derivative market and foreign exchange market. All
these markets complement each other in day-to-day market transactions.
However, in line with this subject on Portfolio Investment Management, we will
focus more to the discussion on capital market.
Having an understanding of the financial market existence and the needs of
various economic agents, the subsequent question now is how these economic
agents fulfill their needs by participating in the financial market. As mentioned
in the earlier section, economic agents have to invest in financial assets to fulfill
their financial needs.
Financial institutions offer financial instruments to investors. When investors buy or
put monies into these instruments, they become the financial assets to the investors.
The decision of investing in different financial assets depends on various factors
such as investment horizon, purpose of holding these instruments and availability.
We can divide financial instruments into several types. They are (i) debt, (ii) cash
and cash-equivalent, (iii) equity, (iv) derivatives, (v) commodity and (vi) precious
metal. All of them are shown in Table 1.1, 1.2 and 1.3 respectively.
Savings Bond
(SB)
Government
Treasury Bill
(T-Bill)
Term Deposit /
Fixed Deposit
Descriptions
Safe, government-backed.
T-Bills have a face value; you purchase it at a discount (less than the
face value) and then redeem it at face value; the difference is your return
(e.g. you may pay $90 for a $100 face value T-Bill you receive the face
value upon maturity).
You invest a sum of money with a financial institution for a set period.
Commercial
Paper
Government/
Municipal Bond
Bankers
Acceptance (BA)
Corporate Bond
Debenture
Mortgage-Backed
Securities
Cagamas
Descriptions
Preferred
Shares/
Stocks
Descriptions
Commodities
Derivatives
Precious Metals
ACTIVITY 1.2
1.4
1.
2.
Check out from internet, what are the functions of these markets?
Unit trust fund is an investment tool that pools monies from individual investor,
household or sometimes institution, and those monies then are invested in stock
market, bond market or other financial markets. The process of how mutual fund
works is shown in Figure 1.4.
In United Kingdom and Commonwealth countries like Malaysia, it is called unit
trust fund, while in the United States it is better known as mutual fund.
10
1.4.1
11
As shown in Figure 1.5, there are three parties involved in unit trust investment.
They are the asset management companies, an independent trustee and the unit
holders. Asset Management Companies (AMC) which is also known as Plan
Sponsors, initiates the fund and looks for investors, while an independent
trustee is the custodian of the funds operation. The unit holders are individual
investors, or institutions. All the three parties are tied together through a trust
deed and Securities Commission (SC) acts as the regulatory body for the unit
trust industry.
SELF-CHECK 1.2
1.
2.
1.4.2
Types of Funds
In this section, we will look at the different types of funds. Table 1.4 summarises
several types of funds available.
As shown in Table 1.4, there are basically seven types of
funds in the market, namely equity funds, fixed income
funds, money market funds, real estate investment trusts
(REITs), exchange traded funds (ETF), balanced funds and
Syariah funds.
In addition, within equity funds, there are aggressive
growth funds, index funds and International equity funds.
12
Type of Unit
Trust Funds
Equity Funds
Descriptions
An equity unit trust is the most common type of unit trust.
The major portion of its assets is generally held in equities or
securities of listed companies.
Equity unit trust funds are popular in Malaysia as they provide
investors with exposure to the companies listed on Bursa
Malaysia. The performance of the units is therefore linked to the
performance of Bursa Malaysia. A rising market will normally
give rise to an increase in the value of the unit and vice-versa.
There is a wide array of equity unit trusts available in the
market, ranging from funds with higher risk, higher returns to
funds with lower risk, lower returns.
(a)
(b)
Index funds
These funds invest in a range of companies that closely
match (or track) companies comprising a particular
index.
(c)
2.
Fixed Income
Funds
3.
Money Market
Funds
13
4.
Real Estate
Investment
Trusts (REITS)
5.
Exchange
Traded Funds
(ETF)
6.
Balanced Funds
7.
Syariah Funds
1.4.3
14
Figure 1.6: Balancing Risk and Return Between Various Types of Funds
Source: http://www.cba.ca/en/viewPub.asp?fl=6&sl=23&docid=26&pg=2#F
1.5
In this section, we will learn about the Capital Market Master Plan (CMP). Firstly,
we will read a little bit regarding CMP background. Following that, we will look
at how it is implemented.
1.5.1 Background
The Capital Market Master Plan or CMP is a comprehensive plan in charting the
strategic positioning and future direction of the Malaysian capital market for the
next 10 years. It will prioritise the immediate needs of the capital market and will
chart its direction and long-term growth in anticipation of deregulation and
liberalisation.
Among other things, the CMP aims to:
15
The CMP was first announced by the then Minister of Finance II and the
Chairman of the SC on 6 August 1999 during the closing of the 1999 Securities
Commission Annual Dialogue, and was subsequently approved by the Minister
of Finance in December 2000.
The CMP was then launched by the Minister of Finance on 22 February 2001.
1.5.2
Implementation
As at 30 June 2007, total of 122 recommendations (80%) of the CMP have been
completed, with the remaining 30 (20%) in progress. The successful
implementation of the CMP was achieved due to the strong commitment and
support from major stakeholders in the Malaysian capital market. Details of the
completed recommendations are shown in Figure 1.7.
The CMP is a strategic blueprint charting the 10-year development of Malaysias
capital market. It adopts a phased approach of implementing 152
recommendations to achieve its vision of a capital market that is:
Internationally competitive;
Highly efficient conduit for the mobilisation and allocation of funds; and
2007 marks the second year of the implementation of the third phase of the CMP,
which spans from 2006 to 2010. CMP Phase 3, which is aligned with the 9th
Malaysian Plan, focuses on further broadening and deepening of the capital
16
1.6
Before we close this topic, let us discuss the various types of work or profession
that exist in the capital market. As we have discussed earlier from 1.1 to 1.5,
behind the scene of a functioning of capital market, we must be aware that we
need various types of professionals to support the good functioning of capital
market. These professions can be your future job opportunities as well!
17
The first group of people is regulators. The regulator whom is given the authority
of watching the functioning of Bursa Malaysia (formerly known as Kuala
Lumpur Stock Exchange (KLSE)) is Securities Commission (SC) (Figure 1.8).
Companies that are listed on the Bursa are known as Public Listed Companies or
PLCs. These companies must comply with the Securities Industry Act (SIA 1983).
Companies (PLCs) are required to submit annual financial report to the SC.
Other than that, Bank Negara Malaysia (BNM) is given the authority of
overseeing the functioning of financial institutions such as commercial banks and
merchant banks.
The second group of people is the finance and banking professionals. They are
bankers, analyst and portfolio managers. Portfolio managers are also known as
fund managers. They basically manage the funds on behalf of the asset
management companies (AMC) as we have discussed earlier.
Supporting this group are analysts. They are known as research analyst,
market analyst or financial analyst. These analysts provide analysis of
companies listed in the Bursa Malaysia to the fund managers, so that fund
managers can select good stocks to be included in their portfolios.
18
The major part of discussion deals with financial assets and asset classes that
are available in the market. These asset classes are invested by fund managers
to provide returns to unit trust investors.
Lastly, we have discussed the various type of careers in the capital market.
Bond portfolio
Indirect finance
Institutional investor
Deficit of funds
Portfolio investment
Direct finance
Regulator
Economic agent
Retail nvestor
Financial market
Suplus of funds
Hot money
1.
2.
Draw supply and demand curve of funds for a financial market. Explain.
3.
4.
5.
6.
7.
8.
1.
2.
3.
4.
5.
6.
7.
8.
19
Topic
Riskand
Return
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1.
2.
3.
4.
5.
INTRODUCTION
Welcome to Topic 2 on risk and return! In the earlier topic, we have touched on
the concept of risk when discussing different types of unit trust funds. In this
topic, we will introduce to you the fundamental concepts of risk and return.
These concepts are the building blocks in understanding portfolio management.
Hence, Topic 2 is very important if you intend to progress well in the subsequent
topics.
We will begin by explaining the underlying concept of risk and return and then
followed by how to measure return and risk. As we move on, we will also talk
about the concepts of correlation and covariance. Finally, we will put together the
concept of risk and return together in what is known as mean variance analysis,
in the context of portfolio investment. We wish to remind you that the story of
risk return is closely related to Topic 3.
Hence, please read on until the end of Topic 3 before you put up any question!
Measuring financial risk is important as highlighted by the speech of Mr. Alan
Greenspan, the former chairman of the United States Federal Reserve Board
(1987-2006), a body that oversees the Federal Reserve Bank. Enjoy the reading!
21
22
2.1
2.1.1
23
2.1.2
Market
Risk
Currency
Risk
Liquidity
Risk
Types of
Risk
Systemic
Risk
Credit
Risk
Operation
Risk
Now, let us look at Table 2.1 that itemise the details about these six different
types of risk.
24
Types of
Risk
Market
Risk
2.
Liquidity
Risk
3.
Credit Risk
4.
Operation
Risk
5.
Systemic
Risk
6.
Currency
Risk
Explaination
Example
Related
to
adverse
movements in the value of
a security or securities.
25
In this topic, we will touch on investment risk and also portfolio risk in
subtopic 2.3.
Investment risk is a general concept. It can take the meaning of market risk,
liquidity risk or credit risk. Portfolio risk refers specifically to the risk of portfolio
i.e. the risk when we combine different financial assets or securities.
Of course, the main idea of portfolio theory is attempting to reduce portfolio risk
by having different combination of financial assets with different correlation
coefficients.
SELF-CHECK 2.1
1.
During the Asian financial crisis in 1997, assuming that you were an
investor in stock market, what kind of risk did your investment
suffer?
2.
2.2
2.2.1
MEASURING RETURN
Rate of Return
How do we measure the Rate of Return?
W I
I
(2-1)
26
From equation (2-1), if we hold a financial asset for a period of time, and during
the period, we receive distribution of dividend (Dt). Then we must write a new
equation (2-2) as shown below. This is known as Holding Period Return (HPR)
for time period t,
Rt
Pt Pt 1 Dt
Pt 1
(2-2)
HPR for time period t is the capital gain (or loss) plus distributions (Dt) divided
by the beginning- period price (Pt-1). Current price or end-of-period is Pt.
The distribution for stocks, it is dividend; for bonds, it is coupon payment. The
time interval, t can be a day, week, month, or year.
Rates of Return are the fundamental units that analysts and portfolio managers
use for making investment decision.
There are two characteristics of HPR. Firstly, there is element of time. For
example, rate of return is a monthly figure. Secondly, no currency unit is attached
to it. The resulting ratio would not have any units because the denominator and
numerator cancel one another.
2.2.2
Let us now look at the scenarios regarding certain and uncertain outcomes.
Scenario 1: Certain Outcomes
The above rate of returns is calculated with the assumption that
certain present value of the investments and the rate of return.
27
2.2.3
End-of-Period Price
$25
$28
$30
$35
$45
Return
16.70%
6.70%
0
+ 16.70%
50%
Expected Return
From the above example, we know we need some statistics to summarise the
range of possible outcomes. We need the Measures of location describe the most
likely outcome in a range of events.
The most often used measure of location is the mean or expectation. The mean is
defined as:
E( X )
Pr X
i
(2-3)
i 1
28
2.3
MEASURING RISK
(ii)
(iii) Investors are better at allocating their savings to various types of risky
securities; and
(iv) Managers better-off allocating shareholders (and creditors) funds among
scarce capital resources.
2.3.1
Investment Risk
Supposed that we invest RM1000 in XYZ firm, we expect to have an end-ofperiod wealth of RM1053.
However, you should ask yourself an important question: what is the risk being
taken?
There is variance.
The variance is the statistic most frequently used to measure risk (this is the
dispersion of the distribution).
Variance is defined as the expectation of the squared differences from the mean:
Var(X)
E[(X ) 2 ]
E[{X E(X)}2 ]
E[X 2 2X 2 ]
E(X 2 ) 2E(X) 2
E(X 2 ) 2
Pr ( X
i
i 1
E( X )
(2-4)
29
Applying this concept to our example of XYZ firm, we will obtain the following:
2
2
2
Var P = 0.1 25 - 31.60 + 0.2 2.8 - 31.60 + 0.4 30 - 31.60
Var P = 0.1 43.56 + 0.2 12.96 + 0.4 2.56 + 0.2 11.56 + 0.1 179.56
Var P = 28.24
2
2
2
2
2
Var P = 0.1 6.6 + 0.2 3.6 + 0.4 1.6 + 0.2 3.4 + 0.1 13.4
ACTIVITY 2.1
1.
2.
2.3.2
Standard Deviation
P Var P RM 5.31
(2-5)
If returns distributions are normal, we can use the expected return and standard
deviation to describe the entire probability distribution.
In this case, the standard deviation is a measure of (downside) risk.
30
2.3.3
If you have a mean and a standard deviation on a monthly basis you can express
them on an annual basis by multiplying them with 12 and, respectively:
Annual 12 Monthly
(2-6)
Annual 12 Monthly
(2-7)
Examples
An average return of 1% per month can be expressed as an average return of
12% per year;
A monthly standard deviation of 6% corresponds to an annual standard
deviation of 21%.
2.4
31
2.4.1
A risk averse individual is one who prefers less risk for the same expected return.
If you give such an investor a choice between RMA for sure, or a risky gamble in
which the expected payoff is RMA, a risk averse investor will go for the sure
payoff.
Individuals are generally risk averse when large fractions of their wealth is at
risk.
This is important because it introduces us to the relationship between an
individuals wealth and utility.
2.4.2
32
There are several factors that influence ones utility function. Factors such as:
(i)
(ii)
How much the investment could affect the investors total wealth.
For example, a potential loss of RM1,000 would probably worry a millionaire less
than someone with earnings of RM100 per week.
We need to put some structure on the concept of risk aversion. In this way we
will better understand the dynamics in the investment process. Although
investors are presumed risk averse, each investor will face different trade-off
decisions between different risk and expected returns.
The indifference curve represents a set of risk and expected return
combinations that provide the investor with the same amount of utility. They
indicate an investors preference for risk and return.
Drawn on a two-dimension where the horizontal axis gives you risk and the
vertical axis provides you expected return.
When we use quadratic utility functions, we can nicely express our utility
functions; one example is the following:
U = E R 0.005 A 2
(2-8)
Hence, the investor just considers risk and return. In other words, you require a
higher expected return, the higher the risk of the investment.
Based on equation (2-8), where U is the utility value and A is an index of
investors risk aversion, then
If A > 0, then the investor is risk averse.
If A < 0 the investor is risk-loving.
33
As shown in Figure 2.3, investors are risk-averse. If they are highly risk-averse,
then their indifference curve will look like Figure 2.4. However, if they are low
risk-averse investors, then their indifference curve will look like Figure 2.5.
34
2.5
2.5.1
Covariance
35
As shown in Figure 2.6, we can observe that the top series (ABC) is moving in the
same direction and similar magnitude as the central series (XYZ). Hence, it is
found that the correlation between the two series is 0.61.
As for the bottom series (KLM), it does not move in similar manner with XYZ. It
is found that the correlation between the two series is 0.27. We can say they are
lowly correlated.
Let us assume we have two variables, X and Y.
Then the covariance between X and Y is given by:
Cov(X,Y)
(2-9)
Cov xy
[R
R x ][ R y R y ]
where:
Covxy
Rx
Return of security x
Ry
Return of security y
Rx
Ry
Number of observations
(2-10)
36
2.5.2
(2-11)
2.5.3
Correlation
37
Cov( X , Y )
sx s y
(2-12)
Where
rxy
Covxy =
sx
Standard deviation of x.
sy
Standard deviation of y
2.6
MEAN-VARIANCE ANALYSIS
Putting together what we have learnt from the above on risk and return on
something known as mean-variance analysis. As shown in Figure 2.8, we view
investors as measuring the expected utility of choices among risky assets by
using the mean and variance of the different combinations of these assets.
For a portfolio, the risk and return are measured by the mean and variance of
weighted average of the assets held in the portfolio.
38
Investors want to have high returns, but they also want the returns to be as
certain as possible. In other words, the investor wants to maximise expected
return and minimise risk. These two objectives must be balanced against each
other when making the investment decision. Hence the shaded area in Figure 2.8
shows all possible mean and variance pairs that an investor can attain by holding
risky assets.
Certain outcomes
Credit risk
Currency risk
Expected return
Liquidity risk
39
Market risk
Operation risk
Rate of return
Systemic risk
Uncertain outcomes
1.
2.
3.
4.
5.
6.
What are the benefits to investors if they can measure and price risk
correctly?
7.
8.
End of Period
Returns
Probability
Return
30
0.10
3.00
40
0.30
12.00
50
0.40
20.00
60
0.10
6.00
70
0.10
7.00
30
0.10
3.00
40
1.
2.
3.
4.
5.
6.
Rx
Ry
10
17
12
13
16
10
18
7.
8.
Topic
Portfolio
Theoryand
Diversification
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1.
2.
3.
4.
5.
6.
INTRODUCTION
Welcome to Topic 3. After we have studied the basics of risk and return as well
as correlation and covariance, we will now expand these ideas to better
understand portfolio theory. This topic introduces students to the fundamental
concepts and terminologies that are used in portfolio theory. These concepts are
important for understanding portfolio construction and management.
In this topic, we will begin by learning the underlying concept of portfolio
formation and the idea of diversification. We will also see the importance of
correlation and covariance in portfolio diversification. Here, the differences
between systematic risk and non-systematic risk are also explained. Figure 3.1
explaining Modern Portfolio Theory of MPT.
42
3.1
In this topic, we would like to discuss the concepts related to portfolio theory. In
simple terms, a portfolio is made from a combination of securities. We can
combine different stocks to make a portfolio, or we can combine stocks and
bonds to make a portfolio. In other words, we can combine different asset classes
(as introduced in topic 1) to make a portfolio.
Having said that, we need to consider the effects of risk and return when
combining different securities. Why we are interested in forming a portfolio?
This is because combining these asset classes into a portfolio may be a good idea
in reducing risk.
Recall the mean-variance analysis we have discussed in sub topic 2.6, for each
security, investors compare the expected return from a range of probable
outcomes with the risk of security. Hence, investors need only to consider
expected returns and standard deviations when choosing securities for their
investment portfolios. There are two possible choices:
43
(i)
Investors can either choose securities that offer highest return given level of
risk; or
(ii)
They can choose the lowest risk for a given level of returns.
3.2
DIVERSIFICATION
Whether the combination of different asset classes into a portfolio will reduce the
risk or not is a question that needs to be answered. Generally, when we combine
different stocks into a portfolio, we are likely to reduce the combined risk or
portfolio risk. The risk of a portfolio is measured by its standard deviation.
How can we explain this matter? For example, lets say a person invests his
monies in two stocks, one in a plantation sector and another one in construction
sector for a two-year period. How can the concept of diversification work in
portfolio investment? In a hypothetical case, lets say, in that period, the
plantation sector is performing extremely well because palm oil is found to be
useful as bio-fuel. At the same time during that period, as construction material
is getting expensive, and in the environment of high interest rates, construction
activities are slow. Hence, the good returns from the investment in the plantation
sector will be able to offset the not-so-good returns from construction sector. So
the investor ends up with a fair return as he diversifies his investment in two
sectors.
From economics, we know that there is such thing as a business cycle (refer to
Topic 9) in an economy. There are certain years where the economy is
performing reasonably well and there are certain years where the economy is
performing not so well. And then, there are certain industries that perform well,
and there are also certain industries that are not performing so well due to
internal or external factors, or some macroeconomic factors.
An example is the Asian financial crisis in 1997 where the economy was not
doing well. The principles of diversification also work in such a scenario, if one
person invests his monies in a developed country like Japan, as well as in a
developing country like Malaysia during the Asian financial crisis. This investor
will end up with a fair return if he diversifies his investment in two countries.
We will soon learn that diversification plays an important role in designing
efficient portfolios. We will explain the concept of diversification in a more
rigorous manner using a mathematical approach. We will use the concept of
correlation we have learned in Topic 2 to do so. This will be explained in
subtopic 3.5.
44
Before that, we will learn how to calculate portfolio return and portfolio risk in
subtopic 3.3 and 3.4 respectively.
ACTIVITY 3.1
We also practice the concept of diversification in our day-to-day
activities? Remember the old adage do not put all your eggs in one
basket? Think of one or two examples that apply this idea.
3.3
PORTFOLIO RETURN
E ( R p ) wi E ( Ri )
(3-1)
i 1
Where w is the weight that each stock has in the portfolio, with the total weight
being equal to 1.
i n
w
i 1
(3-2)
where
E(R p )
E ( R1 )
E ( R2 )
w1
1 w1
(3-3)
3.3.1
45
Example
Lets consider two securities for investment. Aman Berhad and Sentosa Berhad
From the historical record, we know that
Security
Aman
Sentosa
E[R]
15%
21%
SD[R]
18.6%
28.0%
3.4
PORTFOLIO RISK
VAR ( R ) 2 w2 2 w2 2 2 w w
p
p
1 1
2 2
1 2 12
Where
w1
w2
12
22
12
=
=
=
=
=
(3-4)
We can also express the above using the correlation coefficient, 1,2 , between the
two stocks:
Remember the formula (2-12) from topic 2,
Var ( R ) 2 w2 2 w2 2 2w w
p
p
1 1
2 2
1 2 12 1 2
(3-5)
46
3.5
47
3.6
2 P w21 21 w2 2 2 2 2 w1 w2 Cov r1 , r2
or
2 P w21 21 w2 2 2 2 2 w1 w2 1 2 1,2
where 2 P is the variance of the portfolio; 21 and 2 2 are the variance of returns of
asset 1 and asset 2, respectively; Cov(r1,r2) is the covariance of returns between
asset 1 and asset 2; 1 and 2 are the standard deviation of returns of assets 1 and
2; and 1,2 is the correlation of returns between asset 1 and asset 2.
1,2
Cov r1r2
1 2
48
Now you can see that the riskiness of the portfolio depends on the following
three factors:
(a)
(b)
(c)
Of course, when any of the weightings of assets in the portfolio changes, the
corresponding variance of the portfolio will change accordingly. Holding other
things constant, when the standard deviation of each asset in the portfolio varies,
the variance of the portfolio will also change. Furthermore, the variance of the
portfolio not only depends upon the weights and standard deviation of each
individual asset in the portfolio, but also relies on the pair-wise correlation of
returns between assets in the portfolio. For instance, if the correlation of returns
between two assets is very high, then diversification will not lower the variance
of the portfolio. On the other hand, if the correlation of returns between two
assets is very low, then diversification will indeed lower the variance of the
portfolio.
If the correlation of returns between two assets is equal to one (i.e., i,j = 1), which
means that asset is return increases (decreases) by 10%, and asset js return also
increases (decreases) by 10%, then the correlation of returns between asset i and
asset j are perfectly positively correlated. If the correlation of returns between
two assets is equal to zero (i.e., i,j = 0), this means that the movement of asset is
returns has nothing to do with asset js returns. If this is the case, then the
correlation of returns between these two assets indicates that they are
independent of each other. Finally, if the correlation of returns between two
assets is equal to negative one (i.e., i,j = 1), this means that when asset is return
increases (decreases) by 10%, the return of asset j will decrease (increase) by 10%.
In this case the correlation of returns between asset i and asset j shows that they
are perfectly negatively correlated.
Let me show you an example based on actual data from the Hong Kong stock
market. I have to use historical data (ex-post analysis) since I am not able to get
the expected returns on Hong Kong stocks (ex-ante analysis). If I could get the
expected returns data on the Hong Kong stock market, I probably could have
retired by now!
The following table comprises information on the stocks of the Hong Kong and
Shanghai Banking Corporation (HSBC) Holdings and Swire Pacific A (Swire)
during the period of January 2, 2002 to May 31, 2002.
Stock
Standard deviation ()
HSBC
0.041%
1.16%
Swire
0.030%
2.09%
49
HSBC,Swire = 0.38
Data source: Datastream
For simplicitys sake, lets assume that there is an equally weighted portfolio
(i.e., wHSBC = 0.5, and wSwire = 0.5).
The return of the portfolio:
P 1.889 1.374
Now we can obtain the return on the equally weighted portfolio (0.036%) as well
as the standard deviation of the portfolio (1.374%). You should be aware that if
the weights of both stocks are changed, then the portfolios return and variance
will also change accordingly.
As I showed you earlier, the riskiness of the portfolio depends on three factors.
Suppose we keep the first two factors constant (i.e., wi and i) and assume that
the correlation of returns between HSBC and Swire (HSBC,Swire) varies.
Case 1:
If
This result shows that the portfolio variance is much higher than the previous
one when the actual HSBC,Swire = 0.38. Thus diversification does not reduce the
50
This result illustrates that the portfolio variance is almost reduced by half as
compared to the case when HSBC,Swire = 1. In other words, if we combine stocks
with returns that are less than perfectly positively correlated in the portfolio, then
the portfolios variance will be reduced significantly. This illustrates the concept
of diversification.
Case 3:
If
When the two assets are perfectly negatively correlated, the variance of the
portfolio is reduced significantly and approaches zero. If, say, we suppose
2HSBC = 2Swire = 2, then
3.7
In the numerical example stated in the previous section, the question we would
like to address is how low can portfolio variance be? The answer is quite simple
as long as the lowest possible value of correlation coefficient is 1 (1,2 = 1),
representing the case of perfectly negatively correlated assets.
The variance of the portfolio:
51
can be simplified to
2p = (w11 w22)2
and the portfolio standard deviation is
w1 1 1 w1 2 0 set w2 1 w1
w1
2
1 2
Example:
Lets think back to the numerical example of HSBC and Swire that I presented
earlier. We can calculate the proportions of HSBC and Swire in order to obtain a
zero variance portfolio. Let 1 be HSBC and 2 be Swire:
2.09
0.643
1.16 2.09
1 0.643 0.357
wHSBC
wSWIRE
Now we know the exact proportions of wHSBC and wSwire in a perfect hedge
portfolio if and only if HSBC,Swire = 1 (i.e., perfectly negatively correlated).
52
w1
2
1 2
and
w2 1 w1
If you can gain access to databases of stock prices or foreign exchange rates, then
it would be interesting to create a zero variance portfolio by using you yourself
as an activity.
Look at Figure 3.5, by combining both assets 1 and 2, we can create a new
portfolio with minimum variance relative to asset 1 and 2.
Now, lets expand the idea of 2 assets in 30 assets. If we have invested in 30
assets, the combination of different assets in different portfolios will give us a
new frontier known as minimum variance frontier as shown in Figure 3.6. The
frontier looks like a belt. The point where it is nearer to y-axis is the minimum
variance portfolio as shown in the figure.
53
SELF-CHECK 3.1
Learn to sketch the above diagram. Point to where exactly is:
(a)
(b)
(c)
Risk-free asset,
(d)
Efficient frontier,
(e)
3.8
54
In short, unique risks are many of the risks faced by an individual company are
peculiar to its activity, its management, etc. Take for example, company winning
an overseas contract, there are complaints filed on the products produced by the
company and there is pending governmental investigation. This risk can be
eliminated by diversification as shown in Figure 3.8.
On the other hand, businesses face economy-wide risks or market risks! These
risks will threaten each company. Example, there is sudden increase in the
exchange rate of US dollar against local currency, there is hike in the lending rate
in the economy due to policy of the central bank to fight inflation, etc. This risk
cannot be avoided, regardless of the amount of diversification.
55
SELF-CHECK 3.2
1.
2.
We have also learned how to calculate portfolio return and portfolio risk.
The correlation between two assets influences the portfolio risk. Hence, the
first step before forming a portfolio is to find out the correlation between the
two assets.
56
Correlation
Covariance
Diversification
Firm-specific risk
Minimum variance frontier
Minimum variance portfolio
Non-systematic risk
Portfolio return
Portfolio risk
Portfolio theory
Systematic risk
Unique risk
1.
2.
3.
4.
5.
6.
7.
8.
57
Given the monthly rates of return for ABC Berhad and XYZ Berhad for Question
1 to 5.
Month
ABC Berhad
XYZ Berhad
1
-0.04
0.07
0.06
-0.02
-0.07
-0.10
0.12
0.15
-0.02
-0.06
0.05
0.02
1.
2.
3.
4.
5.
Based on the correlation coefficient of ABC and XYZ, can these two stocks
offer diversification effect if we put them in our portfolio?
Given two assets with the following information for Question 6 to 8:
E ( R1 ) 0.15 E ( 1 ) =0.10 w1 0.5
6.
Calculate the mean and standard deviation of the portfolio if r1, 2 =0.40
7.
Calculate the mean and standard deviation of the portfolio if r1, 2 = - 0.60
8.
Plot the two portfolios on a risk-return graph and discuss the results.
Topic
Efficient
Frontierand
Asset
Allocation
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1.
2.
3.
4.
INTRODUCTION
The most important topic covered in this topic is the modern theory of portfolio
management. It has now been more than 50 years since the Markowitz portfolio
was introduced. The Markowitz portfolio theory is a set of methods to select an
optimal or the best portfolio. The landmark paper on Portfolio selection that
was published in the Journal of Finance enabled Markowitz to receive the Nobel
Prize in Economics in 1990.
The other task of this unit is learning to derive the capital market line (CML). The
CML shows the risk-return trade-off for all financial assets and portfolios. To
derive the CML, we will define the efficient frontier as a graph that represents all
portfolios that yield the highest level of return for a given level of risk. A rational
risk-averse investor will choose portfolios on the efficient frontier. The capital
59
market line is the linear combination between a risk-free asset and a risky
portfolio that is tangent to the efficient frontier.
We will introduce the construction and use of market indices. Broadly speaking,
a market index is a numerical value that measures the performance of the market
and also serves as a benchmark for portfolios and mutual funds.
4.1
Up to now you have learned how to reduce risk by forming a two-stock portfolio.
However, in the real world, we need to consider portfolios that consist of more
than two stocks. The Markowitz portfolio theory allows us to examine cases in
which the portfolio consists of more than two stocks. In other words, you can
think of the Markowitz portfolio theory as the generalisation of the portfolio
theory youve studied so far.
The Markowitz portfolio theory is a set of methods used to select the optimal or
best portfolio. According to this theory, an investor calculates and then compares
the rewards and risks of alternative portfolios. As you know, an investor who is
risk averse prefers portfolios with higher returns and with lower risks.
The Markowitz portfolio theory has been used extensively to choose the optimal
portfolio in a complex investment environment. The origin of the theory is vested
in the consumer optimisation theory from microeconomics. Markowitz published
the landmark paper on Portfolio selection in the Journal of Finance more than
50 years ago. This paper and other works on portfolio theory enabled Markowitz
to win the Nobel Prize in Economics in 1990.
You should first read the paper in the Journal of Finance in order to grasp its
insights on the Markowitz portfolio theory. The article is non-technical and you
would enjoy reading it.
In the remainder of this section, we will first review the construction of the
Markowitz portfolio and take you through an example of a three-asset portfolio
case. Next, we will see examples of how to construct the efficient frontier. Finally,
we will derive the capital allocation line (CAL) in a portfolio that consists of one
risk-free asset and one risky asset.
60
4.1.1
E ( rP )
w E (r )
i
i 1
i 1
j 1
i 1
j 1
2 P wi w j Cov(ri , rj )
or
2 P wi w j ij
HSBC,Swire = 0.43
HSBC,CP = 0.43
Swire,CP = 0.46
Standard deviation ()
0.74%
1.56%
1.91%
61
Again, assuming an equally weighted portfolio, the return and the standard
deviation of the portfolio are as follows:
Let HSBC be subscript 1, Swire be subscript 2, and CP be subscript 3.
rP
rP
2P
2(0.33)(0.33)(0.74)(1.56)(0.43) +
2(0.33)(0.33)(0.74)(1.91)(0.43) +
2(0.33)(0.33)(1.56)(1.91)(0.46)
=
=
By the same token, you can calculate the portfolio return and variance for a
portfolio that consists of more than three assets by extending the formula of
calculating the portfolio return as well as the portfolio variance. In Table 7A of
your Bodie textbook, a spreadsheet model shows how to calculate returns and
standard deviations for stock indices from seven countries. Thus you can use
Excel to do the same calculations. I would like to summarise the procedures of
estimating a portfolios return and variance as follows:
Step 1:
Step 2:
Pt Pt 1
Pt 1
Calculate the average return of each stock during the sample period
or holding period.
Step 4:
Once you obtain the average return of each stock in your portfolio,
you need to determine the weight or proportion of each stock in your
portfolio.
62
Step 5:
Step 6:
Now you can calculate both the portfolios return and its variance
(standard deviation) in Excel.
4.1.2
An efficient portfolio is one that gives the maximum return for a given level of
risk. The efficient frontier, on the other hand, is a collection of portfolios that has
the maximum rate of return for every given level of risk, or the minimum risk for
every potential rate of return. In other words, only the efficient frontier contains
all the optimal portfolios. Optimal portfolios implies the portfolios that yield
the highest rate of return for every given level of risk. I will start to develop the
construction of the efficient frontier by considering the case of a two-asset
portfolio again.
Recall, from our previous discussion, the expected return and variance of a twoasset portfolio as follows:
E(rP) = w1E(r1) + (1w1)E(r2)
Asset A
20%
10%
Asset B
10%
6%
Lets first assume that the returns between two assets are perfectly positively
correlated (i.e.,A,B = 1). Next I am going to vary the weights of the two assets and
then present the results in the graph. First, lets assume wA= 1 (i.e., all the wealth
is invested in asset A). The return and standard deviation of the portfolio are:
E(rP) = 1(20%) + 0(10%) = 20%
63
I now add the case in which wA = 0 and wB = 1. In this case, the expected return
and the standard deviation are the same for individual asset B. I can graph these
three computations as three points on the graph, and show what happens to
expected returns and standard deviation as the portfolio weights vary across the
assets. As the correlation between asset A and asset Bs returns = 1 (A,B = 1),
when I connect the three points together, they form a straight line, as shown in
Figure 4.1.
However, when A,B is not equal to 1, then the relationship is not going to be
linear. Let us recalculate the same three points (wA = 0, wA = 0.5, and wA = 1),
but with a different assumption of the correlation coefficient. Suppose that the
correlation coefficient (A,B) is equal to 0.75. In this case the returns on both assets
are positively correlated, but not perfectly correlated. For the two extreme cases
in which all wealth is either invested in asset A or asset B, the expected returns
and standard deviation of the portfolio are the expected returns and standard
deviation for that asset (we have shown this earlier). When wA = wB = 0.5 (i.e., an
equally weighted portfolio), the expected returns and standard deviation under
different assumptions of A,B are:
64
Correlation
coefficient (A,B)
1.0
0.75
0.5
0.25
0
0.5
1.0
wA = 1
E(rP) = 20%
P = 10%
E(rP) = 20%
P = 10%
E(rP) = 20%
P = 10%
E(rP) = 20%
P = 10%
E(rP) = 20%
P = 10%
E(rP) = 20%
P = 10%
E(rP) = 20%
P = 10%
wA = wB = 0.5
E(rP) = 15%
P = 8%
E(rP) = 15%
P = 7.52%
E(rP) = 15%
P = 7%
E(rP) = 15%
P = 6.44%
E(rP) = 15%
P = 5.83%
E(rP) = 15%
P = 4.35%
E(rP) = 15%
P = 2%
wA = 0
E(rP) = 10%
P = 6%
E(rP) = 10%
P = 6%
E(rP) = 10%
P = 6%
E(rP) = 10%
P = 6%
E(rP) = 10%
P = 6%
E(rP) = 10%
P = 6%
E(rP) = 10%
P = 6%
As indicated in the above table, when the correlation coefficient decreases, the
portfolios risk decreases as long as some wealth is invested in each asset. As the
correlation of assets in the portfolio decreases, we can reduce the risk of the
portfolio. We need to pay attention to ensure that the line relating risk and return
was straight when A,B = 1. When A,B = 0.75%, risk is reduced, so the line bends
to the left (i.e., becomes concave), as shown in Figure 4.2.
Figure 4.2: Portfolios return and standard deviation when A,B = 0.75
As shown in Figure 4.3, when the correlation coefficient drops further, the line
becomes even more curved (i.e., more concave).
65
Figure 4.3: Portfolios return and standard deviation when A,B = 0.5
What you have learned so far is that we can diminish risk by investing in assets
that are less than perfectly correlated. We can diversify our portfolio by owning
an amount of each financial asset. We can graph a large number of assets in riskreturn space. This graph looks like the top part of an umbrella. The outer curve
solid line represents the combination of assets that are efficient. This is known as
the efficient frontier (Figure 4.4). These are the efficient portfolios that yield the
highest-level returns given the level of risk (or the lowest level of risk given the
level of returns).
Once the efficient frontier has been set, it not only indicates whether our portfolio
is efficient, but also tells us how to adjust the components of our portfolio in
order to achieve the highest return with the same risk (the standard deviation of
return). However, although youve now been taught how to quantify the efficient
frontier, you might think that it is very complicated and difficult for you to do so,
or securities, because this
especially if a portfolio comprises a lot of stocks
involves a lot of calculations. Please dont worry - we have computers! There are
a lot of computer applications on the market that can help us develop the
66
efficient frontier for optimising our investment portfolio. Some websites even
offer free services for optimising portfolios for higher expected return! In the
following activity you will see how easy it can be for you to check whether your
portfolio is efficient or not!
ACTIVITY 4.1
Although there are some websites which can help us to do portfolio
optimisation
What I am going to introduce to you is an Excel template from Excel
Business Tools. Please visit the following Web address:
<http://www.excelbusinesstools.com/portopt.htm>
After going to the above Web address, you can click Try to download
the Excel template of portfolio optimisation for free. Assume that you
have the following investment portfolio:
Please open the Excel template from the Web address above. You will
see that there is a sample of five US stocks in the template. Please delete
these data and download the previous 32-month stock returns of the
above five stocks from Yahoo Finance, at:
<http://Malaysia.finance.yahoo.com/stock/index.php>.
After that, reset the Min Constraint and Max Constraint of each
stock to 0% and 100%, respectively. Please also change the current units
of each stock according to the number of shares shown above. Finally,
you can click Optimise Portfolio to see how efficient your portfolio is.
4.2
In a broader sense, capital allocation is the choice of investing funds in both risky
and risk-free assets. For instance, if you had RM1 million, how much would you
put into risk-free assets such as time deposits in a reputable bank, and how much
would you put into risky assets such as stocks, bonds, foreign exchanges, options
and futures, etc.? Asset allocation comprises the investment decision making
over the choices of different risky assets that I mentioned earlier. You should
read the following textbook selections as outline in the course guide in order to
learn more about the concept of capital allocation as well as asset allocation.
67
Now that youve read the text, you probably know how to calculate the weights
of a complete portfolio of both risk-free and risky investments.
4.2.1
The capital allocation line (CAL) is derived from the investment of a complete
portfolio that consists of one risky portfolio and a risk-free asset. You should
consult the following readings, after which I will summarise the concept of CAL
and provide you with numerical examples of the construction of the CAL.
Let us make a summary of the concept of CAL as follows:
Lets say the risk-free asset has a return rf (since the return is certain and there is
no expectation sign attached to it). The risky portfolio, however, has an expected
return E(rp) and variance 2P, and let y and (1 y) be the risky and risk-free
weights. Here I use y instead of w to represent the weights for differentiation of a
conventional risky portfolio to a complete portfolio.
Then the expected return of a complete portfolio (E(rCP)) holding positions in
risk-free and risky assets is:
E(rCP) = y E(rp) + (1 y)rf
Re-arranging the equation yields:
E(rCP) = rf + y[E(rp) rf]
The variance of the complete portfolio (2CP) is
P,rf is the correlation coefficient between the risky portfolio and the risk-free
asset, which is equal to zero.
In the equation of 2CP, the second and third terms are zero; it then reduces to
2CP = y22P, and the standard deviation is simply yP.
In Malaysia, the one-month or three-month Kuala Lumpur inter-bank offer rate
(KLIBOR) is a proxy for the return of the risk-free asset. In the US, the 90-day
treasury bill rate (TB) is a proxy for the return of the risk-free asset.
68
Suppose the one-month KLIBOR is 3% and the expected return and standard
deviation of a portfolio consisting of Malaysian stocks are 15% and 8%,
respectively. Then the return and standard deviation of the complete portfolio
are as follows:
E(rCP) = 3% + y[15% 3%]
CP = y(8%)
The actual outcomes depend on the value of y (i.e., the weight of risky stock
portfolios). Suppose y takes the values of 0, 0.5, and 1 and we obtain the
following table.
y
Expected return
Standard deviation
3%
0.5
9%
4%
15%
8%
The above table indicates that if y = 0, then the expected return is exactly the
same as the rate of return of the one-month KLIBOR (risk-free asset), and the
standard deviation is zero. If y = 1, then the expected return and standard
deviation are the same as the risky stock portfolio. If y = 0.5, then this is the linear
combination between the risky portfolio and the risk-free asset. This information
can be plotted in the following graph (Figure 4.5).
The straight line is known as the capital allocation line (CAL), and it represents
the risk-return combination that investors must encounter.
69
SELF-CHECK 4.1
The following table is an extension of the table in the topic above. Fill in
the blanks and plot the capital allocation line (CAL).
y
Expected return
Standard deviation
3%
0.5
9%
4%
15%
8%
1.5
ACTIVITY 4.2
How can you invest more than what you have in the portfolio P,
(i.e., Y > 1)?
4.2.2
Reward-to-risk Ratio
You should now see that the slope of the CAL is the reward-to-risk ratio:
S
E(rP ) rf
P
This is also known as the Sharpe Index, and it represents the risk-adjusted excess
rate of return. The definition of excess rate of return is [E(rP) - rf], which is the
numerator of the reward-to-risk ratio. The Sharpe Index is a performance
measure of portfolios and mutual funds. The higher the value of S, the more
preferable it is to investors or mutual funds managers, since it implies a higher
risk-adjusted excess rate of return. In order to have a higher value of S, we tend
to maximise the excess rate of return and to minimise the risk of the risky
portfolio.
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4.3
The derivation of the capital allocation line (CAL) is based on the assumption of
an active portfolio strategy. The derivation of the capital market line (CML),
however, is based on the assumption of a passive portfolio strategy. Instead of
constructing our own portfolio, the derivation of the CML employs a market
portfolio as the benchmark. In this section, I will first show you how to derive a
CML by using the market portfolio as the benchmark, and then I will talk about
the CML and the separation theorem. You should now refer to the textbook
sections to gain a better understanding of the CML and the separation theorem.
4.3.1
As you have learned, the efficient frontier contains the only efficient portfolios. I
will therefore construct a portfolio with the risk-free asset and one of the efficient
portfolios. This CML is drawn from the risk-free rate of return to a point just
tangent to the efficient frontier as shown in Figure 4.6.
Note that the CML is tangent to the efficient frontier at point M. Point M is
known as the market portfolio, which has to include all assets if investors are risk
averse. An investor who is risk averse chooses portfolio A such that the investor
allocates part of his/her funds to the risk-free asset, and the remaining funds to
the market portfolio. On the other hand, if the investor chooses portfolio B, then
that investor would borrow money at the risk-free rate, and invest all of his/her
funds - including the borrowed funds - in the risky portfolio, M.
71
We can derive the CML within the context of a two-asset case portfolio. The two
assets in the portfolio are the risk-free asset with the rate of return (rf) and the
market portfolio with the expected rate of return E(rM). Let w be the proportion
of the portfolio invested in the risk-free asset and (1 w) be the proportion
invested in market portfolio. The expected return of the portfolio will be:
E(rP) = wrf + (1 w)E(rM)
where rM is the rate of return on the market portfolio.
P = (1 w) M
From the standard deviation equation we can solve for w:
w = 1 (P/M)
We can also solve for 1 w:
1 w = P/M
We can then substitute for (w) and (1 w) in the expected return equation. This
substitution reveals:
E(rP) = [1 (P/M)]rf + (P/M)E(rM)
Simplifying the equation gives:
E(rP) = rf + [E(rM) rf] (P/M)
The above is the equation for the CML.
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SELF-CHECK 4.2
1.
2.
4.3.2
The separation theorem implies that portfolio choice can be separated into two
independent tasks. The first task is to determine the optimal portfolio purely
based on existing information from the market portfolio. This is rather passive
investment decision making. That is, if an investment analyst has data on the
market portfolio then he or she can achieve the optimal portfolio, as can other
investment analysts using the same data. This is exactly the point M on the
capital market line in Figure 4.6, which is tangent to the efficient frontier. The
second task is the personal choice of the best mix of the risky portfolio and the
risk-free asset. This means that the choice of any of the points moving along the
capital allocation line depends upon the risk preferences of individual investors.
We will talk more about the relationship between risk tolerance and asset
allocation in the next section.
4.4
4.4.1
The textbook provides a very good numerical example to show you how to
superimpose an investors indifference curves onto the capital allocation line.
You should consult the following reading to enhance your understanding of the
relationship between risk tolerance and asset allocation.
73
The first investor has a lending portfolio (i.e., has a lower tolerance for risk). This
investor chooses to invest part of his wealth in the risk-free asset and part of his
wealth in the risky portfolio. The lending portfolio is tangent at point L. This is
the point at which the highest indifference curve just touches the CAL. The
second investor has a borrowing portfolio (i.e., has a higher tolerance for risk).
This investor chooses to invest all her wealth in the risky portfolio. In addition,
this investor also borrows money from financial institutions at a set borrowing
rate, and has a leveraged portfolio. Here we implicitly assume that the lending
rate is the same as the borrowing rate, and is exactly the same as the risk-free rate
(i.e., rL = rB = rf). The tangency point of the indifference curve and the CAL is at
point B. Point B therefore yields the highest level of satisfaction for the investor
who has a high tolerance for risk.
As you can see, both the lending and borrowing portfolios have invested in the
same risky portfolio. However, the investor who holds the lending portfolio is
more risk averse and invests in both the risk-free asset and the risky portfolio.
The investor who holds the borrowing portfolio is less risk averse and invests all
her wealth in the risky portfolio.
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ACTIVITY 4.3
What will the CAL look like if the lending rate and borrowing rate are
not the same? In reality, the borrowing rate is, of course, greater than
the lending rate (i.e., rB > rL).
4.4.2
Your textbook illustrates the simple case for optimal weightings in a portfolio of
one risk-free asset and two risky assets. You are advised to read the following
section from your textbook; you should work carefully through the numerical
example provided, and be sure you should know how to calculate the optimal
weightings for a portfolio of one risk-free asset and two risky assets. Activity 2.9
in the textbook then guides you in obtaining the optimal weightings in a
portfolio for a two risky asset portfolio case; if you can handle Activity 2.9 easily,
then you should have no problem understanding the construction of an optimal
portfolio. However, if your portfolio has more than two risky assets, then you
will likely want to make use of computer software to figure out the optimal
weightings of your portfolio.
ACTIVITY 4.4
Suppose you have the following data on two risky assets:
Expected return
Standard deviation
Asset 1
12%
10%
Asset 2
8%
5%
2.
3.
4.
5.
4.5
75
In the construction of the capital market line (CML), we need to have the
information on the market portfolio (M). As youve learned, a stock market index
can serve as a proxy for this market portfolio. A stock market index is a number
that indicates the relative level of prices or value of securities in a market on a
particular day compared with a base-day figure, which is usually 100 or 1000.
There are three main types of index, namely price-weighted indices, valueweighted indices and equally weighted indices. You should learn more by
working through the following readings on the construction of stock indices in
the US as well as in Malaysia. The two commonly quoted stock market indices in
the US are the Dow Jones Industrial Average (DJIA) and the Standard and Poor
500 (S&P500) indices. In Malaysia, the Kuala Lumpur Composite Index (KLCI) is
the most important stock market index.
The main objective of constructing market indices is to measure the performance
of the relevant markets. By comparing the values of a market index over time, we
can see how a market is performing over different periods. Technical analysts
also use market indices to forecast the up and down trends of markets. They
argue that these patterns of market index movements tend to repeat themselves.
This kind of analysis requires a way to measure market performance. Besides
measuring market performance, however, returns on market indices may be used
as benchmarks to evaluate the performance of particular portfolios and mutual
funds.
Finally, market indices may be used to make comparisons on the performance
and riskiness of various international markets, thereby providing information
that can be used for international investments. We can try to find out, for
example, which market has out-performed others. In fact, there are lots of
financial futures instruments attached to market indices, such as the Hang Seng
Index futures (Hong Kong), the Dow Jones Industrial Average Index futures
(US), and the Nikkei 225 futures (Japan). See Figure 4.8 for an example.
76
77
investors hold a portfolio that consists of at least 20 stocks, then the portfolio is
considered to be well-diversified. A well-diversified portfolio implies that all you
have to be concerned with is non-diversifiable, or systematic, risk.
We have also learned the concept of capital allocation line and its application.
The construction of market indices and their usefulness have also been
discussed.
Asset allocation
Asset allocation Strategies
Benchmarks
Capital allocation
Capital allocation Line (CAL)
Capital Market Line (CML)
Dow Jones Industrial Average (DJIA)
Efficient frontier
KLIBOR
Kuala Lumpur Composite Index (KLCI)
Market indices
Markowitz portfolio theory
Optimal complete portfolio
Optimal allocation
Reward-to-risk ratio
Risk tolerance
Separation theorem
Sharpe index
Standard and poor 500 (S&P500)
Two-asset portfolio
78
1.
2.
3.
Standard deviation
T-bills
4%
0%
Bond A
12%
40%
Stock B
20%
60%
Calculate the weight, risk and expected return of the optimal risky
portfolio formed by bond and stock.
(b)
4.
5.
6.
Expected return
Standard deviation
T-bills
4%
S&P500 index
12%
20%
Portfolio A
15%
25%
Expected return
Standard deviation
8%
12%
10%
16%
30%
40%
9%
20%
15%
25%
7.
8.
79
Expected return
Standard deviation
T-bills
4%
0%
10%
11%
18%
16%
23%
18%
24%
20%
25%
25%
(a)
(b)
Asset 2
Expected return
12%
8%
Standard deviation
10%
5%
(b)
(c)
(d)
1.
2.
How efficient frontier can be used with an investors utility function to find
the optimal portfolio?
3.
4.
What does the term relevant risk refer to and how is it measured?
80
5.
How can one measure the beta of a portfolio when we know the beta for
each of the assets included in it?
6.
Discuss the feasible or attainable set of all possible portfolios with relation
to efficient frontier.
7.
8.
Discuss how to apply the concept of modern portfolio theory (MPT) from
the perspective of individual investor.
Topic
CapitalAsset
Pricing
Model
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1.
2.
3.
4.
5.
6.
INTRODUCTION
Investors want to know the fair value or equilibrium price of an asset. Once
they find out the appropriate, i.e. fair, price of an asset, they will compare it
with the market price. If the market price is higher than the fair price, then the
asset is said to be over-priced. By the same token, if the market price is lower
than the fair price, then the asset is said to be under-priced. For decades,
academics in the fields of finance and economics have tried to develop a model
that accurately predicts the fair value of an asset. In this topic you are
introduced to several asset-pricing models that can help us predict or explain the
fairor equilibrium returns on securities.
The capital asset pricing model (CAPM) serves exactly this purpose, i.e. of
predicting the fair value of an asset, so this is the first model we will discuss.
The CAPM is an extension of Markowitzs portfolio selection, which does not tell
us the fair value of an asset. Professor William Sharpe initiated the CAPM in
1964. The main theme of Professor Sharpes CAPM is to predict the return
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5.1
The CAPM is a simple asset-pricing model that helps us to determine the fair
values of assets. The integral element of the CAPM is the estimation of the beta
coefficient; that is, determining the CAPMs beta coefficient can help investors
select which securities to invest in. For example, if the beta value of a particular
asset is very high, say greater than 1, then we know that this particular stock has
a higher risk than the market portfolio.
CAPM is a simple model that requires certain strong assumptions to be held. If
these assumptions are not held, then the CAPM collapses. You should also note
that empirical tests of the CAPM show that the CAPM fails to predict and explain
the fair value of assets. The main reason for this failure is that some of
assumptions of the CAPM are not held in reality. Nevertheless, the CAPM is an
easy model to learn, and the construction of the CAPM is not sophisticated, so it
provides useful information on the risk characteristics of securities.
However, Markowitz portfolio selection is based on the information about
expected returns and the co-variances of the stocks concerned. However, using
historical information to construct a well-diversified portfolio will not make a
fortune for us. Only if we can measure the expected returns on stocks can we
make profits from our investments! In reality, the expected returns on stocks are,
of course, very hard to measure.
One thing that would be very useful, but which we dont yet have, of course, is a
model that accurately predicts what the expected returns on stocks should be.
The capital asset pricing model (the CAPM) is an equilibrium model that
represents the relationship between the expected rate of return and the return covariances for all assets. As you will learn later, this equilibrium is the most
important assumption of the CAPM. Equilibrium is an economic term that
characterises a situation where no investor wants to do anything differently.
83
Lets look at this example: if, for instance, you think the equilibrium price of
TENAGA stock at this moment is RM10 per share, and the market price of
TENAGA is exactly RM10 per share, then you may not want to trade (buy or sell)
TENAGA stock at this moment.
In other words, you would say that the stock of TENAGA is fairly priced.
However, if the market price of TENAGA stock were below the equilibrium
price, say RM9 per share, then TENAGA stock would be said to be under-priced.
If you know the equilibrium price of TENAGA is RM10, then you have the
incentive to buy TENAGA stock at RM10 per share, since you will earn a profit of
RM1 per share if the market price of TENAGA goes back to RM10 per share (i.e.,
the equilibrium price). When investors realise that TENAGA stock is underpriced, then the overall buying pressure will push the price up. After the market
adjusts, the price of TENAGA stock might eventually go back to RM10 per share
(i.e., the equilibrium price).
On the other hand, if the market price of TENAGA were RM12 per share, the
market price would be above the equilibrium price. Thus, TENAGA stock is said
to be over-priced. Investors have the incentive to sell over-priced stock. The
selling pressure would eventually take the price back to the equilibrium price, i.e.
RM10 per share.
In the real world, the equilibrium price will of course not be constant; it may
change in accordance with Malaysias economic fundamentals, or the internal
developments of TENAGA, the company.
Instead of using price, therefore, the CAPM expresses its results in terms of
returns to predict or forecast the equilibrium expected return of all assets.
Professor William Sharpe developed the foundations of the CAPM in a 1964
article. The contributions of Professor Sharpe earned him the Nobel Prize in
Economics in 1990.
Practically speaking, the CAPM is very useful for predicting the equilibrium
expected return on assets. Fund managers do, in fact, use this model to select
stocks in their portfolios. In the process of capital budgeting, financial managers
use the CAPM to evaluate the risk of new projects.
5.1.1
Before you learn more about the CAPM, you have to understand its assumptions.
This model must make a number of assumptions to formally derive the CAPM
relationship. Some of these assumptions can be relaxed without too much effect
on the results. In the later section on the extensions to the CAPM, we will discuss
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the effects on the model when some of its assumptions are relaxed. Of course,
relaxing its assumptions makes the CAPM more amenable to practical usage.
It is important to stress that the CAPM is a theory about the real world; it is not
necessarily a description of the real world. In order to evaluate the usefulness
and applicability of the CAPM we must thus try to determine how much the
theory corresponds to the real world. You can refer to the textbooks mentioned to
learn more about the assumptions of the CAPM.
You should now have a good grasp of the basic assumptions of the CAPM. Let
me make some critical remarks here regarding some of these assumptions.
(a)
Investors can borrow and lend any amount at a fixed, risk-free rate. The
implication of this assumption is that the rate of borrowing and rate of
lending are equal to the risk-free rate, in short (rB = rL = rf). However, in the
real world, the rate of borrowing is higher than the rate of lending (rB > rL).
The difference between the rate of borrowing and the rate of lending is the
spread that is regarded as the profit to the financial institutions (rB rL =
spread). In Malaysia, the Base Lending Rate (BLR) is much higher than the
savings and time deposit rates. Therefore, the difference between the BLR
and the time deposit rate is the spread that it provides profits for financial
institutions. By definition, the risk-free rate is the interest rate that provides
an appropriate default-free (riskless, guaranteed) investment. In the US, the
Treasury Bill Interest Rate is the proxy for the risk-free rate. In Malaysia,
Kuala Lumpur Interbank Offer Rate (KLIBOR) is the proxy for the risk-free
rate.
(b)
(c)
85
The simplifying assumptions underlying the CAPM were relaxed one at a time.
Each time, the implications of the model were slightly obscured. I will show you
in the subsequent section how the CAPM is altered if the assumptions are
relaxed one at a time. If all assumptions are relaxed simultaneously, however, the
results of the CAPM cannot even be determined. However, the fact that such
analysis is not derivable under realistic assumptions does not mean it has no
value. The CAPM still rationalises the complex behavior that is observed in the
financial markets.
ACTIVITY 5.1
That all investors are rational is an implicit assumption of both
efficient diversification and the CAPM. Do you think this assumption
is realistic? Why or why not?
In the real world, we do not expect all individual investors to behave rationally.
Of course, we expect most investors to be rational. Still, there are some investors
who behave irrationally. For instance, a risk loving investor might invest all of
her wealth in a single stock.
5.2
The market portfolio is an integral part of the CAPM. By definition, the market
portfolio is a portfolio of all risky securities held in proportion to their market
value. This means that the return on the market portfolio is given by the
following:
rM
v r
i i
i i
where
vi
86
financial time series databases such as Data Stream International. Fund managers
use these national market indices as the benchmarks for their locally or globally
diversified portfolios. Once we have the information on the market portfolio, we
can easily estimate the market portfolio risk premium. Youre introduced to this
in the next reading.
Investors now face two different investment instruments: namely, the risk-free
rate investment and investment in the risky market portfolio. If investors allocate
their wealth in these two investments, then the risk-free rate is considered as the
opportunity cost of holding the risky market portfolio. The opportunity cost is
defined as an implicit cost that equals the difference between what was actually
earned and what could have been earned in the highest-paid alternative use of
the capital. For instance, suppose a risk-averse investor has RM1 million to
invest. Lets say he allocates RM0.5 million to the risk-free rate investment and
the other RM0.5 million to the risky market portfolio. However, if another
investor is less risk-averse, she could invest the entire RM1 million in the risky
market portfolio. This investor will earn a higher rate of return because she bears
more risk.
The market risk premium is simply defined as the difference between the return
on the market portfolio and the return on the risk-free investment:
Market portfolio risk premium = E(rM) rf
The market portfolio risk premium is also known as the excess expected return
on the market portfolio. If the risk-free rate is getting smaller, then the excess
expected return on the market portfolio, or the market portfolio risk premium,
will be higher according to the definition of the market portfolio risk premium.
For example, if the annual expected return for the KLCI is 5%, and the annual
rate of the 1-month KLIBOR (the proxy for the risk-free rate) is 2%, then the
market portfolio risk premium is simply 5% 2% = 3%. The market portfolio risk
premium will not be constant over time; the market portfolio risk premium is a
time-varying parameter, which means that the market portfolio risk premium
will change from time to time. Both the expected return on the market portfolio
and the KLIBOR will change over time to reflect the changing economic
fundamentals in Malaysia.
5.2.1
Similar to the excess market portfolio return, the excess expected return on an
individual stock is defined as the difference between the expected return on that
individual stock and the risk-free rate (i.e., excess expected return = E(ri) rf).
The excess expected return on an individual stock could also be considered as the
risk premium of that individual stock. If the opportunity cost of holding risky
87
stocks is higher (i.e., the higher the level of the risk-free rate), then the risk
premium for an individual stock is smaller if the expected return on individual
stock is held constant. On the other hand, if the opportunity cost of holding risky
stocks is lower, then the risk premium for an individual stock is greater than if
the expected return on individual stock is held constant. Both the expected return
on an individual stock and the risk-free rate will change in response to economic
fundamentals. Thus, the risk premiums of individual stocks will also change over
time.
5.2.2
You need to know how the return on an individual stock is determined under the
framework of the CAPM. In the following reading youll learn more about the
theoretical background of the CAPM. After the reading, I will make some
comments that emphasize the application of the model.
So far we have discussed two important risk premiums, namely the market risk
premium [E(rM) rf ] and the individual stock risk premium [E(ri) rf]. The main
objective of the CAPM is to explain the relationship between these two risk
premiums. The relationship can be written in the following fashion:
E(ri) rf = i[E(rM) rf]
If we switch the term for the risk-free on the left-hand side to the right-hand side,
then we obtain the following:
E(ri) = rf + i[E(rM) rf]
This is the well-known relationship characteristic of the CAPM that shows that
the expected return on an individual stock is equal to the sum of the risk-free rate
plus the beta (i) times the expected market risk premium. The beta (i)
coefficient is the measure of the systematic risk of a stock, i.e. the tendency of a
stocks returns to respond to swings in the market portfolio. We will discuss the
beta coefficient and the estimation of beta in subsequent sections.
The intuition of the CAPM is quite precise. The expected return on individual
stock is equal to the opportunity cost of holding risky assets (i.e., rf) plus the
reward of bearing more risk, which is the second term of the CAPM (i.e., i[E(rM)
rf]). For example, if the annual rate of the 1-month KLIBOR (the proxy for the
risk-free rate in Malaysia) is 2%, the expected growth on the KLCI is 5%, and the
beta coefficient of HSBC stock is 1.2, then the expected return on HBSC is as
follows:
E(rHSBC)
= 2% + 1.2(5% - 2%)
5.6%
= 2% + 1.2(5% - 2%)
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5.2.3
There are two versions of the CAPM, namely the ex-ante version and the ex-post
version.
Ex-ante version: E(ri) = rf + i[E(rM) rf]
Ex-post version: ri = rf + i[rM rf]
The ex-ante version is based on information about the future market risk
premium, and the ex-post version is based on historical data related to the
market risk premium.
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SELF-CHECK 5.1
Lets say youve used historical data to obtain the following information:
Market risk premium = 10%
The required rate of return of an individual stock = 16%
The beta coefficient of the individual stock = 1.2
Assuming the CAPM holds, what is the risk-free rate (rf) in this case?
5.3
The CAPM analyses the linear relationship between an individual stock and the
market risk premium. We can actually plot this linear relationship into a graph.
This graphical presentation makes it easier for us to visualise the CAPM. When
the CAPM is depicted graphically, it is known as the security market line (SML).
Plotting the CAPM, we find that the SML will, in fact, be a straight line which is
similar to the capital market line (CML). The SML indicates the equilibrium
expected rate, or sometimes we refer to the required rate of return the investor
should earn in the stock market for each level of systematic risk (i.e., the beta). I
will now show you how to graph the SML and discuss the implications of the
SML thereafter.
5.3.1
The CAPM can be plotted by simply calculating the equilibrium expected return,
or the required rate of return for a series of betas when holding the risk-free rate
and the return on market portfolio constant. Referring back to our previous
example with HSBC using the ex-post version of the CAPM:
rHSBC = 2% + HSBC(5% - 2%)
The following table shows the required rate of return for a number of betas when
we apply the above CAPM to HSBC:
Beta of HSBC
0
0.5
1
1.5
2
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Plotting these values on a graph (with the beta on the horizontal axis and the
required rate of return on the vertical axis), we have a straight line that is known
as the SML (Figure 5.1). The SML clearly shows that as the beta (i.e. the
systematic risk) increases, so does the required rate of return. Any point along
the SML is considered as the equilibrium rate of return.
5.3.2
According to the CAPM, the SML reflects the equilibrium condition of a stocks
required rate of return and that of the market return. However, the securitys
actual return may not be on the SML. For instance, points U and O are not on the
SML in Figure 5.2.
As shown in Figure 5.2, point U lies above the SML and point O is below the
SML. When the actual return of a stock is above the SML, it is considered to be an
under-priced stock. In other words, the expected return of stock U is higher than
that predicted by the CAPM. Therefore, when investors identify stock U as an
under-priced stock, there will be pressure in the marketplace for buying it. As a
result, the price of stock U will be bid up and the expected return on stock U will
be lower. Please bear in mind that when the price of a security is bid up, its
return becomes lower since return at time t is defined as follows:
rt = (selling price buying price)/buying price
When the buying price is bid up because of buying pressure in the marketplace,
then the return at time t will be lower because the denominator is getting larger.
Eventually, point U will move towards the SML and an equilibrium condition
will be re-established.
91
By the same token, stock O is an over-priced stock, since its expected return is
lower than that of the equilibrium return. When investors see that stock O is
over-priced, then there will be pressure in the market for selling stock O. As a
result, the price of stock O will drop, and the required rate of return on stock O
will be higher when the equilibrium condition is re-established. Thus, when there
is a disequilibrium situation in the market place, the market forces of supply and
demand will push prices toward the equilibrium position suggested by the
CAPM.
The SML will not stay at the same position all the time it will move up and
down in accordance with economic fundamentals. In the real world, fund
managers tend to use the SML as an indicator to manage stocks in their
portfolios. Nowadays, thanks to widespread ease of access to financial databases,
we can easily estimate betas and plot the SML. The SML therefore serves as a
preliminary procedure for identifying under-priced and over-priced securities.
There are real limitations on using the CAPM/SML to predict return patterns for
securities. We cannot totally rely on the CAPM/SML to make our investment
decisions. You should understand right now, however, that the CAPM is not the
only tool that we can use to predict the returns on stocks. There are, of course,
other tools such as the multifactor model and arbitrage pricing theory (APT)
models, and using them is preferable to simply employing the CAPM on its own.
One of the major shortcomings of the CAPM is that we assume beta is stable over
time. In fact, the beta value of any stock will keep on changing. For example, lets
say you obtain a beta during a bull market period. Then, all of a sudden, the
market experiences a downturn. If you still keep on using the same beta to make
92
predictions, then the outcome will definitely be unfavourable. In this case, you
need to have a dynamic CAPM to handle the problem. The dynamic CAPM
allows the beta to be changed over time. In this case, the predictions that result
will be more reliable.
SELF-CHECK 5.2
Use all the information you have obtained from Activity 3.3 and plot
the security market line (SML). If the actual market return of the stock
is 18%, what is your investment decision?
5.4
SYSTEMATIC RISK
You know by now that the beta coefficient is a measure of systematic risk or nondiversifiable risk. It is your task in this topic to learn how to estimate the beta
coefficient of a stock. Once we obtain the value of the beta coefficient, we can
then use this beta value and plug it into the CAPM equation in order to obtain
the appropriate equilibrium expected return for an individual stock.
ACTIVITY 5.2
Lets say you are considering investing in two stocks, Stock X and
Stock Y. After doing your research, youve come up with some
information on these stocks, as given below:
Stock
X
Y
Beta
0.35
1.85
After you show the information above to your classmate he points out
that you have made some mistakes in your analysis. He further
explains that, as the beta of Stock Y is much greater than that of Stock
X, it is impossible for these two stocks to have similar total risk
(standard deviation of annual return). Do you think his argument is
correct? Why or why not?
5.4.1
93
To gain deeper insight into systematic risk, lets consider the estimation of the
beta coefficient from an ordinary least squares regression:
rit rft = i + i(rMt rf) + it
where
rit rft
rMt rf
it
In the above characteristics line regression, which is also known as the Market
Model regression, the alpha is the intercept in the regression, and the beta is the
slope of the regression. Remember, this is not the CAPM equation. This is a
regression that allows us to estimate the security beta coefficient. The CAPM
equation suggests that the higher the beta value, the higher the equilibrium
expected return. Note that this is the only type of risk that is rewarded in the
CAPM. The beta risk is referred to as systematic, non-diversifiable, or market
risk. This risk is rewarded with expected returns. The other type of risk, which
we mentioned in earlier topics, is known as unsystematic risk, or diversifiable
risk. This type of risk is represented by the error terms in the above states timeseries regression.
To sum up, the term i(rMt rf) represents the systematic risk or non-diversifiable
risk, and the it represents the error terms, which are also known as residual
terms in the regression, and which represent unsystematic risk or diversifiable
risk. The security characteristics line is the line of the best fit for the scatter plot
that represents simultaneous excess returns on an individual stock and the
market portfolio. This was illustrated in Figure 5.3
94
As you can see, this is just the fitted value from a regression line. As you learned
earlier, the beta will be the regression slope and the alpha will be the intercept.
The error in the regression, the epsilon, is the distance from the line (predicted) to
each point on the graph (actual). The CAPM implies that the alpha is zero. So we
can interpret, in the context of the CAPM, the alpha as being the difference
between the expected excess return on the individual stock and the actual excess
return. Therefore, in an equilibrium situation, the expected excess return on the
individual stock is same as the predicted excess return in the market. The alpha
value should be zero. If a disequilibrium exists in which the expected excess
return on the individual stock is not the same as the actual excess return, the
value of alpha should be non-zero.
Now, let me summarise the procedures for estimating the coefficients of alpha
and beta as follows:
(a)
Obtain the historical data on the individual stock (HSBC), the market
portfolio (the KLCI) and the risk-free return (the 1-month KLIBOR).
(b)
Calculate the excess return on the individual stock and the excess return on
the market portfolio (i.e., market risk premium).
(c)
(d)
Obtain the values of alpha and beta from the regression line.
(e)
95
You can also calculate the error terms or residual terms using the actual
data minus the values predicted from the regression line.
This is the most simple and standard way to obtain the values of alpha and beta
for an individual stock. There is, however, another even more direct way to
obtain the value of beta for an individual stock, as depicted in the following
equation:
i = Cov(ri,rM)/Var(rM)
where
Cov(ri,rM)
Var(rM)
The covariance between returns on the individual stock and the market portfolio
can also be written in the following equation:
Cov(ri,rM) =ri,rMrirM
Note also that ri,rM is the correlation coefficient of returns between the
individual stock and the market portfolio, which you have learned about in topic
2 in the context of portfolio risk. ri is the standard deviation of the individual
stock and rM is the standard deviation of the market portfolio. In other words,
once we know the covariance of returns between the individual stock and the
market portfolio and the variance of the market portfolio, we can easily obtain
the beta value right away.
Finally, note that the beta of the market portfolio is 1:
M = Cov(rM,rM)/Var(rM) = Var(rM)/Var(rM) = 1
The market portfolio (M) serves as a benchmark for investment decisionmaking. This provides a reference point against which the risks of other
securities can be measured. The average risk (or beta) of all securities is the beta
of the market portfolio, which is one. Stocks that have a beta greater than one
have above average risk, tending to move more than the market portfolio. On the
other hand, stocks with betas less than one are of below average risk and tend to
move less than the market portfolio. If we invest in a stock with a beta value
greater than 1, this is known as an aggressive investment (i.e., well encounter
risk that is higher than the average risk). Conversely, if we invest in a stock with
a beta value of less than 1, this is considered a defensive investment (i.e., well
encounter risk that is lower than the average risk).
96
5.5
So far we have focused on the use of the CAPM for an individual stock. We need
to be able to construct the CAPM to cover a portfolio comprising a series of risky
securities. This is so-called portfolio CAPM. In addition, in this topic we look into
the stability problem of beta - in other words, whether beta is constant over time.
Finally, we examine what happens to the CAPM if some of its assumptions are
relaxed.
5.5.1
Instead of having an individual stock, lets say we now have a portfolio that
consists of risky securities. The CAPM for a portfolio can be set out as follows:
rP = rf + P(rM rf)
97
where
rP is the equilibrium rate of return of a portfolio
p i wi
i 1
and
wi is the weights of individual stocks in the portfolio
The beta of the portfolio is the weighted average of the individual stock betas
where the weights are the portfolio weights. Thus we can think of constructing a
portfolio with whatever beta we want. All the information we need is the betas of
the underlying stocks. For instance, if I wanted to construct a portfolio with zero
systematic or non-diversifiable risk, then I could choose an appropriate
combination of stocks and weights that delivers a portfolio beta of zero.
Once we obtain the information on P, we can easily calculate the equilibrium or
the required rate of return of the portfolio. At this point you should understand
that the CAPM not only applies to individual stocks, but also to portfolios that
comprise a series of risky assets. Practically speaking, then, portfolio managers
can employ the CAPM to help manage their portfolios. The portfolio beta (P)
provides information on the risk profile of the entire portfolio and is useful in
portfolio managers investment decision-making.
SELF-CHECK 5.4
Lets say a well-diversified portfolio is composed of the following five
stocks:
Stocks
A
B
C
D
E
Prices
$10
$20
$5
$35
$50
Shares held
1,000
1,500
5,000
2,000
1,500
Beta ()
0.8
0.9
1.2
1.3
1.5
Lets also say that the capital asset pricing model (CAPM) holds, the
expected return on the market portfolio is 12%, the market portfolios
standard deviation is 8%, and the risk-free rate is 4%. What is the
expected return on this five-stock portfolio?
98
5.5.2
You should now be aware that beta is a measure of systematic or nondiversifiable risk. However, there is one question concerning the stability
problem of beta that we must raise here: is beta constant over time? I am sorry to
tell you that the answer is that beta is not constant over time. In other words, beta
is a time-varying parameter so its value will change at different time periods.
If the beta coefficient is not constant over time, then the CAPM will fail to predict
the equilibrium expected return or the required rate of return for an individual
stock as well as for a portfolio of stocks. This means a more advanced version of
the CAPM should be used to counter the stability problem of beta. However,
pursuing this is not within the scope of this course.
5.6
It is important to stress that the CAPM is a theory about the real world. It is not
necessarily a description of the real world. In order to evaluate the usefulness
and applicability of the CAPM, we must therefore try to determine how well the
theory actually corresponds to the real world. One way of doing this is to relax
some of its assumptions and thereby allow the CAPM to be more flexible and
correspond to the real world:
(a)
We can relax the assumption that the borrowing rate is equal to the lending
rate, and assume instead that the borrowing rate is higher than the lending
rate (i.e., rB > rL). As we have mentioned before, in the real world the
borrowing rate is indeed higher than the lending rate, and the spread
between borrowing rate and lending rate is the operating cost as well as the
profit of financial institutions. If separate borrowing and lending rates are
assumed, then two different CAPMs emerge:
E(ri) = rB + i(rM rB)
and
E(rj) = rL + j(rM rL)
The corresponding SMLs are depicted in Figure 5.4.
99
Figure 5.4: The SML for a borrowing rate that does not align
perfectly with the SML for the lending rate
(b)
There may be only a few percentage points of spread between the top and
bottom transaction cost bands. Within this band, it is not profitable for
investors to trade securities, because the transaction costs would consume
100
the potential profit that would induce such trading. Consequently, the
market will never attain the equilibrium situation indicated in the solid line
of SML, even if there are no changes in the other assumptions.
(c)
Incorporate taxes into the CAPM model. Many countries in the world have
legislated capital gains taxes as well as dividend income taxes for buying
and selling stocks. In the US an investor is subject to both capital gains tax
and dividend income tax when trading stocks. However, there are no such
taxes in Hong Kong except for the stamp duties that are levied on the
trading of stocks. With the existence of taxes taken into account, every
investor would see a slightly different CAPM in terms of after-tax returns,
since those returns would depend upon their particular tax situations. As a
result, a static equilibrium condition will never emerge, even if other
assumptions are maintained.
(d)
I believe that you are now very familiar with the CAPM. Before you go on to the
next section, I just want to ask you one more question. What useful implications
does the CAPM have for investors, in spite of its shortcomings?
For investors, the CAPMs implications can be summarised as follows:
(a)
If you are a diversified investor, all you need to be concerned with is the
systematic risk you bear. Total risk or the volatility of any individual
security in your portfolio is irrelevant.
(b)
(c)
101
The empirical evidence of CAPM has been shown using example a stock,
KLCI and KLIBOR.
Attainable frontier
Base Lending Rate (BLR)
Beta
Capital asset pricing model
Equilibrium price
Excess return
Expected returns
Fair value
Feasible frontier
Market portfolio
1.
2.
3.
102
4.
5.
Discuss the role of beta in the Capital Asset Pricing Model (CAPM).
6.
Discuss the relationship between security market line (SML) and the
Capital Asset Pricing Model (CAPM)?
7.
8.
1.
Given that the risk-free rate (Rf) is 10 percent and the market return (RM) is
14 percent. Compute the required return
2.
Stock
Beta
ABC
0.85
XYZ
1.25
E(R)
Beta
1.40
0.80
-0.90
(a)
(b)
(c)
Discuss the relative risk of each security based on (a) and (b).
3.
103
Use Capital Asset Pricing Model (CAPM) to find the required return for
each of the following securities.
Security
Rf (%)
Market Return(%)
Beta
1.30
13
0.90
12
-0.20
10
15
1.00
10
0.60
Given that the risk-free is 7% , market return is 12% and the following asset
classes which you are interested to invest in (for Questions 4 to 6):
Asset Classes
Beta
1.50
1.00
0.75
2.00
4.
5.
Using CAPM, calculate the required return on each of these asset classes.
6.
Draw the security market line (SML), based on answers from no. 5.
You are given a number of portfolios with their returns and risk (for
Questions 7 to 8):
Portfolio
Return(%)
Risk(%)
14
10
12
14
11
11
10
12
16
16
104
7.
8.
(a)
(b)
(a)
Which portfolio lies on the efficient frontier and explain the reason
why is these portfolios dominate the others in the feasible or
attainable set ?
(b)
Topic
TheArbitrage
PricingModel
APT
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1.
2.
3.
4.
5.
INTRODUCTION
106
6.1
Arbitrage Pricing Theory (APT) was introduced by Ross (1993, 1994) as a new
approach to explain the pricing of financial assets.
It is based on the law of one price i.e. two items that are similar must be sold at
the same price.
There are two assumptions:
(a)
(b)
Based on the (ii) assumption, security returns is said to be linearly related to a set
of indices as shown in equation 7.1.
(7.1)
Where:
ai = the expected level of return for stock i if all indices have a value of
Ij =
zero
the value of the jth index that affects the return on stock i
ei2
All indices are assumed to be unconnected with each other. Equation 7.1
represents a return-generating process that expresses the return of any security
as a linear function of a series of indices.
Using the above framework, a model can be constructed to explain stock returns.
Roll and Ross (1995) uses four macroeconomic factors to their model to explain
stock returns as shown in equation 7.2.
ER =
R f + 1 INF + 2 IP + 3 RP + 4 I + e
(7.2)
107
Where:
ER
=
Rf =
i =
INF =
IP =
RP =
I =
e =
Equation 7.2 assumes that stock returns are affected by four macroeconomic
factors, therefore it can also be known as a four-factor model. The unexpected
changes in the macroeconomic factors that affect returns are captured by the
sensitivities of the respective factors.
6.2
Figure 7.1: A positive relationship between factor returns and stock returns
108
Figure 7.2: A negative relationship between factor returns and stock returns
6.2.1
Passive Management
6.2.2
Active Management
As an active management tool, APT can be used to determine stocks that are
under-valued or over-valued.
109
1 INF + 2 IP + 3 RP + 4 I + e
(7.3)
If the estimated or forecasted return is above the required return given by the
stock sensitivity and the value of factors, the particular stock is purchased.
6.2.3
Performance Evaluation
As a multi-index model, the APT models are used in the area of portfolio
performance evaluation. In the example given in equation 7.3, it can be seen that
under APT, the expected performance of any portfolio is a function of the
portfolios sensitivity to inflation, the level of industrial production, bond risk
premium and interest rates. Hence, in evaluating the performance, these
influences on the return-generating process must be taken into account.
6.3
CAPM is a special case of the APT when there is only one factor involved and
that factor is the return to the market portfolio. In this instance, CAPM is
equivalent to APT.
APT is used in passive management, active management and portfolio
evaluation.
Generally, APT differs from CAPM in a few aspects:
(a)
APT recognises that there are other factors than market index that can affect
on securities returns.
(b)
(c)
(d)
The focus of APT is not on market portfolio, but rather on portfolios which
are sensitive to other macroeconomic factors such as inflation or industrial
production.
110
More importantly, the APT does not require the following assumptions:
(a)
(b)
(c)
The market portfolio contains all securities and is mean variance efficient.
ACTIVITY 6.1
As a fund manager, which are the macroeconomic factors that likely to
impact the performance of stock portfolios given rising price in the
goods market?
This topic introduced you to both the theoretical and practical aspects of
asset-pricing models. Generally speaking, asset-pricing models enable us to
predict assets returns. If investors can predict the returns on assets, then they
can make their investment decisions based on these predictions.
The CAPM is, in fact, a special case of a single index or factor model. A single
index model can be easily estimated by a simple regression. The slope of the
regression is the risk measure for a particular factor.
The arbitrage pricing theory (APT) is a model that asserts that, given that
certain securities are exposed to common factors and are on the same level of
risk, the returns on these securities should be identical. If the returns on such
securities are not identical, then arbitrage opportunities exist.
Practically speaking, both the CAPM and APT cannot pass empirical tests.
Tests of the CAPM indicate that the model fails to explain or predict the
return behaviour of securities. On the other hand, one can hardly perform
empirical tests on the APT.
111
Macroeconomic variables
Multifactor model
Risk factors
1.
2.
3.
What does the steepness of the slope of factor sensitivity in an APT model
reflect?
4.
5.
6.
7.
1.
2.
3.
4.
What kind of unit trust fund that mostly employ passive management
strategy?
5.
6.
7.
Name the three assumptions that APT model does not require to have.
8.
Given a APT model with risk free rate of 6%; sensitivities to factor 1 and 2
are 0.5 and 2; risk factor 1 and 2 is 0.02 and 0.01. What is the expected
return from the security?
Topic
Efficient
Markets
Hypothesis
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1.
2.
3.
4.
5.
INTRODUCTION
Previously, we have studied the Capital Asset Pricing Model (CAPM) in Topic 6.
From there, we have learnt how the returns of securities are measured against
market benchmark like Kuala Lumpur Composite Index (KLCI) or EMAS Index.
Hence, from Topic 6, we know that there are many market participants that
would like to sell and buy securities or stocks in the financial markets. Will the
price of stocks be influenced by the number of market participants?
In this topic, we are going to discuss the concept of Efficient Market Hypothesis
(EMH). This is an important concept on explaining how the flow of information
will affect the price of stocks with the assumption that there are many market
participants.
EMH has become one of the cornerstones of modern finance theory ever since it
was introduced in 1970. It has attracted researchers to conduct empirical works
on many stock markets. On the practical aspect, it has helped to explain the
formation of price in stock market. The speed of price formation can also be seen
113
as one aspect of stock market development. In well developed stock markets like
the US and Japanese markets, where the flow of information is faster, the changes
of stock price is sensitive to any social, political or economic news. For example,
the moment the news of worse than expected economic data is released to the
market, we can see that the US dollar will lose its value. We can also observe
certain stocks which are related to the economic sectors will suffer losses. This
phenomenon show that EMH works in these advance markets.
Having said the importance of EMH, we will also discuss market rationality in
the last part of this topic. The recent research on behavioral finance is a new
phenomenon. The new area attempts to explain what cannot be explained by
EMH.
In a glance, for this topic, we will firstly look at what is market efficiency.
Secondly, we will discuss on what are the different degrees of market efficiency.
Thirdly, we will learn about how we know that the market is efficient. Here we
will learn some empirical test to confirm or reject the hypothesis. Fourthly, we
will discuss the implication of EMH on activities of investing in stock market.
Finally, we will discuss the issue of market rationality.
7.1
EFFICIENT MARKETS
From investors point of view, under the assumption EMH, it can also be said
stocks are always traded at their fair value in stock exchanges, and investors are
unable to purchase undervalued stocks or sell overvalued stocks.
Fair value is the amount at which an asset could be exchanged or a liability
settled, between knowledgeable, willing parties in arms length transaction.
Also, under EMH, it is also impossible for investors or fund managers to
outperform the overall market through stock selection or market timing. The
implication is that, the only way investors can obtain higher returns is by
114
E ( p j ,t i | t ) [1 E ( R j ,t i | t )] p jt
(7.1)
Where
E
p jt
7.1.1
The nature of information does not have to be limited to financial news and
research. Any information about political, economic and social events, combined
with how investors perceive such information, whether they are true or false, will
be reflected in the stock price.
According to EMH, as prices respond only to the information available in the
market, and, because all market participants are privy to the same information,
no one will have the ability to out-profit anyone else in the market. In other
words, if the market is truly efficient, no investor will have the ability to out
perform the market.
115
The above paragraph is certainly a bad news for investors who want to out-beat
the market. But in the real world, is our stock market really efficient? We will
examine the question whether the market is truly efficient in Sub topic 7.5. Right
now, let us proceed to subtopic 8.2 to read about the degrees of efficiency.
ACTIVITY 7.1
1.
2.
7.2
DEGREES OF EFFICIENCY
According to Efficient Market Hypothesis (EMH), there are three types of market
efficiency as reflected by the degree to which it can be applied to as illustrated
Figure 7.1:
116
Degrees of Efficiency
Descriptions
Weak Efficiency
ii
Semi-strong Efficiency
iii
Strong Efficiency
SELF-CHECK 7.1
1.
2.
7.3
7.3.1
117
There are different empirical test for EMH for different degrees of efficiency. To
test for weak form efficiency, it is sufficient to use statistical investigation on time
series data of prices. News is generally assumed to occur randomly, so share
prices changes must also be random. To test for weak form efficiency, we can
use runs test, Von Neumanns ratio test and Ljung-Box Q Test.
Let us now elaborate runs test. Based on Table 7.2, we have 31 daily stock prices
of stock XYZ.
Consider a price series p1 , p 2 ,...., p n. in column two. The first step is to define the
natural log price changes as vt in column three:
vt ln pt ln pt 1
In Microsoft Excel, we can use ln(Pt/Pt-1) since log A log B is equivalent to log
(A/B).
In column four, we will state a positive sign for positive value of Vt, and a
negative sign for negative value of Vt.
118
119
In column five, we can count the blocks of positive change, negative change and
no change. In our example, number of blocks for positive change or m1 is 17,
number of blocks for negative change or m2 is 11. The number of blocks for no
change is 2. The total number of blocks for all the three groups or R is 15.
We sum up the total of m2, m3 as 414 and 6252 respectively. Since we lose one
data point when we calculate the return of this stock price, the number of
observations, n is only 30.
And we can calculate the Expected value of R and Variance of R with the
following formula:
mi 2
i 1
n
30 1 414 / 30
E R n 1
17.2
Var R
3
i 1
mi 2
3
i 1
mi 3 n n 1 2n
2
n n 1
3
i 1
mi 3 n3
3
414 414 30 30 31 2 30 6252 30 / 302 29
5.91172
R 0.5 E R
Var R
N 0,1
1/ 2
0.69918
If the R <= E(R), we add 0.5. If R>= E(R), we minus 0.5
Rejection region is Reject H0 if Z< - Z0.05 @ Z < -1.645
Decision : Do not reject H0 at =0.05 because -0.69918 > -1.645.
Conclusion: The stock returns are random (independent)
120
7.3.2
7.4
In order for a market to become efficient, investors must perceive that a market is
inefficient and possible to beat. Ironically, investment strategies intended to take
advantage of inefficiencies are actually the fuel that keeps the market efficient.
A market has to be large and liquid. Information has to be widely available in
terms of accessibility and cost, and released to investors at more or less he same
time. Transaction costs have to be cheaper than the expected profits of an
investment strategy.
Investors must also have enough funds to take advantage of inefficiency until,
according to the EMH, it disappears again. It is important for the investors to
believe that there are always positive possibilities to outperform market.
Sufficient conditions for capital market efficiency are:
(a)
(b)
(c)
121
If these conditions are met, in such market, the current price of a security
obviously fully reflects all available information.
In reality, are these conditions really met in the stock market? In real practice to
have costless information available to all participants is not what something we
can observe. In addition, the not all participants may agree on the implications of
current information for the stock price.
Recall the example of oil and gas company previously in subtopic 7.1, not all
participants in the stock market would agree that the stock price of this company
must go up. Some participants may think the discovery of new oil fields may
yield better gain to the company in the immediate future, but not instanteneous.
Hence, not all investors may immediately invest in this stock upon knowing the
news.
7.5
MARKET RATIONALITY
In the real world, the market cannot be absolutely efficient and totally inefficient.
It is more likely to see that the markets are a mixture of both. Some of
information is not able to be reflected immediately into the market. However, in
the age of information technology (IT), more and more people have greater
access to information via cable tv and internet, hence greater efficiency in terms
of speed. However, there is a downside of this excess information. Some times,
this information or news may not be true. Hence, IT can be said to cause less
efficiency if the quality of the information is questionable, investors are hesitate
to buy and sell stocks based on suspicious information.
7.5.1
The first argument against EMH is behavioural finance. This field of study
argues that people are not nearly as rational as stated by traditional finance
theory. The idea of psychology drives stock market movement as evidenced by
internet bubble and that subsequent dot come crash in the US.
The second argument against the EMH is market anomalies. Figure 7.2 illustrates
various market anomalies.
122
Market Anomalies
January effect
Turn of the month effect
Monday effect
January effect states that stocks in general have high historically generated
abnormally high returns during the month of January.
Turn of the month effect states that stocks consistently show higher returns on
the last day and first four days of the months.
Monday effect shows that Monday tends to be the worst day to invest in the
stock market.
Both of these phenomenon (behavioural finance and market anomalies) pose a
challenge to EMH.
SELF-CHECK 7.2
1.
2.
3.
Strong form;
(b)
Semi-strong; and
(c)
Weak form.
123
There are various empirical tests for different degrees of market efficiency.
One of the empirical test is known as runs test of which is used to test weak
form efficiency.
The impact of EMH to investment strategies and the need to have sufficient
condition where EMH can operate;
In the real world scenario EMH may not operate smoothly if there is an
absence of the sufficient conditions.
Overall EMH explains the flow of information with respect to stock market
investments.
Market anomalies
Market efficiency
Monday effect
Runs test
Semi-strong form efficiency
Strong form effficiency
Turn of the month effect
Von Neumanns ratio test
Weak form efficiency
1.
Why do think advanced financial markets like the US and Japan have
greater market efficiency?
2.
3.
4.
124
5.
What is ironical aspect of thinking that the market is inefficient in the first
place?
6.
7.
8.
1.
2.
3.
State the null and alternative hypothesis for testing weak form of efficiency.
4.
5.
6.
7.
.Hence, we can say that strong form hypothesis is valid with regards to
private information. Explain.
8.
Topic Fundamental
Analysisand
SecuritySelection
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1.
Discuss the meaning of fundamental analysis;
2.
Analyse the economic environment of investment;
3.
Evaluate the impact of business cycle to a company;
4.
Conduct industry analysis;
5.
Assess company based on principles of valuation; and
6.
Value common stocks using dividend discount models and the
earnings model.
INTRODUCTION
We have studied the basic portfolio theory and market models from Topic 1 to 7.
In this topic, we would like to go one step further to study what is known as
fundamental analysis and security selection. This topic is important because it
touches on the practical aspect of how fund managers select or make their
investment decision. Making investment decision is a complex process. It has to
be looked from many angles before final decision is made. We will begin the
topic by look into what is the meaning of fundamental analysis. We will relate
this analysis with the process of investment decision, various types of analysis
such as domestic and global economy analysis, business cycle analysis and
industrial sector analysis. Subsequently we look into company analysis.
Again, before we start this topic, we will like to introduce Mr Warren Buffet - the
world greatest investor (Figure 8.1). He is one of the famous investors who has
started the idea of value investing. He is certainly famous for his stock picking
skills. Enjoy the reading!
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TOPIC 8
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8.1
FUNDAMENTAL ANALYSIS
We start this topic by looking into fundamental analysis. Before we look into any
investment process, we must first examine the economic environment, then the
industrial sector we want to invest, and finally the company of which the stock
we want to invest into. As shown in Figure 8.2, the sequence of looking at the
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TOPIC 8
economy first, then industrial sector and finally company is known as top-down
approach.
In a snapshot, we can see that a company operates inside an industry, and the
industry operates in an economy. Hence, if the economy is in its upswing in
business cycle, then there is likelihood that company will have growth in sales
volume, translating into higher profit figure. Hence, it is important for any
investor to monitor the macroeconomic environment. The process of looking into
these three levels of analysis i.e. economy, industrial and company is known as
fundamental analysis. We start this topic by looking into fundamental analysis.
In Figure 8.2, in a snapshot, we can see that a company operates inside an
industry, and the industry operates in an economy. Hence, if the economy is in
its upswing in business cycle, then there is likelihood that company will have
growth in sales volume, translating into higher profit figure. Hence, it is
important for any investor to monitor the macroeconomic environment.
However, there is another aspect of looking at Figure 8.2, we can start by looking
at potential companies we want to invest, then the industry, and finally the
economy. This is known bottom-up approach. This approach is more suitable if
there are profitable companies with good prospect to invest in. This company can
be the market leader in its own right, either through high product differentiation
or low cost strategy.
8.1.1
TOPIC 8
Macroeconomic Analysis
Industry Analysis
Company Analysis
Figure 8.3: Analysis conducted using the top-down approach
The top-down approach finally comes down to picking the right, i.e. most
valuable, stock. This involves the valuation of a company. In addition to the
model we are going to introduce, of course there are many other models based
on free cash flow, operating cash flow, price/cash, price/sales, etc. You will learn
some of the details in the next reading. We start by considering the dividend
discount model and then the earning models.
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TOPIC 8
ACTIVITY 8.1
1.
2.
8.2
ECONOMIC ANALYSIS
There are three aspects we are going to talk about in this section. Firstly, we will
discuss components of Aggregate Expenditure. Secondly, we look into the key
economic variables and economic indicators. Lastly, we will put all the above in
business cycle analysis. We will apply the concept of business cycle analysis
again in industrial analysis in subtopic 8.3.
8.2.1
Aggregate Expenditure
In simple terms,
AE = C + I + G + X - M
where net exports are exports minus imports.
Hence, by looking at the above equation, we have to understand the performance
of an economy depends on the performance of the four components. Key
questions we ask about an economy are:
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132
8.2.2
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We look into key economic variables that are important to the economy. One of
the important macroeconomic variables is growth domestic product (GDP).
Gross domestic product (GDP) measures the value of output produced within
the domestic boundaries of the Malaysia over a given time period. An important
point is that our GDP includes the output of foreign owned businesses that are
located in Malaysia following foreign direct investment in the Malaysian
economy.
Another key economic variable is consumer price index (CPI). The Consumer
price index (CPI) is a weighted price index which measures the monthly change
in the prices of goods and services. The spending patterns on which the index is
weighted are revised each year, mainly using information from the Family
Expenditure Survey. The expenditure of some of the higher income households,
and of pensioner households mainly dependent on state pensions, is excluded.
As spending patterns change over time, the weightings used in calculating the
CPI are altered.
From the concept of CPI, we can measure the inflaction. The definition of
inflation is as follows: .Inflation is best defined as a sustained increase in the
general price level leading to a fall in the value of money Inflation is a key
variable for macroeconomics management of the Central Bank. By looking at the
inflation rate, Central Bank will decide whether to increase or decrease the
overnight policy rate (OPR) that will alter the level of economic activities.
There are many key variables in the economy. As stated in Table 8.1, there are a
number of macroeconomic variables that are categorised into three indices,
namely the leading economic index (LEI), coincident economic index (CEI) and
lagging economic index (LGEI). As shown in Table 8.1, coincident, leading and
lagging indices have six, eight and five components respectively. These economic
indicators are jointly developed by the Department of Statistics, Malaysia and
Center for International Business Cycle Research (CIBCR) at Columbia
University. Coincident indicators inform users on the current state of the
economy.
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Table 8.1: The Components of Economic Indicators in Malaysia LeadingCoincident and Lagging Economic Indices
1
2
3
4
5
6
1
2
3
4
5
6
7
8
1
2
3
4
5
8.2.3
Business Cycles
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TOPIC 8
another throughout the period from May 1997 to May 2003. We will relate the
graphs with the concept of business cycles.
140.00
300
120.00
250
100.00
80.00
MSCI
200
150
60.00
100
40.00
50
20.00
0.00
Ma
y
J u - 97
Se l- 97
p
No - 97
v
J a - 97
n
Ma - 98
Ma r- 98
y
J u - 98
Se l- 98
p
No - 98
v
J a - 98
n
Ma - 99
Ma r- 99
y
J u - 99
Se l- 99
p
No - 99
v
J a - 99
n
Ma - 00
Ma r- 00
y
J u - 00
Se l- 00
p
No - 00
v
J a - 00
n
Ma - 01
Ma r- 01
y
J u - 01
Se l- 01
p
No - 01
v
J a - 01
n
Ma - 02
Ma r- 02
y
J u - 02
Se l- 02
p
No - 02
v
J a - 02
n
Ma - 03
Ma r- 03
y03
Coincident
Lead
Lag
Growth
Value
Figure 8.2: The graphs of MSCI style benchmark and economic indicators
Source: www.mscibarra.com
TOPIC 8
As shown in Figure 8.3, in the passage across time, there different phases such as
economic boom (peak), slow down, recession and recovery. Economic Boom
occurs when real GDP grows much faster than the trend growth rate. In a boom
phase, aggregate demand (AD) is high and typically, businesses respond by
increasing production and employment. The main characteristics of a boom are
as follows: high aggregate demand, a tightening of the labour market, high
demand for imports and a wider trade deficit, strong company profits and
investment, a risk of a pick-up in inflation. In addition, companies many increase
prices and this can cause cost-push and demand-pull inflation.
Then there is economic slowdown. A slowdown occurs when real GDP continues
to expand but at a reduced pace. If a country can achieve growth without falling
into a recession, this is termed a soft-landing. Whereas a full recession is coined
a hard-landing. Next, there is economic recession. A recession means an actual
fall in real national output and a contraction in employment, incomes and profits.
In technical terms a recession is a period of two quarters (i.e. six months) when
real GDP declines.
During economic recession, government can use fiscal policy like having surplus
budget to activate the level of economic activities. The government can also
lowers interest rates, increasing consumption and investment. This is monetary
policy. By lowering the interest rates, the level of cash in the economy will be
increasing, as people will probably like to spend than save as the interest rate is
low.
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Next, as time passes by, the general economy is likely to become active again.
One of the reasons is that as more and more stocks of goods are being consumed,
people will start to demand for new goods and services. Hence, the production of
goods will become active again. Once the economy is in recovery phase, people
start to consume more goods, firms are keen to invest in plants and machinery,
government makes new purchases and the economy is once again moving
toward economic boom.
In addition to the above, economy is also bound to external shocks or crisis. As
stated in Table 8.2, there are many events that are responsible for the economic
shocks along the business cycle. They are the Asian financial crisis in 1997-98. It
was a crisis that started with the float of Thai currency the Baht which
eventually triggered shock wave to countries like Malaysia, Indonesia, South
Korea and other Asian countries. There is also dot-com bubble in the end of 2000,
which the stocks of many ICT companies lost substantial of their market price.
On the other hand, the 911 event in the US brought many repercussions to
international travel. Many airlines suffered losses as people were not willing to
travel. There was also SARS epidemic that was related to air-borne viruses.
Again, people were unwilling to travel due to the outbreak of this epidemic.
Table 8.2: Economic Events that affect the Business Cycle
8.3
Period
Event
1997-98
2000
Dot-com bubble
2001
911 event
2002
SARS epidemic
INDUSTRY ANALYSIS
TOPIC 8
The following reading from your text provides a very good introduction to
industry analysis.
Generally speaking, investors can obtain valuable insights about an industry by
looking for the answers to the following questions:
(a)
(b)
(c)
(d)
(e)
What are the governments policies towards the industry? To what extent is
the industry regulated? Is it regulated like public utilities are and, if so, how
friendly are the regulating bodies?
The above five questions can be answered in terms of an industrys growth cycle.
Generally speaking, there are four stages for the development of a particular
industry:
Stage 1:
The initial stage of the industry. Investors are not familiar with the
new industry. The industry is new and untried so the risk in investing
in this new industry is very high, especially the financial leverage risk.
Stage 2:
Stage 3:
Stage 4:
This is the last stage of the industry. The industry is either stable or in
decline. During this stage, the demand for the industrys products is
diminishing, and firms are leaving the industry since profits are
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8.4
COMPANY ANALYSIS
ri a b FR i e i
where:
ri is the return on ith companys equity, i = 1, 2, .., n (n companies)
is the intercept of the regression
is the slope of the regression and is also known as the sensitive measure
to the companys equity
FRi is the ith companys financial ratio, i = 1,2, , n (n companies)
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i is the random error disturbance term with zero mean and constant
variance i.e., i ~ N(0, 2).
To be more specific, supposing the price-to-earnings (P/E) is the most important
ratio that determines the equity value of a firm, the cross-sectional regression can
be written as follows:
ri a b P/ E i e i
We will discuss the relationship between equity value and the (P/E) ratio in
greater detail in the following section.
Once you understand ratio analysis, you can go through the following example
of financial statement analysis in your textbook. This example shows you how to
perform financial statement and ratio analyses in a practical fashion.
SELF-CHECK 8.1
Why is the price-earnings (P/E) ratio considered to be one of the
most important financial ratios that indicate the value of a stock?
8.5
In this form of valuation process, the intrinsic value of any investment is equal to
the present value of the expected cash flow benefits. In the case of common stock,
this converts to the cash dividends each year, plus the future sale price of the
stock. Another way to view the cash flow benefits from common stock is to
assume that the dividends will be received over an infinite time horizon - an
assumption that is appropriate so long as the firm is considered a going
concern.
The basic idea is that the value of common stock is simply the discounted value
of all the cash flows associated with the common stock. In general, the following
formula seems reasonable for making this calculation:
V0
D /(1 k)
t
t 1
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TOPIC 8
where:
V0 is the value of a common stock at time t=0
Dt is the estimated dividend to be paid by the common stock at time t
k is the appropriate disscount rate; k is also known as the required rate of
return from the CAPM.
The formula stated above cannot really be used in practice, however, since it is
unfeasible to estimate dividends for the infinite future! To make the formula
useful, we need to make some assumptions about the growth rate of the
dividends. For simplicitys sake, we assume that dividends are paid annually, so
D0 is the last years dividends (i.e., paid yesterday) and D1 is the amount of
dividends to be paid in one year, and so on.
8.5.1
In this case, dividends are assumed to remain unchanged forever. Thus, the cash
flows paid by the common stock constitute a perpetuity, and we have the
following formula:
V0 D1 / k
Solving the above formula for k*, i.e., the implied discount rate, and using P0 (i.e.,
the price of common stock at t = 0) to replace V0, we obtain:
P0 D1 / k * and k * D1 / P0
ACTIVITY 8.3
What kind of stock has a dividend growth rate equal to zero?
8.5.2
The constant growth model assumes that dividends grow at a fixed rate, which is
denoted by g, forever. In this case, the formula for the value of a common stock is
the following:
TOPIC 8
V0 D1 / k g and k g
Solving the above formula for k*, the implied discount ra te, and using P0 to
replace V0, we obtain:
P0 D1 /(k g) and
k*
D1
g
P0
Intuitively, the implied discount rate (k*) is the sum of dividend yield (D1/P0),
and the dividend growth rate or capital gain yield (g).
SELF-CHECK 8.2
Suppose the expected annual return on the S&P500 (the market
portfolio) is 8%, and the annual risk-free rate is 3.5%. The beta value
of IBM (IBM) is 1.2. IBMs dividends per share in 2006 were as
follows: first quarter US$0.50, second quarter US$0.45, third quarter
US$0.55, and fourth quarter US$0.60. Assuming a dividend growth
rate of 5%, estimate the value of IBMs stock in January 2008.
8.5.3
In the case of the constant growth model, we simply assumed that the dividend
grows in a constant fashion. This assumption is rather naive, as in reality a
dividend can be expected to grow in a non-constant matter over time. In
particular, according to the industry growth cycle hypothesis that we mentioned
previously, a company is likely to expand during the second stage of its industry
life cycle. If this is true, then the dividend may grow in accordance with the
firms expansion. Figure 8.4 displays a two-stage dividend growth model for a
particular firm. In the first stage, the dividend grows at a rate of 5% over the first
five years, and it grows at 9% forever thereafter.
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The multi-stage growth model assumes that before time T the dividend growth
rates can be changing from year to year in the way you find most appropriate.
Then, dividends grow at a constant rate g, i.e., dividends grow at g from T to T +
1, T + 1 to T + 2, and so on. Figure 8.5 shows a multi-stage dividend growth
model. In the first stage, the dividend growth rate is 5%, it grows at a rate of 9%
in the second stage, and the dividend grows at a rate of 7% forever thereafter.
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In the multi-stage dividend growth model, the formula for valuing a stock is:
V0
Dt
(1 k)
t 1
DT 1
(1 k)T (k g)
The above formula indicates that when T = 0, we have the constant growth
model.
8.6
The previous discussion was based on a model which states that a share of stock
is worth the present value of future dividends expected to be paid on the share.
This makes perfect sense. The only way a share of stock can improve the
investors ability to consume is for it to pay dividends. A stock is bought for the
future consumption opportunities it provides. And this comes only from the
dividends it provides. Without the potential for future dividends, a stock is
worth nothing.
In other valuation models, such as the earnings valuation model, dividends are
not explicitly part of the equation. In theory, underlying any ongoing stream of
dividends are the earnings of the firm. These earnings belong to the equity
shareholders. However, a firm will retain a portion of earnings (not pay them out
as dividends) to make additional investments, and it can be argued these
earnings should also be valued.
To do so, we can use the concept of earnings per share (EPS) to value stock. By
definition EPS is total earnings divided by total number of shares outstanding. It
is perfectly all right to value the EPS of stock as long as the reinvestment of
earnings is also valued. The worth of a share of common stock is equal to the
present value of all future expected earnings per share less the present value of
all future investments per share. The general earnings valuation model can be
expressed as follows:
P0
t 1
EPSt
(1 k)t
IPSt
(1 k)
t 1
and
P0
t 1
EPSt IPSt
(1 k) t
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where:
EPSt = the expected earnings per share in year t
IPSt = the expected investment per share in year t
This equation values the expected future earnings per share stream, which
legally belongs to the common stock shareholders. But it also values expected
future investments made by the shareholders in order to generate the EPS
stream.
8.6.1
The general earnings valuation model introduced in the preceding section can be
simplified considerably if future growth is expected to be constant. Again, using
g as the expected constant growth rate, the constant growth earnings valuation
model can be written as follows:
P0
EPSt IPSt
kg
The earnings valuation model is the equivalent of the dividend valuation model.
The dividend model relies upon net cash flows received by the investors in the
form of dividends. However, the earnings model explicitly takes into
consideration both legal ownership of earnings per share and the incremental
future reinvestment of earnings.
8.7
The price-earnings (P/E) ratio simply measures the market price of a share of
stock divided by earnings per share in that year.
P/E ratio
Market price
Earnings per share
The P/E ratio indicates the dollar price being paid for each dollar of a firms
earnings. P/E ratios are widely used by practitioners as a measure of the relative
prices of different stocks. The stocks current market price is easy to determine,
since it is reported in the financial press. Earnings per share (EPS), however, are
more difficult to determine. The easiest way of determining earnings figures is to
use the latest EPS shown on the firms financial statements. In this topic, I will
first discuss the valuation of stocks using the P/E ratio and then show you how
professional analysts use the P/E ratio.
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(b)
(c)
The easiest way to demonstrate this is to use the constant dividend growth
model that you learned in the previous section:
P0
D1
kg
Defining E1 as next years expected earnings per share, and using the fact that
g = (ROE x B) where ROE is the return on equity and B is the retention ratio, the
constant growth price model can be rearranged into a P/E ratio model as follows:
P0
E1 (1 B)
k (ROE B)
P0 / E1
E1 (1 B) / E1
1 B
k (ROE B) k (ROE B)
The above equation states that if dividends are expected to grow at a constant
growth rate, the P/E ratio is theoretically equal to the stocks expected dividend
payout ratio (1 B) divided by the difference between the required return and
the expected growth rate g = (ROE x B).
8.7.1
The P/E ratio provides information on stock capitalisation. A high ratio may be
an indication that investors expect high earnings in the future, while a low ratio
could indicate that investors do not expect high earnings in the future. The ratio
is of primary interest to practitioners and investors because it may provide
indications of future changes. A firm can also use the ratio as an estimate for its
cost of raising capital through equity (i.e., a low P/E ratio makes the cost higher).
The P/E ratio also serves as an index of risk: the higher the P/E ratio, the higher
the risk for that particular stock. In 2000, during the Internet bubble, some
Internet companies listed on the GEM board had a P/E ratio of over 500! You can
definitely see how high the risk of such Internet companies stock was at that
time.
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In this instance, we can observe that there is a concept called products life
cycle or growth cycle. We can apply this concept to a new car model, for
instance. When a new model such as SUV is introduced, the demand for this
new model will increase, and hence it is a growth stage.
Eventually more and more companies are producing this type of model, and
the market of the product will mature, and finally decline as new generation
of consumers prefer other type of car model.
Hence, a stock that can provide streams of future cash inflow from future
profitable projects will have higher price than other stock assuming similar
market capitalisation and risk.
From the projected dividends, we can value the stock using different models
such as the dividend discount model (DDM), the Gordon growth model or
multi-stage dividend discount model. Subsequently, we have also discussed
the valuation of common stocks using earnings model, the usage of P/E ratio
and how it can used to check whether a stock is overvalued.
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Bottom-up approach
Business cycle
Coincident Economic Index (CEI)
Company analysis
Consumer Price Index(CPI)
Crisis
Dividend Discount Model (DDM)
Earning model
Economic analysis
Economic boom
Economic environment
Economic indicators
External shocks
Fundamental analysis
1.
2.
3.
4.
5.
6.
7.
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8.
How is the Gordon Growth Model different from dividend discount model
(DDM)?
1.
2.
Using the Gordon growth model which assumes that dividends grow at a
constant rate rate forever, what is the value of a stock that pay a dividend of
RM1 per share next year, if the expected growth rate of dividends is 6% and
the shareholder require a return of 16% from their investment?
3.
In another scenario, using the Gordon growth model, what is the value of a
stock that paid a dividend of RM1per share last year, if the shareholder
require a return of 16% from their investment and if the expected growth
rate of dividends is 6%?
4.
Discuss the weakness of Gordon growth model? How this weakness can be
overcome?
5.
6.
ABCs stock earnings per share has decreased from RM7 to RM5, its
dividends per share has also decreased from RM2 to RM1.50, and its share
price decreased from RM70 to RM60. Given the above information,
comment what has happened on the P/E ratio of ABC stock?
7.
8.
Topic
Managing
Portfolios
Activeand
PassiveStrategies
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1.
2.
3.
4.
INTRODUCTION
150
9.1
INDIVIDUAL INVESTORS
9.2
INSTITUTIONAL INVESTORS
What are institutional investors? You may think of some big firms or banks with
lots of money. You would be right. How do these big firms differ from individual
investors? One of the major differences between institutional and individual
investors is that the former manage large amounts of funds. Individual investors
have more flexibility in terms of the type of investment they can invest in because
the investment policies of institutional investors are often restricted by laws,
regulations and rules. Institutional investors include pension funds, mutual
funds, insurance funds and banks. The constraints, objectives and investment
policies depend on the type of investor, and we will learn about all the aspects in
detail in this section.
9.2.1
Pension Funds
Pension funds are funds for retirement planning. The funds receive contributions
from individuals, firms and their employees. Two major types are defined benefit
and defined contribution.
Defined benefit pension plans promise to pay retirees a specific income stream
after retirement. The company contributes a certain amount to the fund each year
and the company also takes up the risk of paying the future pension to the
retirees. Any shortfall (due to poor performance of the fund) should be
compensated for in the future. The plan can take a conservative approach or a
more aggressive approach, but the return objective is to meet the plans actuarial
rate as set by actuaries. The actuarial rate of return depends on the firms benefit
formula, retirement pattern, worker age, current and future salaries, etc. These
factors are all constraints on the plan. The details of calculations are left for
professional actuaries.
On the other hand, defined contribution pension plans make no promise on
return. The benefits depend on the employees contribution and the return on
investment. The contribution plans are tax-exempted. The objectives and
constraints for the plan depend on individuals.
152
Which kind of plan would you want? It depends on whether you are the boss of
a firm or an employee. For the defined contribution plan, the firm has no
obligation and risks are borne by the employee. Do you want to contribute to
your pension? I cannot answer for you as you may have different views on the
risks involved and on the expected returns. You might choose a guaranteed fund
while I might choose a balanced fund. Your returns may be better than mine due
to the recent poor performance of the stock markets around the world. How
about the returns when you and I retire? I might end up getting much more than
you. Who knows?
9.2.2
Insurance Firms
I am sure you have directly or indirectly paid into some kind of insurance plan.
You might have paid for life or medical insurance. Your employer might have
paid for injury/accident insurance for you. We can classify insurance firms into
two categories in terms of investment objectives and constraints: life insurance
firms or non-life insurance firms.
For life insurance firms, cash outflows are generally more predictable based on
mortality rate. These firms receive premiums during the lifetime of an insured
person until a death benefit is claimed. The basic investment policy is to earn a
spread, like banks, which borrow at a lower interest rate (imagine what interest
rate banks pay to your deposit account) and lend out at a higher interest rate. A
positive spread means a surplus of reserve. The risk categories insurance firms
can invest in are limited. If an insurance firm invests too much in high-risk
categories of stocks or bonds, an extra fund must be set aside to protect
policyholders.
For non-life insurance firms, the cash flow is not predictable due to the nonpredictability of claims from accidents, lawsuits, disaster, etc. Casualty insurance
firms put their insurance reserve in bonds for safety purposes and for provision
of a source of income for claims. The capital and surplus funds are invested in
equities for growth.
Liquidity needs also constrain insurance firms investment policies. A life
insurance policy requires a long-term investment. Owing to the nonpredictability of the claim pattern of non-life insurance firms, their investment
time horizons are shorter.
Tax may be a concern for return as insurance firms pay income and capital gains
taxes at the corporate rate.
9.2.3
Mutual Funds
You may recall that mutual funds are pools of money from different investors.
Each mutual fund has its own objective like high growth, high income, capital
appreciation, etc. Investors should understand the objectives of a mutual fund
before they choose one. Although there are rules and regulations restricting the
investment a fund can make, fund managers can choose the investments within
restrictions. This means that although you are free to choose, for example, an
equity fund, you are not free to choose which particular equities the fund itself
actually invests in.
9.2.4
Banks
Many of you have likely worked in banks or know a lot about them. You know
that there are banking ordinances governing the operations and requirements of
a bank. You can go to <http://www.bnm.gov.my> to look at the banking policy
and supervision. Although it contains lots of details, you might start with the
Three-Tier Banking System to understand the basics.
A bank must attract investors in order to have funds to lend. It is obvious that
banks have to generate returns in excess of their costs in order to be successful. In
other words, a spread must be earned from lending out. If you were the banks,
think about how you could achieve these goals.
9.3
Having understood the concept of individual and institutional investors, you will
proceed to portfolio construction. There are two styles of constructing a portfolio,
namely active portfolio management and passive portfolio management. Active
portfolio management involves buying and selling portfolios with the objective
of earning positive abnormal profit. An active management investment style
attempts to engage in:
(a)
Selectivity, that is, identifying securities or portfolios that are winners (and
losers); and/or
(b)
Timing, that is, identifying when weights in asset classes (stocks, bonds,
cash, real estate, gold, foreign stocks, foreign bonds and foreign currencies)
should be changed.
154
9.4
In this section, I wish to share with you the proper approaches to active
management and how to construct a portfolio in the framework of the active
portfolio management style. You may be aware that an institutional investor will
spend millions of dollars to subscribe to financial databases and hire doctoral
graduates in financial engineering to conduct financial analysis in order to earn
positive abnormal profits. The concept is very simple: if the institutional investor
invests 5 million dollars in subscribing to financial databases, purchasing superpower computers and hiring doctoral graduates in financial engineering in order
to earn 6 million dollars of profit, it is still worth it to that institutional investor to
do so. On the other hand, individual investors do not have proper resources for
them to perform the active portfolio management style. It is no wonder that on
average, institutional investors are able to make positive abnormal profits better
than individual investors.
The following analysis of approaches to active portfolio management is from the
perspective of an individual investor, and then we will go on to discuss the
approaches to active portfolio management from the perspective of an
institutional investor.
9.4.1
(a)
Security Selection
Security selection is the process by which an investor identifies the optimal
portfolio considering all the individual securities at the same time. Observe
that to generate an efficient set from all the securities in the market, you
need forecasts for the expected returns, standard deviation, and covariances for all available securities. However, excessive costs would be
incurred if the optimal portfolio were determined by taking into account all
the individual securities simultaneously.
(b)
Strategic asset allocation refers to what the investor wants the weights
to look like, on average, over the long term.
(ii)
Tactical asset allocation refers to what the investor wants the weights
to look like now, given the current conditions in the financial
markets.
Note that this two-stage procedure simplifies our problem of finding the
optimal portfolio by constructing efficient sets of subsets of securities.
(c)
(d)
Market Timing
Market timing mainly focuses on forecasting asset classes without security
selection (i.e., do not try to identify winners and losers). For instance,
assume you invest in three classes of assets: stocks, bonds and currencies.
Then based on forecasts for the expected returns and risks of these three
classes of assets in the immediate future, you may determine the weights in
your portfolio. It follows that for each class, you may want to buy a welldiversified representative portfolio of the securities in that class.
(e)
Portfolio Revision
Portfolio revision involves changing the current holdings in the portfolio.
An investor with an active portfolio management style must conduct costbenefit analysis.
Benefits - intended to improve risk-return profile, expect either higher rate
of returns or lower risk, or both.
156
Commission
Bid-ask spread
Making use of derivatives (i.e., forwards, futures, options and swaps, etc.)
allows the investor to change the weight of each class of assets in the
investors portfolio at minimal cost.
ACTIVITY 9.1
You have a portfolio consisting of local and foreign equities and bond
funds. They are maintained at a fixed percentage. Recently, you heard
that rebalancing once or twice a year can boost your return by one to
three per cent per year. What do think about this strategy?
9.4.2
(b)
(d)
(e)
Implementation stage
The implementation stage beings by periodically adjusting the asset mix to the
optimal mix, which is known as strategic asset allocation. In addition, the
selection of the fund manager, the tactical asset allocation and the security
selection decision are made at this stage. Figure 9.2 summarises all the processes
at the implementation stage.
158
Monitoring stage
There are three processes involved at the monitoring stage. In the first place, the
actual portfolio held should be examined to ensure that it is compliant with the
statement of investment policy to determine whether any rebalancing of the asset
mix is required. Second is the evaluation of investment performance. This
consists of an evaluation of returns on the aggregate portfolio, each asset class
and the fund managers, and the returns from any speculative strategies used.
Thirdly, adjustments to the statement of investment policy and fund managers
should be made if deemed necessary. Figure 9.3 summarises the process of the
monitoring stage.
Example
The following information in Tables 9.1 and 9.2 was obtained from the 1999
annual report of Fidelity Magellan Fund and Bloomberg. These tables serve as an
example to show you how an institutional investor revises the portfolio during
the monitoring stage.
160
Weight in
Magellan
Weight in
Magellan
Weight in
the S&P 500
Rank in the
S&P 500
as of
03/31/98
as of
09/30/97
as of
03/05/99
as of
03/05/99
3.5%
3.0%
3.3%
Microsoft Corp.
2.2%
1.3%
3.7%
1.7%
1.2%
1.9%
Citicorp
1.5%
1.4%
1.3%
14
Cendant Corp.
1.4%
1.2%
0.1%
160
1.4%
1.0%
2.0%
1.4%
1.1%
0.9%
25
1.3%
1.1%
1.2%
16
1.1%
0.6%
1.5%
Philip Morris
Companies, Inc.
1.1%
1.3%
0.9%
24
STOCKS
Weight as of
03/31/98
Weight as of
09/30/97
Technology
15.3%
16.8%
Finance
13.1%
12.3%
Health
11.7%
9.2%
Retail &Wholesale
8.6%
7.2%
8.1%
8.2%
Stocks
96.2%
95.9%
Short-term investments
3.8%
4.1%
Foreign investments
8.6%
8.2%
ASSETS
ACTIVITY 9.2
The investment decisions made by most of the institutional investors
are based on qualitative judgements. Can you think of any types of
quantitative investment decision-making techniques that might be
implemented?
9.5
What are active management strategies? As the words imply, you have to
actively participate in forming the strategies.
Active management strategies can be categorised into three areas:
(a)
Fundamental analysis.
(b)
Technical analysis.
(c)
162
9.5.1
Fundamental Analysis
You learned about fundamental analysis: the top down and bottom up in
Topic 8. You should review those topics if you have forgotten what they are. These
are the basic strategies for fundamental analysis in active management. As
mentioned in the reading, active managers generally use three generic tactics when
attempting to add value to their portfolios relative to the benchmark. They are:
Try to time the equity market by shifting funds into and out of stocks, bonds
and T-bills depending on broad market forecasts and estimated risk
premium.
Shift funds among different equity sectors and industries (property, finance,
high tech., etc.) or among investment styles (large capitalisation, value,
growth, etc.) to catch the next hot concept.
The reading pointed out that asset and sector rotation strategies can be extremely
profitable but also very risky. On the other hand, stock-picking strategies can be
more reliable but less profitable strategies. Do you agree?
Can an individual investor follow the above strategies? It would not be that
difficult for you to pick stocks as the Internet can provide a lot of information on
individual stocks or you can simply subscribe to some information providers
(like Bloomberg, etc.) for financial information. On the other hand, shifting funds
among assets or sectors may be more difficult for small investors.
Moreover, the transaction costs will be higher than for institutional investors.
Institutional investors may also have more information on which assets or sectors
have more potential than you do.
9.5.2
Technical Analysis
These strategies are not difficult for individual investors to implement; however,
you need to have a large database and some computer programs in order to track
the stocks performance. Therefore, unless individual investors have plenty of
resources or access to past stock prices, they will find it hard to implement the
strategy effectively. Some financial websites and newspapers do provide
information such as which stocks had the biggest rise/fall of the day and
technical analysis facilities; these are some cheap resources for implementing the
strategies. As we mentioned in the previous topic, Yahoo Finance allows you to
do some technical analysis on stocks you picked. Of course you cannot do it on a
larger scale, such as ten stocks at the same time.
Figure 9.4 shows an example showing the top ten gainers of the day. You can
monitor the performance of the gainers to see whether the information helps.
164
9.5.3
In the reading, it mentioned anomalies like the January effect and the weekend
effect and pointed out that the annual fees of the former strategy are not justified
while the latter strategy is not cost effective. The reading suggests the approach
of forming portfolios based on the characteristics or attributes of companies is
more promising. Again, financial websites do provide that kind of information,
e.g. firm sizes, P/E, P/BV and other financial ratios. The key point is that we are
analysing many stocks instead of a few individual stocks, and this poses
difficulties to individual investors with limited reso
9.6
In this section we will talk about bond portfolio management strategies rather
than the calculation details.
The participation rate of individual investors, especially small investors, in fixed
income securities is much less than the participation rate in equities. Therefore,
the topics covered here apply mostly to large or institutional investors.
According to the reading Active management strategies, for bond portfolio
management strategies there are five management strategies available:
Valuation analysis
Credit analysis
Bond swaps.
this strategy is whether you have the ability to forecast the direction of the
interest rate. The reading also discusses what will happen if the interest rate
moves in the opposition direction.
(b)
Valuation Analysis
Valuation analysis involves the portfolio manager trying to select
undervalued/overvalued bonds based on their intrinsic value, which
depends on the characteristics of the bonds. The key to success depends on
the understanding and accurate estimation of the important characteristics
of a bond. Bond valuation has been covered before, and therefore will not
be repeated here.
(c)
Credit Analysis
As the name tells you, this is about the analysis of the credit of the bond
issuer. The key is to correctly project rating changes prior to the
announcement by rating agencies. The reading has detailed discussion of
the credit analysis of high-yield (junk) bonds and credit analysis models.
You should make sure that youve read the relevant sections carefully so
that you have an overall picture of how this method works; you dont need
to remember the details of the model.
(d)
(e)
Bond Swaps
These involve swapping (exchanging) one bond for another hoping to
improve return. As mentioned in the reading, the market may move against
you and cause you to incur loss. You should go through the details of the
three bond swaps (pure yield pickup swap, substitution swap and tax
swap) in the reading. Make sure you understand the benefits and the
potential risks of the swaps.
In addition to what we have just learned, you can find additional references
about active bond portfolio management strategies in Chapter 17 of Bond
166
9.7
9.7.1
Have you ever bought stock? If so, what was your trading strategy? Did you buy
stock and then plan to hold on to it for years? Or, did you buy it with the aim of
making a quick profit and then end up waiting for years because its price has
been dropping since the day you bought it? How about TENAGA stock, for
example? Are you still holding it now if you bought it at, say, $20, $10 or even $6
per share?
The point is, we cannot assume that a buy and hold strategy is really so simple.
On the one hand, of course, you can randomly buy some assets and then leave
your portfolio unattended for years. In so doing, it could be said you are actually
using a buy and hold strategy, but this is hardly likely to produce a good
return on average in the long run. On the other hand, the buy and hold strategy
has some very successful practitioners. Warren Buffet, one of the wealthiest
investors in the world, applies a buy and hold strategy but this does not imply
that everyone using a buy and hold strategy will end up a billionaire!
In the buy and hold strategy, a portfolio manager typically buys stocks in such a
way that her portfolios returns track those of an index over time. To track an
indexs performance (an indexing strategy), you have to keep track of the change
of the index constituent stocks. Occasional rebalancing occurs because dividends
are reinvested and stocks merge or drop out of the target index and other stocks
are added. Usually this kind of portfolio is not targeted to beat or outperform the
index but just to match/track its performance. Of course, an active strategy
would try to beat the index.
Lets now take a closer look at how a passive index portfolio can be constructed.
The following three approaches are common ways to form a passive index
portfolio under a buy and hold strategy.
(a)
Full Replication
In this variation on the buy and hold strategy, all securities in an index are
purchased in proportion to their weights in that index. For example, in a
Bursa Malaysia Composite Index portfolio, you would have to buy the 100
constituent stocks according to their market value. What are the
disadvantages of this strategy? High transaction costs and the reinvestment
risk of dividends cannot be ignored! A good example is the Tracker Fund
which tries to track the performance of the Bursa Malaysia Composite
Index.
(b)
Sampling
This strategy entails buying only a representative sample of stocks that
comprise the benchmark of an index. That is, the difference between
sampling and full replication is that sampling considers a sample of stocks
that can represent the movement of the index instead of holding all the
constituent stocks. Again, what would you do if the portfolio tracks the
Bursa Malaysia Composite Index (BMCI)? Yes, buy a few stocks with large
market capitalisations. What are they? TENAGA, TELEKOM, Maybank etc.
Sampling saves on transaction costs, but it may not closely track the index.
168
(c)
Programming
This strategy uses historical information on price changes and correlations
between securities to determine the composition of a portfolio that will
minimise the tracing error of the index. The drawback is that it depends on
historical prices. For example, adding any stock to a portfolio tracking the
BMCI can be a reasonable choice, if the correlation between the returns on
the particular stock and BMCI is close. A simple way to calculate such a
correlation is by using the correlation function of Excel to determine the
correlation coefficient of the two assets within a given period. Of course
you should not add stocks with negative correlation. A drawback of this
strategy is that without programming team support or good programming
knowledge, you may find it hard to conduct in practice.
9.7.2
Dollar-cost Averaging
9.7.3
Constant Beta
Unlike an active strategy, a passive strategy will not try to change a portfolios
beta based on economic forecasts. You have learned about beta in previous units.
Please revise if youve forgotten what a portfolio beta is. The key is to manage
cash inflows and outflows without harming the portfolio index tracking ability.
Futures contracts are typically used to fulfill such tasks.
Before ending this section, you should note that a passive strategy is not a
strategy trying to earn maximum returns, which requires experts searching for
value stocks continuously. You should now do the following activity.
We have also discussed the two types of strategies i.e. active strategies and
passive strategies.
Active equity portfolio management for equity portfolio involves three areas:
fundamental analysis, technical analysis and anomalies and attributes.
Active equity portfolio management for bond portfolio involves interest rate
anticipation, valuation analysis, credit analysis, yield spread analysis and
bond swaps.
Passive equity portfolio management involves buy and hold, dollar cost
averaging and constant beta.
Fundamental analysis
Individual investors
Institutional investors
Interest rate anticipation
Passive equity portfolio management
Technical analysis
Valuation analysis
Yield spread analysis
1.
2.
Has the widespread access of internet reduced the information gap between
individual investors and institutional investors?
3.
4.
5.
Who are institutional investors? What are their strengths and limitations?
6.
There are two types of pension scheme. Explain the differences between
them.
7.
170
8.
1.
2.
What are the stages for institutional investors when they implement active
portfolio investment strategies?
3.
What are the two types of asset allocation strategies usually used by
investors?
4.
Discuss the five stages within the initial planning stage of an institutional
investor.
5.
6.
What is the strategy of sampling and how it differs from full replication?
What are the pros and cons of this strategy?
7.
8.
Topic Evaluationof
10
Portfolio
Performance
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1.
2.
3.
4.
5.
6.
INTRODUCTION
We have finally come to the last topic of this module. In this topic, we are
interested in measuring the portfolio investment we have made. Like anything
else in life, we want to measure whether our investment has achieved the goals
we have set for it. It is important to measure the portfolio performance. Why?
Each of us may have different financial goals like providing education fund for
our children or saving up monies for retirement when we invest in financial
assets. Hence we want to know whether these financial goals can be achieved
after a period of time. We start this topic by explaining the importance of
performance evaluation. This is followed by the methods of measuring returns
and adjusted returns.
We also discuss benchmarking and a series of new indices introduced by Bursa
Malaysia to Malaysian stock market. Subsequently we discuss Sharpe ratio,
Treynors measure, Jensens Alpha and the application of these measurements.
Lastly, we explain what is meant by market timing and stock selection skills.
172
TOPIC 10
Again, we will start this topic by introducing the excerpt of an article from the
Journal of Portfolio Management written by Professor William Sharpe. This
article is published in 1994, 25 years after Sharpe ratio was first introduced.
Enjoy the reading!
The Sharpe Ratio
William F. Sharpe
Stanford University
Reprinted fromThe Journal of Portfolio Management, Fall 1994
This copyrighted material has been reprinted with permission from The Journal of Portfolio Management.
Copyright
Institutional
Investor,
Inc.,
488
Madison
Avenue,
New
York,
N.Y.
10022,
Over 25 years ago, in Sharpe [1966], I introduced a measure for the performance
of mutual funds and proposed the term reward-to-variability ratio to describe it
(the measure is also described in Sharpe [1975] ). While the measure has gained
considerable popularity, the name has not. Other authors have termed the
original version the Sharpe Index (Radcliff [1990, p. 286] and Haugen [1993, p.
315]), the Sharpe Measure (Bodie, Kane and Marcus [1993, p. 804], Elton and
Gruber [1991, p. 652], and Reilly [1989, p.803]), or the Sharpe Ratio (Morningstar
[1993, p. 24]). Generalized versions have also appeared under various names (see.
for example, BARRA [1992, p. 21] and Capaul, Rowley and Sharpe [1993, p. 33]).
Bowing to increasingly common usage, this article refers to both the original
measure and more generalized versions as the Sharpe Ratio. My goal here is to
go well beyond the discussion of the original measure in Sharpe [1966] and
Sharpe [1975], providing more generality and covering a broader range of
applications.
THE RATIO
Most performance measures are computed using historic data but justified on the
basis of predicted relationships. Practical implementations use ex post results
while theoretical discussions focus on ex ante values. Implicitly or explicitly, it is
assumed that historic results have at least some predictive ability.
For some applications, it suffices for future values of a measure to be related
monotonically to past values -- that is, if fund X had a higher historic measure
than fund Y, it is assumed that it will have a higher future measure. For other
applications the relationship must be proportional - - that is, it is assumed that
the future measure will equal some constant (typically less than 1.0) times the
historic measure.
TOPIC 10
To avoid ambiguity, we define here both ex ante and ex post versions of the
Sharpe Ratio, beginning with the former. With the exception of this section,
however, we focus on the use of the ratio for making decisions, and hence are
concerned with the ex ante version. The important issues associated with the
relationships (if any) between historic Sharpe Ratios and unbiased forecasts of
the ratio are left for other expositions.
Throughout, we build on Markowitz' mean-variance paradigm, which assumes
that the mean and standard deviation of the distribution of one-period return are
sufficient statistics for evaluating the prospects of an investment portfolio.
Clearly, comparisons based on the first two moments of a distribution do not
take into account possible differences among portfolios in other moments or in
distributions of outcomes across states of nature that may be associated with
different levels of investor utility.
When such considerations are especially important, return mean and variance
may not suffice, requiring the use of additional or substitute measures. Such
situations are, however, beyond the scope of this article. Our goal is simply to
examine the situations in which two measures (mean and variance) can usefully
be summarised with one (the Sharpe Ratio).
Summary
The Sharpe Ratio is designed to measure the expected return per unit of risk for a
zero investment strategy. The difference between the returns on two investment
assets represents the results of such a strategy. The Sharpe Ratio does not cover
cases in which only one investment return is involved.
Clearly, any measure that attempts to summarize even an unbiased prediction of
performance with a single number requires a substantial set of assumptions for
justification. In practice, such assumptions are, at best, likely to hold only
approximately. Certainly, the use of unadjusted historic (ex post) Sharpe Ratios
as surrogates for unbiased predictions of ex ante ratios is subject to serious
question. Despite such caveats, there is much to recommend a measure that at
least takes into account both risk and expected return over any alternative that
focuses only on the latter.
For a number of investment decisions, ex ante Sharpe Ratios can provide
important inputs. When choosing one from among a set of funds to provide
representation in a particular market sector, it makes sense to favor the one with
the greatest predicted Sharpe Ratio, as long as the correlations of the funds with
other relevant asset classes are reasonably similar. When allocating funds among
several such funds, it makes sense to allocate funds such that the selection
(residual) risk levels are proportional to the predicted Sharpe Ratios for the
174
TOPIC 10
selection (residual) returns. If some of the implied net positions are infeasible or
involve excessive transactions costs, of course, the decision rules must be
modified. Nonetheless, Sharpe Ratios may still provide useful guidance.
Whatever the application, it is essential to remember that the Sharpe Ratio does
not take correlations into account. When a choice may affect important
correlations with other assets in an investor's portfolio, such information should
be used to supplement comparisons based on Sharpe Ratios.
All the same, the ratio of expected added return per unit of added risk provides a
convenient summary of two important aspects of any strategy involving the
difference between the return of a fund and that of a relevant benchmark. The
Sharpe Ratio is designed to provide such a measure. Properly used, it can
improve the process of managing investments.
References
BARRA Newsletter, September/October 1992, May/June 1993, BARRA,
Berkeley, Ca.
Bodie, Zvi, Alex Kane and Alan J. Marcus. Investments, 2d edition. Homewood,
IL: Richard D. Irwin, 1993.
Capaul, Carlo, Ian Rowley, and William F. Sharpe. "International Value and
Growth Stock Returns," Financial Analysts Journal, January/February 1993,
pp. 27-36.
Elton, Edwin J., and Martin J. Gruber. Modern Portfolio Theory and Investment
Analysis, 4th edition. New York: John Wiley & Sons, 1991.
Grinold, Richard C. "The Fundamental Law of Active Management," Journal of
Portfolio Management, Spring 1989, pp. 30-37.
Haugen, Robert A. Modern Investment Theory, 3d edition. Englewood Cliffs, NJ:
Prentice-Hall, 1993.
"Morningstar Mutual Funds User's Guide." Chicago: Morningstar Inc., 1993.
Radcliff, Robert C. Investment Concepts, Analysis, Strategy, 3d edition. New
York: HarperCollins, 1990.
Reilly, Frank K. Investment Analysis and Portfolio Management, 3d edition.
Chicago: The Dryden Press, 1989.
Rudd, Andrew, and Henry K. Clasing. Modern Portfolio Theory, The Principles
of Investment Management. Homewood, IL: Dow-Jones Irwin, 1982.
TOPIC 10
176
TOPIC 10
TOPIC 10
index fund aims to replicate the Kuala Lumpur Composite Index (KLCI). Hence,
an index fund effectively holds a market portfolio.
We will explain the issue of benchmark in subtopic 10.3.
Comparing within the same risk profile
Another issue crises when comparing funds with their peer groups. It is always
important to remember that a stock fund or equity fund should be compared
with other similar stock funds - ones that invest in the same type of companies.
A bond fund should be compared with bond funds that invest in bonds of similar
maturities and credit quality (rating). You can usually find the name of the
appropriate market index or benchmark on a fund's prospectus or manager's
(annual and semi-annual) report.
ACTIVITY 10.1
1.
2.
In the market, we have equity funds, index funds, and bond funds
what is the appropriate benchmark for these funds?
178
TOPIC 10
This is the simple case where all we need to know is the funds market value at
the beginning of the period and end of the period.
Return = END
BEGINNING
V
BEGINNING
(10.1)
Example 1:
Consider a portfolio with a market value of $50 million at the beginning and
$56 at the end of the period.
The return is 12% [=($56m - $50m)/$50m]
In reality, performance measurement is not that simple! The main problem is
that the investor may deposit or withdraw cash from the fund. In this case, the
market values will be influenced by these cash flows and by only using the
previous formula without considering other factors, you will get misleading
results.
Example 2:
Consider the case of a fund whose market value at the beginning of the period
was $200 million. Towards the end of the quarter an investor deposits $10
million in the fund. At the end of the quarter the funds market value is $206
million.
When you use the previous formula, disregarding the cash inflow, you find
that the return was 3%. But this is incorrect! The increase in market value was
not the result of the fund managers skills.
The accurate measure of the funds returns over the quarter must take into
consideration the $10 million cash inflow.
Considering this fact, results in a return of -2% [={($206m -$10m) $200m}/$200m].
TOPIC 10
$200m
$10m $206m
1 r 1 r 2
10.2.3 Comparison
The dollar-weighted returns are influenced by both the size and the timing of the
cash flows. The time-weighted returns do not present this problem. For this
reason, the time-weighted return is generally preferred to dollar-weighted in
evaluating portfolio performance.
180
TOPIC 10
SELF-CHECK 10.1
1.
2.
10.3 BENCHMARKING
In performance analysis you need to make relevant comparisons. The investor
has to compare the returns of his/her manager with the returns that would have
been obtained had he/she invested in an alternative portfolio with identical risk.
In the context of topic, performance evaluation discusses the issue whether the
performance was superior or inferior relative to a benchmark, or whether the
performance was due to skills or luck.
The investor must make use of benchmark portfolios to assess the fund
managers performance. These benchmark portfolios must be relevant (similar
risk), feasible and known in advance.
For example, let us say that you decide to invest in a diversified equity portfolio
with average risk. You see that your return was 20%. Is this good or bad?
Now let us say that you find out that the KLCI has gone up, for the same period,
14%. Then you can say that your fund, for this period in particular, had a
superior return.
TOPIC 10
The FTSE Bursa Malaysia Index Series is designed to measure the performance of
the major capital segments of the Malaysian market. All Malaysian companies
listed on the Bursa Malaysia Main Board, Second Board and MESDAQ Market
are eligible for inclusion, subject to meeting FTSE's international standards of free
float, liquidity and investability.
The index series covers all stock sizes within the market and is suitable for the
creation of investment products such as ETFs, derivatives and index tracking
funds.
As shown in Figure 10.1, there are two type of indices. The first group is tradable
Indices. The second group is benchmark indices.
We will first examine the four tradable indices, and then the five benchmark
indices in next section.
Tradable Indices
(a)
182
TOPIC 10
This tradable index comprises the 30 largest companies in the FTSE Bursa
Malaysia (FBM) EMAS index by market capitalisation.
(b)
(c)
(d)
Benchmark Indices
(a)
(b)
(c)
(d)
TOPIC 10
(e)
(f)
Table 10.1 shows all the details of the new indices lauched in 2006. It is important
to take note that existing indices like EMAS, Second Board and Mesdaq are
readjusted to become part of the new indices lauched. In line with the Islamic
finance, two Shariah Indices as shown in Table 10.2 and 10.3 were also launched.
Table 10.1: FTSE Bursa Malaysia Index Series
US
Index/Sector Number of
Dollar
Name
Constituents
Index
FTSE Bursa
Malaysia 100
100
9327.39
Index
FTSE Bursa
Malaysia
216
6678.50
Second Board
Index
FTSE Bursa
Malaysia Large
30
9346.08
30 Index
FTSE Bursa
Malaysia Mid
70
9105.32
70 Index
FTSE Bursa
Malaysia
366
9567.67
EMAS Index
FTSE Bursa
242
8501.50
Malaysia
Fledgling Index
FTSE Bursa
Malaysia
121
5595.25
MESDAQ
Index
FTSE Bursa
Malaysia Small
266
11434.31
Cap Index
Base
Base
US
Currency Dollar Currency
Index
TRI
TRI
Mkt Cap
(USD)
8077.23
9897.29
5783.38
6821.44
5906.90
8093.42
9944.76
7884.93
9574.35
8291.10
2305.900424
7352.363501
30129.160919 96066.829590
7362.04
8819.08
7636.98
3943.654938
12574.343770
4845.31
5629.23
4874.73
1429.111314
4556.721426
184
TOPIC 10
Number of
Constituents
US
Dollar
Index
FTSE Bursa
Malaysia Hijrah
Shariah Index
30
11183.86
Base
US
Base
Currency Dollar Currency
Index
TRI
TRI
Mkt Cap
(USD)
US
Base
Number of
Dollar Currency
Constituents
Index
Index
269
9945.36
8612.38
Base
US
Dollar Currency
TRI
TRI
Mkt Cap
(USD)
Source: http://www.bursamalaysia.com/website/bm/market_information
/ftse_bursa_index.html
TOPIC 10
manner, the stock listed in Bursa Malaysia are selected regrouped under the new
indices based on different criteria. Hence, although the new indices are only
launched in 2006, the stocks that become the sample of these different indices
have been in existence before 2006. By using the historical data of the listed
stocks that forms the new indices, their respective pair-wise correlation can be
calculated.
Rp
( NAVt NAVt 1 ) Dt C t
NAVt 1
(10.2)
where
NAVt
= Net Assets Value per unit at the end of the holding period.
NAVt 1
Dt
Ct
This one period rate of return on a portfolio is also known as holding period
yield. The return is stated in percentage.
186
TOPIC 10
compensated above risk free rate, hence they must receive risk premium. The
higher the ratio of reward per unit of risk, the fund is better in terms of
performance. We can use this ratio to rank the unit trust funds.
We will learn three methods of risk adjusted performance measurement in
subtopic 10.4, 10.5 and 10.6 subsequently.
Rp R f
(10.3)
Where:
R p = Realised return on the portfolio
Rf
Rp R f
(10.4)
TOPIC 10
Where:
Rp
Rf
Portfolio beta
10.6
JENSENS ALPHA
Like Jack Treynor and William Sharpe, Michael Jensen recognised the CAPMs
implications for performance measurement.
The Jensens alpha is the average funds return above the predicted return from
the CAPM, given the portfolios Beta and average market return.
Using the CAPM model, the expected return of the portfolio can be calculated as
follows:
E(Rp) = Rf + p (Rm-Rf)
(10.5)
Where:
E(Rp)
Rf
Rm
=
=
=
Jensen
R R
R
P M
f
f
Where:
Rp
E(Rp)
(10.6)
188
TOPIC 10
If p has a positive value, it indicates the superior return has been earned by the
fund managers due to either selection or timing skills, or both. If p has a zero
value, it indicates neutral performance. This means that the fund managers have
done just as well as unmanaged portfolio with buy and hold stocks that are
selected randomly. However, if p has a negative value, it means that the fund
managers performed worse than of the market.
Market Portfolio, M
Average Return
35%
28%
Beta
1.20
1.00
Standard Deviation
42%
30%
Non-systematic Risk
18%
0%
Assuming the risk free rate is 6% and market return is 15%, calculate the Sharpe
ratio, Treynor measure, Jensens Alpha for Portfolio L and M.
Solution:
Sharpe ratio for Portfolio L = (35-6) / 42 = 0.69
Sharpe ratio for Portfolio M = (28 6 )/ 30 = 0.73
It can be concluded that Portfolio L underperformed Portfolio M.
Treynors measure for Portfolio L = (35 6) / 1.20 = 24.17
Treynors measure for Portfolio M = (28 6 )/ 1.00= 22
It can be concluded that Portfolio L has performed better Portfolio M.
Jensens measure for Portfolio L = 35 [ (6 + 1.20 (28-6) ] = 2.6
It can be concluded that Portfolio L has a positive alpha of 2.6.
TOPIC 10
SELF-CHECK 10.2
1.
2.
If the fund manager really has good timing abilities (good and accurate forecasts
of market movements), then the portfolio will do better than a benchmark
190
TOPIC 10
portfolio that has a constant Beta (that is equal to the average Beta of the timers
portfolio).
Figure 10.2 indicates that the relationship between the portfolios excess returns
and the markets excess return was not linear.
The exhibit suggests that the portfolio consisted of high-Beta securities during
periods when the market return was high and low-Beta securities when the
market dropped.
In this case, it appears that the investment manager successfully identified
market timing (alpha is positive).
TOPIC 10
A new series of indices has been launched in 2006. It is a joint effort by Bursa
Malaysia and FTSE, a company based in the United Kingdom.
(Refer the website: http://www.ftse.com/)
There are three measurements for portfolio. Which are Sharpe ratio,
Treynors measure and Jensens Alpha.
192
TOPIC 10
Benchmarkin
Benchmark indice
Dollar-weighted returns method
Indice
Institutional investor
Jensens alpha
Time-weighted returns method
Treynors measure
Sharpe ratio
1.
2.
If your portfolio has foreign stocks, what particular risk your portfolio has?
3.
4.
5.
6.
7.
8.
1.
2.
Fund
Return (percent)
Beta
ABC
XYZ
KLCI
(Market Index)
12
19
18
25
0.7
1.3
15
20
Assuming the risk free rate is 7 percent, calculate Sharpe ratios for ABC,
XYZ and KLCI.
Compare the performance of ABC and XYZ relative to market index based
on answer from no. 1.
TOPIC 10
3.
Assuming the risk free rate is 7 percent, calculate Treynors ratio for ABC,
XYZ and KLCI.
4.
Contrast the performance of ABC and XYZ based on answer from no. 3.
5.
6.
If the actual returns realised from ABC and XYZ funds are 12 and 19
percent respectively, given that the market return is 15 percent and beta is
0.7 and 1.3, calculate the expected return for both funds?
7.
Calculate the differential return or alpha value for ABC and XYZ funds.
8.
194
ANSWERS
Answers
TOPIC 1:
Self-Test 1
1.
2.
Demand
Supply
Fund
4.
5.
6.
7.
ANSWERS
195
Self-Test 2
1.
2.
Various types of financial instrument are (i) debt, (ii) cash and cashequivalent, (iii) equity (iv) derivatives (v) commodity and (vi) precious
metal.
3.
They are the asset management companies, independent trustee and unit
holders.
4.
They are Securities Commission Act (1993) and Securities Industry Act
(1983).
5.
6.
Three.
7.
Within equity funds, there are aaggressive growth funds, index funds and
International equity funds.
8.
TOPIC 2:
Self-Test 1
1.
2.
Market risk, Liquidity risk, Credit risk, Operation risk, Systemic risk,
Currency risk
196
3.
4.
ANSWERS
5.
E ( X ) Pri X i
i 1
If investors and managers can measure and price risk correctly, then:
(a)
(b)
(c)
(d)
7.
8.
Self-Test 2
1.
Step (2):
ANSWERS
End of Period
Return
30
40
50
60
70
2.
Probability
197
Return
0.10
0.30
0.40
0.10
0.10
Total:
3.00
12.00
20.00
6.00
7.00
48.00
Step (2):
Step (3):
Step (4):
End of Period
Return
30
40
50
60
70
Probability
Return
0.10
0.30
0.40
0.10
0.10
3.00
12.00
20.00
6.00
7.00
48.00
Deviation
-18.00
-8.00
2.00
12.00
22.00
Deviation
squared
324.00
64.00
4.00
144.00
484.00
Product
32.4
19.2
1.6
14.4
48.4
116
3.
Using equation (2-4) in the text, the squared root of 116 is 10.77 percent.;
4.
5.
(2-10)
198
ANSWERS
rxy
Cov( X , Y )
sx s y
Where
7.
rxy
Cov xy
sx
Standard deviation of x.
sy
Standard deviation of y.
Year
Rx
1
2
3
4
10
12
16
18
14
Rx
Covxy
8.
rxy
[ R
10.5
3.65 3.92
Ry
Rx- Rx
-4
-2
2
4
17
13
10
8
12
Ry
Rx ][ Ry Ry ]
Cov( X , Y )
sx s y
0.734
Deviation
Deviation
Ry- R y
42
10.5
4
5
1
-2
-4
Product
-20
-2
-4
-16
-42
ANSWERS
TOPIC 3:
199
Test 1
1.
2.
j1
rj
s p (rp r )2 (n 1)
i 1
3.
(b)
200
(c)
ANSWERS
4.
5.
6.
7.
8.
ANSWERS
201
Self-Test 2
Month
1
2
3
4
5
6
Sum
ABC
Berhad
(RABC)
XYZ
Berhad
(RXYZ)
-0.04
0.06
-0.07
0.12
-0.02
0.05
0.10
0.07
-0.02
-0.1
0.15
-0.06
0.02
0.06
R ABC E ( R ABC )
R XYZ E ( R XYZ )
-0.057
0.043
-0.087
0.103
-0.037
0.033
0.060
-0.030
-0.110
0.140
-0.070
0.010
[ R ABC E ( R ABC ) ]
x
[ R XYZ E ( R XYZ ) ]
-0.003
-0.001
0.010
0.014
0.003
0.000
0.0222
1.
2.
4.
5.
Since the correlation of these two stocks is positive, they will move in the
same directions. Risk of the portfolio cannot be reduced if they are
combined in portfolio. Hence, there will be no diversification effect if we
combine them.
0.0037
= 0.682
(0.06549)(0.08287)
202
6.
ANSWERS
= 0.12845
7.
r1, 2 = 0.60
= 0.08062
8.
ANSWERS
203
The more risk-averse you are, the more the expected return you demand for
an extra risk.
2.
y = (10-4)/(0.01*5*142) = 0.61
Therefore you should invest 61% of your money in portfolio X and 39% in
T-bills.
0.61*70% = 42.7% bonds
0.61*30% = 18.3% stocks
and 39% T-bills
3.
(a)
(b)
Sp = (16
4)/42 = 0.29
4.
Slope = (12
4)/20 = 0.4
5.
Considering the slope joining risk-free rate and your portfolio choice, we
have:
SlopeS&P500 = (12
SlopePortfolio = (15
4)/20 = 0.4
4)/25 = 0.44
204
ANSWERS
7.
Portfolio C is the optimal risky portfolio because it has the highest reward
to variability ratio.
8.
Asset 1
Asset 2
Expected return
12%
8%
Standard deviation
10%
5%
w1
and
w2 = 1 w1
Substituting the data in the above table, the solution is:
w1
w2 = 1 0.33 = 0.67
ANSWERS
(b)
(c)
(d)
205
9.32 4
0.956 (rounded off)
5.564
Self-Test 2
1.
The efficient frontier is the site of all efficient portfolios (those with the best
risk-return tradeoff). All portfolios on the efficient frontier are preferable to
the others in the feasible or attainable set.
2.
3.
The two kinds of risk associated with a portfolio are diversifiable (or
unsystematic) risk and nondiversifiable (or systematic) risk. Diversifiable
(unsystematic) risk is the risk unique to each investment vehicle that can be
eliminated through diversification, by selecting stocks possessing different
risk-return characteristics. Nondiversifiable risk is possessed by every
investment vehicle. It is the risk that general market movements will alter a
securitys return. The total risk of a portfolio is the sum of its
nondiversifiable and diversifiable risk. A fully diversified portfolio will
possess only nondiversifiable risk.
4.
Relevant risk is this type of risk that represents the contribution of an asset
to the risk of the portfolio. It is also known as Nondiversifiable risk
possessed by every investment vehicle. One cannot eliminate
nondiversifiable risk through diversification. Beta measures only the
nondiversifiable, or relevant, risk of a security or portfolio.
5.
206
ANSWERS
The feasible or attainable set of all possible portfolios refers to the riskreturn combinations achievable with all possible portfolios. It is derived by
first calculating the return and risk of all possible portfolios and plotting
them on a set of risk-return axes as shown in the diagram below.
7.
8.
(b)
ANSWERS
207
(c)
(d)
2.
The market return is typically measured by the average return of all stocks
or large sample of stocks. In our example, KLCI as a broad index is used to
measure market return. The beta for the overall market is the benchmark
beta i.e. 1.0.
3.
The beta and other betas are viewed in relation to this benchmark. The
positive or negative sign on a beta indicates whether the stocks return
changes in the same direction as the general market (positive beta) or in the
opposite direction (negative beta). In terms of the size of beta, the higher the
stocks beta, the riskier the security.
Stocks with betas greater than 1.0 are more responsive to changes in market
returns, and stocks with betas less than 1.0 less responsive than the market.
4.
Betas are typically positive and range in value between 0.5 and 1.75. Most
securities have positive betas. This means that the returns on most stocks
move in a direction (though not in magnitude) similar to the market as a
whole. This is quite intuitive to understand as macro economic factors
affect most securities in a similar manner. Hence the betas tend to be
positive.
208
5.
ANSWERS
The capital asset pricing model (CAPM) links together risk and return to
help investors make investment decisions. It describes the relationship
between required return and systematic risk, as measured by beta. The
equation for the CAPM is:
ri RF [ b (rm RF )]
As beta increases, so does the required return for a given investment. The
risk premium, [b (rm RF)], is the amount by which return increases
above the risk-free rate to compensate for the investments nondiversifiable
risk, as measured by beta.
6.
7.
8.
ANSWERS
209
Self-Test 2
1.
2.
3.
Security A return
Security B return
Security C return
18.48%
1.4 13.2%
10.56%
0.8 13.2%
0.9 13.2% 11.88%
(b)
Security A return
Security B return
Security C return
(c)
Investment
ri
8.9%
12.5%
8% [0.90 (13%
8.4%
9% [ 0.20 (12%
9%)]
15.0%
8.4%
8%)]
10%)]
210
ANSWERS
4.
Given that the risk-free rate is 7% and the market return is 12%, Asset class
E is the most risky because it has the highest beta, 2.00. Asset class D, with a
beta of 0, is the least risky.
5.
6.
14.5%
12%
7% [1.00 (12%
10.75%
7%
17%
7%)]
ANSWERS
7.
8.
(a)
211
212
ANSWERS
2.
(a)
(b)
3.
The steepness of the slope reflects the sensitivity of stock to the changes in
the factor.
4.
ai = the expected level of return for stock i if all indices have a value of zero
I j = the value of the jth index that impacts the return on stock i
bij = the sensitivity of stock is return to the jth index
ei = a random error term with mean equal to zero and variance equal to ei2
All indices are assumed to be uncorrelated with each other.
5.
The empirical issues of APT Model are the testability of APT and
determination of number of APT factors.
6.
7.
APT recognises that there are other factors than market index that can
have effect on securities returns.
(b)
(c)
ANSWERS
(d)
213
Self-Test 2
1.
2.
3.
Indexing.
4.
Index funds.
5.
6.
An empirical version of the APT where the investor chooses the exact
number of the common risk factors used to describe an assets risk-return
relationship.
7.
8.
TOPIC 7:
Self-Test 1
1.
2.
E ( p j ,t i | t ) [1 E ( R j ,t i | t )] p jt
(7.1)
214
ANSWERS
Where :
E is the expected value operator;
p jt is the price of security j at time t;
p j ,t i is random variable at time t;
R j ,t i is the one-period percentage return;
t is a general symbol for information set.
3.
The third type is strong efficiency. This is the strongest form which states
that all information in a market, whether they are private or public
information, will be reflected in the stock price. No one can have excess
returns in these markets, even insider information cannot give investors
any advantage.
4.
5.
Investors must begin to think the market is inefficient and possible to beat.
Investment strategies intended to take advantage of inefficiencies are
actually the fuel that keeps the market efficient.
6.
Weak form efficiency states the stock prices only reflect its own historical
prices. Semi-strong form states that stock prices reflect its own historical
prices and also public information.
7.
(ii)
Self-Test 2
1.
2.
3.
ANSWERS
215
This field argues that people are not nearly as rational as stated by
traditional finance theory.
5.
(a)
(b)
(c)
6.
7.
8.
Market anomalies are January effect, turn of the month effect, Monday
effect, etc.
January effect states that stocks in general have high historically generated
abnormally high returns during the month of January.
Turn of the month effect states that stocks consistently show higher returns
on the last day and first four days of the months.
Monday effect shows that Monday tends to be the worst day to invest in
the stock market.
Both of these phenomenon pose a challenge to EMH.
TOPIC 8:
Self-Test 1
1.
216
ANSWERS
3.
4.
5.
Stage 1: The initial stage of the industry. Investors are not familiar with the
new industry. The industry is new and untried so the risk in investing in
this new industry is very high, especially the financial leverage risk.
Stage 2: The rapid expansion of the industry. During this stage, product
acceptance is spreading and investors can foresee the industrys future
more clearly. Economic variables have little to do with the industrys
overall performance during this stage. As a result, investors will be
interested in investing almost regardless of the economic condition.
Stage 3: The mature stage. During this stage, most industries do not
experience rapid growth for a long period. Most eventually slip into the
category of mature growth. However, during this stage, investors must take
into account the economic situation.
Stage 4: This is the last stage of the industry; the industry is either stable or
in decline. During this stage, the demand for the industrys products is
diminishing, and firms are leaving the industry since profits are shrinking
in the decline phase. Furthermore, the investment opportunities are almost
nonexistent, so investors seek only dividend income. In reality, few
ANSWERS
217
companies reach this stage because they try to introduce product changes
and to develop other product lines that will help to continue mature
growth. Avoiding this stage is obviously a concern for most investors.
6.
Share price is determined or valued based on the present value of its future
dividends. Hence, a stock that can provide streams of future cash inflow
from future profitable projects will have higher price than other stock
assuming similar market capitalization and risk. From the projected
dividends, we can value the stock using different models such as the
dividend discount model (DDM), the Gordon growth model or multi-stage
dividend discount model.
7.
DPS t
(1 r )
t 1
Since a share of stock has no finite end, the dividends go forever. Hence the
weakness of this general model is that the dividends have to be estimated
over an infinite number of periods. The idea from DDM form as the basis of
more relevant models in the future.
8.
DPS1
rg
DPS1 is the expected dividend per share in one year, r is the shareholders
required rate of return, and g is the constant growth rate in dividends.
Hence, Gordon growth model is also referred as constant dividend
discount model.
Self-Test 2
1.
2.
1.00
DPS
RM10
r g 0.16 0.06
218
ANSWERS
DPS 0 (1 g ) t 1.00(1.06)1
=
RM10.60
rg
0.16 0.06
3.
4.
5.
6.
When the original stock is priced at RM70 with EPS of RM7, the stock was
trading at 10 times P/E. When the stock price was at RM60 and EPS was at
RM5, ABCs P/E was increased to 12 times. We can conclude that ABCs
stock experienced P/E expansion.
7.
8.
D0 (1 g )
= 1.40 / (0.105 0.08) = RM56
(k g )
ANSWERS
219
2.
With the advent of the Internet, individual investors are better informed;
however, they are still less informed than institutional investors
3.
4.
Herd behaviour will eventually lead to stock market bubble. One such
example was IT bubbles or dot-com bubbles in 2000-2001.
5.
6.
Two major types are defined benefit and defined contribution. Defined
benefit pension plans promise to pay retirees a specific income stream after
retirement. The company contributes a certain amount to the fund each
year and the company also takes up the risk of paying the future pension to
the retirees. Any shortfall (due to poor performance of the fund) should be
compensated for in the future. On the other hand, defined contribution
pension plans make no promise on return. The benefits depend on the
employees contribution and the return on investment. The contribution
plans are tax-exempted.
7.
8.
220
ANSWERS
Self-Test 2
1.
Security selection;
(ii)
(iii) Security selection coupled with sector selection and asset allocation;
(iv) Market timing; and
(v)
Portfolio revision
2.
There are three stages for institutional investors when they implement
active portfolio investment strategies. These are planning, implementation
and monitoring stages.
3.
They are Strategic asset allocation (SAA) and Tactical asset allocation
(TAA). SAA refers to what the investor wants the weights to look like, on
average, over the long term. TAA refers to what the investor wants the
weights to look like now, given the current conditions in the financial
markets.
4.
ANSWERS
221
Full replication as a variation of the buy and hold strategy, all securities in
an index are purchased in proportion to their weights in that index. For
example, in a Bursa Malaysia Composite Index portfolio, you would have
to buy the 100 constituent stocks according to their market value. What are
the disadvantages of this strategy? High transaction costs and the
reinvestment risk of dividends cannot be ignored! A good example is the
Tracker Fund which tries to track the performance of the Bursa Malaysia
Composite Index.
6.
7.
8.
222
ANSWERS
Compare fund with the same investment objectives and fund policies.
2.
3.
4.
5.
6.
7.
ANSWERS
8.
223
The figure below indicates that the relationship between the portfolios
excess returns and the markets excess return was linear. In this case, it
appears that the investment manager successfully identified and invested
in some underpriced securities (alpha is positive).
Self-Test 2
1.
2.
Fund XYZ has performed better than the benchmark market index. Fund
ABC has performed worse than the market index.
3.
4.
Fund XYZ has performed better than the benchmark. Fund ABC has
performed worse than the market index.
5.
6.
7.
224
8.
ANSWERS
The negative alpha value for fund ABC indicates inferior performance
relative to the market index.
The positive alpha value for fund XYZ indicates superior performance
relative to the market index.
References
Bodie, Z., Kane, A., & Marcus, A. J. (2005). Investments. (6th ed.). USA: Irwin
McGraw-Hill.
Elton, E. J., & Gruber M. J. (1995). Modern portfolio theory and investment
analysis (5th ed.) USA: John Wiley & Sons, Inc.
Fabozzi, F. J. (2003). Bond markets, analysis and strategies (5th ed.). Upper
Saddle River, NJ: Prentice Hall Press.
Fabozzi, F. J. (2003). Bond markets, analysis and strategies (5th ed.). Prentice
Hall Press.
Radcliffe, R. C. (1989). Investment: (concepts, analysis, strategy (3rd ed.). Harper
Collins Publishers.
Reilly, F. K., & Brown, K. C. (2006). Investment analysis and portfolio
management (8th ed.). Thomson South-Western.
M. (2002). Markowitzs portfolio selection:
retrospective. (Journal of Finance). 57, 1041-1045.
Rubinstein,
fifty-year
Sharpe, W. F., Alexander, G. J., & Bailey J. V. (1999). Investments 6th ed. NJ:
Prentice Hall.
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