Efficient Markets Performance Evaluation

Lecture 8: Efficient MarketsSAPM [Econ F412/FIN F313]

Ramana Sonti

BITS Pilani, Hyderabad Campus

Semester II, 2014-15

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Efficient Markets Performance Evaluation

Agenda

1 Efficient MarketsIntroduction

2 Performance EvaluationContextPerformance AttributionExampleMutual fund performance

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Efficient Markets Performance Evaluation

Introduction

What is market efficiency?

Market efficiency refers to informational efficiency Efficient market hypothesis (EMH): Prices fully reflect all available

information on the asset

Implications Prices need not equal intrinsic value at all times We require that pricing errors, if any, are random, i.e., at every point, a

stock is as likely to be overvalued as undervalued No profits to be made in excess of a risk-adjusted return on information

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Introduction

Grossman and Stiglitz (1980) Existence of (perfectly) informationally efficient markets is

impossible There are a lot of investors in the market. Some trade on information

(informed traders) and some others are uninformed (trade for liquidityreasons etc.)

Information is costly to acquire and process Informed traders work hard to uncover inefficiencies and make a profit

that at least recoups their costs. Paradoxically, the very act of trying toactively discover inefficiencies drives prices closer to values, i.e.makes the market more efficient

However, if the market is perfectly efficient, it would drive away all theinformed traders (as they have no incentive to participate), which wouldlead the market to be inefficient, which would make them all re-enterthe market, which would make the market more efficient and drivethem all away... and so on...a vicious circle...a state of disequilibrium

The only equilibrium possible is that a market will be efficient to theextent that informed traders exactly recoup their costs, i.e., we cannever have a 100 % efficient market where price always equals value

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Introduction

Grossman and Stiglitz (1980) ... 2

The Grossman-Stiglitz argument implies Since there are so many investors looking for inefficiencies, easy

pickings are rare the market will be efficient to a large degree The probability of finding inefficiencies in a market increases as the

cost of exploiting inefficiencies increases. Investors who canacquire/process information at a marginally lower cost than the nextinvestor will be better positioned to exploit these inefficiencies

The degree of inefficiency of a market depends upon the number ofinformed investors in the market who are more closely looking toexploit any opportunities

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Introduction

Versions of the EMH

Weak form efficiency History of past prices useless in predicting future prices to make extra

profits Technical analysis is useless

Semi-strong form efficiency Publicly available information cannot be used to make extra profits Fundamental analysis is useless

Strong form efficiency No information (public or private) can be utilized to make extra profits Insider trading for instance, is useless

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Introduction

Issues in testing the EMH

Magnitude How efficient is the market? Can we observe the magnitude of

inefficiency?

Selection bias If you could beat the market, would you publicize the fact?

Are fund managers just lucky monkeys? How do we separate skill from luck?

How do we define risk-adjusted returns Joint tests of the EMH and the asset pricing model (CAPM, factor

models etc.)

Tests of the EMH Weak form: Filter rules, Tests of the random walk hypothesis Semi-strong form: Anomalies, event studies Strong form: Insider trading

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Introduction

Anomalies: Size Size effect: Portfolios of small cap stocks earn abnormal returns

(positive alphas), even after (beta) risk is taken into account

!

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Introduction

Anomalies: Value vs. Growth

Book-to-market effect: Portfolios of high Book-to-Market ratio stocksearn abnormal returns (positive alphas), even after (beta) risk istaken into account

!

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Efficient Markets Performance Evaluation

Introduction

Volatility: Value vs. Growth

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Efficient Markets Performance Evaluation

Introduction

Anomalies: Momentum Portfolios of stocks with high returns in the recent past significantly outperform those

with low returns in the recent past Returns to momentum strategies cannot be explained by risk measures like standard

deviation or beta Not explained by FF 3 factor model, and is the most robust anomaly to date

!

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Context

Why measure performance?

There is over $1 trillion under active management in the U.S. alone INR 4-5 trillion in India

Active fund managers typically charge a higher fee than passivefund managers

Fidelity Magellan (active fund): Annual fee of 0.63% Fidelity Spartan 500 (index fund): Annual fee of 0.10% Vanguard 500 (index fund): Annual fee of 0.18%

Assuming an average fee of 0.40%, investors spend >$4 bn on feein the U.S. alone

Clearly, there is a need for investigating performance

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Performance Attribution

Performance attribution

Step 1: Define benchmark or bogey portfolio, reflecting passiveinvestment strategy

Step 2: Compare return of active or managed portfolio withbogey portfolio

Step 3: Attribute difference in return to Asset allocation Security selection

Sector allocation Security allocation

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Performance Attribution

Attribution framework!

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Example

Attribution example

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What accounts for the (5.34%-3.97%) difference of 137 basispoints?

In particular, how much is portfolio allocation and how much securityselection?

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Example

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Efficient Markets Performance Evaluation

Example

Security selection

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Manager selects his own secruities within asset classes Impact due to asset allocation: 106 bp Can be further split into the part due to sector allocation versus

security allocatio

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Mutual fund performance

Mutual fund performance...1 A typical study by Malkiel (Journal of Finance, 1995) of 239 mutual funds during

1971-1991

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Average alpha (both pre- and post-expenses is indistinguishable from zero withWilshire index

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Efficient Markets Performance Evaluation

Mutual fund performance

Mutual fund performance...2 A good representative piece of research is by Daniel, Grinblatt, Titman and Wermers

(Journal of Finance, July 1997) Virtually every mutual fund in existence between 1975 through 1994 Explore benchmark-free Selectivity and Timing measures based on stock

characteristics These authors find that a number of funds appear to have consistent, abnormally high

returns (pre-expense) relative to CAPM benchmarks, but most of this performance isdue to buying high momentum stocks

Even after controlling for anomalies, including momentum, the averageaggressive-growth fund manager exhibited some selectivity ability; almost all thisoutperformance concentrated in first half of sample

!

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Efficient Markets Performance Evaluation

Mutual fund performance

Mutual fund performance...3

Chevalier and Ellison (1999) show that There is manager persistence, not fund persistence Manager characteristics predict future performance

Younger managers better Managers with MBAs better Undergraduate institution matters for performance

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Mutual fund performance

Why invest in mutual funds?

Diversification benefits Opportunity costs of keeping up with and monitoring markets Transaction costs Hope: The next Magellan fund?

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Efficient MarketsIntroduction

Performance EvaluationContextPerformance AttributionExampleMutual fund performance