FIN 3102

Investment Analysis and

Portfolio Management

Prof. Luis Goncalves-Pinto

Lecture 1:

Introduction

• Course Introduction and Syllabus

• Overview of Capital Markets

Readings:

BKMJ chapters 2, 3, and 4

2

• Luis Goncalves-Pinto (just call me Luis, easy!)

• Office hours: Fridays 14.00-16.00

• Office: MRB BIZ1 / 7-43 (7th floor of Mochtar Riady

Building)

• By appointment (set up after class or by email)

• Post questions on https://ivle.nus.edu.sg/

• By email: lgoncalv@nus.edu.sg

(If of general interest, your questions will be posted

on IVLE together with my answers)

How to reach me:

3

- Course Introduction:

. What is this class about?

. Syllabus and course details

- Overview of Capital Markets:

. Investing directly: markets and trading

. Delegated portfolio management: mutual

funds

Lecture Outline:

4

What Is This Class About?

Introductory knowledge of portfolio management:

How much should I invest in each asset?

1. Optimal portfolio selection

What’s the trade-off between risk and return?

2. Asset pricing theories

How can I assess my portfolio’s performance?

3. Performance evaluation

Should I invest beyond equities?

4. Fixed income securities, Derivatives

5

1. Optimal portfolio selection

• How do we pick the portfolio (of asset classes or of

individual securities) that maximizes return for a

given level of risk?

• How does this allocation depend on our investment

horizon, risk aversion, and existing assets in place?

• How can we solve implementation problems

stemming from estimation error, short-sale

restrictions, and portfolio constraints?

What Is This Class About?

Harry Markowitz

(Nobel prize)

6

[Lecture 3]: How Vanguard does it

Source: Vanguard

preview

7

[Lecture 3]: How Vanguard does it

Source: Vanguard

preview

8

2. The relation between risk and return

• What is the relevant measure of risk in each risk-

return tradeoff?

• What expected return should the market demand for

each asset?

– CAPM

– APT

– characteristic-based model

• How well does the evidence support these theories?

What Is This Class About?

William Sharpe

(Nobel prize)

9

preview

[Lectures 5-6]: Fama-French 3-Factor Model

Three Equity Factors:

. MARKET : Stocks have higher expected returns than bonds

. SIZE: Small caps beat large caps (on average)

. VALUE: “Value" stocks beat “Growth" stocks (on average)

Source: Dimensional Fund Advisors

10

3. Performance Evaluation

• How can a fund manager’s performance be measured?

• Can we separate skill in picking stocks from skill in picking sectors?

• How do we test the manager’s ability to time the market?

What Is This Class About?

11

[Lecture 9]: Performance Evaluation of Fidelity Magellan

(FMAGX in finance.yahoo.com)

hit “Profile”

preview

12

[Lecture 9]: Performance Evaluation of Fidelity Magellan

(FMAGX in finance.yahoo.com)

hit “Performance Details”

preview

13

[lecture 9]: Performance Evaluation of Fidelity Magellan

(FMAGX in finance.yahoo.com)

hit “Risk Details”

preview

14

4. Other Instruments

• Fixed Income Securities: [* FIN 3131 *]

- What portfolio of bonds should be purchased to

satisfy a given investment objective?

- What is the relation between prices, interest

rates, and yields? How risky are bonds of

different maturities and issuers?

• Options and Futures: [* FIN 3116 *]

- What are the reasons to trade derivatives?

- What is the fair value of a derivative?

What Is This Class About?

15

What This Class Is Not Really About

• How to pick stocks (i.e. individual stock selection)

• How to trade (trading and exchanges)

• How companies invest (capital budgeting)

• Banking and financial intermediaries

• Focus on equity, will not be thorough examination of:

- fixed income, derivatives, real estate, etc.

16

Syllabus Highlights

• Prerequisites

– Intro finance course, statistics course, Excel

• Readings:

– Bodie, Kane, Marcus, and Jain

Investments,

Asia Global Edition

– Lecture Notes

– Extra Readings (Finance Press)

• All course materials will be distributed using IVLE

(http://ivle.nus.edu.sg)

– Lecture Notes, Group Assignments,

Supplementary Reading Material

17

Syllabus Highlights

• Grading (Continuous Assessment):

- Group Assignments:

. Case Studies and www.stocktrak.com

- Test 1: <Sat, 04 Oct 2014, 10-12, Room TBA>

- Test 2: <Sat, 08 Nov 2014, 10-12, Room TBA>

• Test 1 30%

Test 2 20%

Assignments 35% (20% Case, 15% StockTrak)

Class Participation 10%

CFA Ethics Test 5% (Prof. Lee Hon Sing)

18

Syllabus Highlights

• Student Teams of 4-6 People (Due Next Class: Name, Composition/Identification, and Photos of Members, Sample Form on IVLE under “Assignments”)

• Case Studies (1 Case Per 2 Teams, Assigned Randomly):

1. Gold as a Portfolio Diversifier

2. Warren Buffett

3. Dimensional Fund Advisors

4. Behavioral Finance at JP Morgan

5. Zeus Asset Management

• StockTrak

19

• Why invest in an asset?

Put cash-flow today in exchange for cash-flow in future

• Future cash-flow may be:

- Certain (money market, government bonds)

- Uncertain (stocks, corporate bonds, etc)

• What are the issues?

- Time value

- Riskiness of investments

… make the problem challenging

1. Overview of Capital Markets:

20

• Which assets to invest in?

Real vs. financial assets

- Real assets: Assets used to produce goods and

services (ex: factories, land, human capital, etc)

- Financial assets (focus of this class): Claims on real

assets (ex: money, stocks, bonds, etc)

1. Overview of Capital Markets:

21

• Taxonomy of Financial Assets:

http://online.wsj.com/mdc/public/page/marketsdata.html

- Money Markets

short-term deposits

- Fixed Income Securities

bonds: promises fixed stream of income

- Equity

ownership, claim to funds after all debts

have been paid

- Investment Companies

mutual funds, pension funds, hedge funds

- Derivatives

payoff depends upon values of other assets

1. Overview of Capital Markets:

22

• How do financial asset returns compare?

1. Overview of Capital Markets:

23

• Going forward: what happened after 2000?

(type ^RUT in http://finance.yahoo.com/)

1. Overview of Capital Markets:

Nasdaq

Dow Jones

S&P500

Russsel 2000

24

• Going forward: the 2007-08 Credit Crisis

1. Overview of Capital Markets:

25

• The long-run picture is still that equity beats bonds!

1. Overview of Capital Markets:

27

• This course: focus on Equity

• Equity:

- Future cash-flows are (typically) uncertain

- Maturity is (typically) indefinite

- High risk, variable liquidity

• Two main classes of equities:

> Common stocks

> Preferred stocks (more like debt than equity)

2. Equity Markets:

28

2. Equity Markets:

• Investing in Equity :

go long (+) go short (-)

directly: buy short-sell

buy on margin

indirectly: mutual funds, pension funds

hedge funds

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• How do you buy a stock in a company?

- Buy on the primary market:

New issues to raise capital for firm: IPO (Initial

Public Offering), SEO (Seasoned Offering)

- Buy on the secondary market:

Existing owner sells to another party, does not

raise capital for firm (not involved)

- Organized Exchanges.

- Over-the-Counter (shorthand OTC).

- Electronic Networks.

2. Equity Markets:

30

• Types of Orders:

Market orders

Price-Contingent orders:

2. Equity Markets:

31

• Costs of Trading

Commission: fee paid to broker for making the

transaction

Spread: cost of trading with dealer/ market

Bid: price dealer will buy from you

Ask: price dealer will sell to you

Spread = Ask - Bid

2. Equity Markets:

32

- Buy on Margin (Margin Purchase):

> The investor borrows part of the purchase

price of a security from his broker

> The interest charged to the investor is the

broker’s call money rate plus a service spread

> The securities purchased by the investor are

held by the broker as a collateral on the loan

made (lose voting rights)

2. Equity Markets:

33

2. Equity Markets:

• Initial margin is set by the Fed

– Currently 50%

• Maintenance margin

– Minimum equity that must be kept in the margin

account

– Margin call if value of securities falls too much

34

- Buy on Margin (Margin Purchase): Example 1

2. Equity Markets:

Share price $100

60% Initial Margin

30% Maintenance Margin

100 Shares Purchased

Initial Position

Stock $10,000 Borrowed $4,000

Equity $6,000

35

- Buy on Margin (Margin Purchase): Example 1

Maintenance Margin

2. Equity Markets:

Stock price falls to $70 per share

New Position

Stock $7,000 Borrowed $4,000

Equity $3,000

Margin% = $3,000/$7,000 = 43% (still some slack!)

36

-Buy on Margin (Margin Purchase): Example 1

Margin Call:

2. Equity Markets:

How far can the stock price fall before a margin call? Let maintenance margin = 30%

Equity = 100P - $4000

Percentage margin = (100P - $4,000) / 100P

(100P - $4,000) / 100P = 0.30

Solve to find:

P = $57.14

37

-Buy on Margin (Margin Purchase): Example 2

Downside Risk of Buying on Margin:

P(0)=$100, Margin=$10,000, Loan=$10,000, Interest

rate on the loan: 9%/year

2. Equity Markets:

38

- Buy on Margin (Margin Purchase): A message from FINRA –

Financial Industry Regulatory Authority http://www.finra.org/Investors/ProtectYourself/InvestorAlerts/MarginAndBorrowing/P005973

Investing with Borrowed Funds: No "Margin" for Error

Investor purchases of securities "on margin" have grown dramatically in recent months. The

amount of debt taken on to buy securities has been growing steadily over the past few

months and reached a record high of $321.2 billion in February 2007.

We are re-issuing this Alert because we are concerned that many investors may

underestimate the risks of trading on margin and misunderstand the operation and reason

for margin calls. Investors who cannot satisfy margin calls can have large portions of their

accounts liquidated under unfavorable market conditions. These liquidations can create

substantial losses for investors.

Before you decide to open a margin account, make sure you understand the following risks:

- Your firm can force the sale of securities in your accounts to meet a margin call

- Your firm can sell your securities without contacting you

- You are not entitled to choose which securities or other assets in your accounts are sold

- Your firm can increase its margin requirements at any time and is not required to provide you with

advance notice

- You are not entitled to an extension of time on a margin call

- You can lose more money than you deposit in a margin account

- More advice from the SEC

…http://www.sec.gov/investor/pubs/margin.htm

39

- Short Sale:

> Sell something you don’t own: selling shares

of a firm not owned by borrowing security, and

later replacing it (cover it)

> A profit is made if the short position is covered

at a price lower than the one at which it was

established

> Short sale proceeds must remain with the

broker and investor is required to deposit a

collateral (to “post margin”)

2. Equity Markets:

40

2. Equity Markets:

41

- Short Sale: Example (Bearish on Dot-Bomb)

2. Equity Markets:

Dot Bomb 1000 Shares

50% Initial Margin

30% Maintenance Margin

$100 Initial Price

Sale Proceeds $100,000

Margin & Equity $50,000

Stock Owed 1000 shares

42

- Short Sale: Example (Dot Bomb Falls to $70)

2. Equity Markets:

Assets

$100,000 (sale proceeds)

$50,000 (initial margin)

Liabilities

$70,000 (buy shares)

Equity

$80,000

Profit = ending equity – beginning equity

= $80,000 - $50,000 = $30,000

= decline in share price x number of shares sold short

43

- Short Sale: (Margin Call)

2. Equity Markets:

How much can the stock price rise before a margin call

(maintenance margin = 30%)?

($150,000* - 1000P) / (1000P) = 30%

P = $115.38

* Initial margin ($50,000) + sale proceeds ($100,000)

1000P = value of shares owed

44

What more to talk about on short-selling? …

- Margins/fees

- “Naked short-selling”

- Dividends / Voting: The short-seller pays the dividend to the

stock lender. The naked short-seller pays the dividend to the

buyer of the promised stock. Vote: “holder of record.”

- More advice from the SEC …

http://www.sec.gov/spotlight/keyregshoissues.htm

- NYSE Top 100 Stocks by short interest

http://www.nyse.com/financials/sitable.html

- Stocks with High Short interest

http://www.highshortinterest.com/

45

Regulating short-selling:

- U.S.: SEC banned for 900 financial firms (lifted Oct 8)

- U.K.: FSA banned for 34 financial stocks (lifted 2009)

- France: AMF banned for bank stocks (Sept 22 for 3 months)

…

2008 Credit Crisis :

46

2008 Credit Crisis (cont.):

47

The curious case of a “short squeeze” …

48

• Investing in Equity :

go long (+) go short (-)

directly: buy short-sell

buy on margin

indirectly: mutual funds, pension funds

hedge funds

3. Delegated Portfolio Management:

49

• Why do individuals use investment companies (mutual

funds, pension funds, hedge funds)?

- each invests $10,000 individually

- add all classes’ money and invest collectively

3. Delegated Portfolio Management:

50

• U.S. Households Investments In Funds, Bonds, Stocks

3. Delegated Portfolio Management:

Source: ICI

FactBook

2014

51

• Why do individuals use investment companies (mutual

funds, pension funds, hedge funds)?

- Investment diversification at lower transaction cost

- Security selection skills (?) or portfolio tailoring to meet

specific objectives

- High liquidity and lower administration costs (record

keeping, reinvesting dividends)

- Sophisticated tax management (?)

3. Delegated Portfolio Management:

52

• U.S. Households Financial Assets in Investment Firms

3. Delegated Portfolio Management:

Source: ICI FactBook 2014

53

3. Delegated Portfolio Management:

• Some mutual fund management companies: • Independent (Vanguard)

• Broker-dealer (Charles Schwab)

• Bank (Wells Fargo)

• Insurance company (USAA)

• Browse http://www.morningstar.com/cover/funds.aspx

Source: ICI FactBook 2014

54

3. Delegated Portfolio Management:

• Investment policies for all tastes …

- Bonds (“fixed income”), stocks (“equity”), or mixed

(“balanced”). Attractive to investors with different

horizons and levels of sophistication

Source: ICI

FactBook

2014

55

3. Delegated Portfolio Management:

• Equity Mutual Funds and Market Returns (96-10)

Source: ICI

FactBook

2014

56

3. Delegated Portfolio Management:

• Redemption Rates of Equity Funds (86-10)

3. Delegated Portfolio Management:

Source: ICI

FactBook

2014

58

3. Delegated Portfolio Management:

• Fees are in the forms of:

- Management and operating expenses (0.4%-3.0%/year)

- Sales load (0%-5% at purchase [front-end load] or sale

[back-end load])

- 12b-1 fees (advertising)

- Incentive fees (for hedge funds, up to 20% of gains)

• use FINRA mutual fund expense analyzer:

http://apps.finra.org/investor_Information/ea/1/mfetf.aspx

59

3. Delegated Portfolio Management:

• Funds typically have more than 1 Share Class:

Class A Class B Class C No-Load***

Front-end load 5%* 0% 0% 0%

Back-end load 0% 4%** 1% 0%

12b-1 fees 0.25% 1% 1% 0.5%

Expense Ratio 1% 1% 1% 1%

*: depends on size of investment

**: depends on number of years till sale

***: sold directly by fund sponsor or fund supermarket

60

3. Delegated Portfolio Management:

• Fees … . 56% of funds have sales load. Mean = 3.6%. 2003 cost = $2.8B

. 66% of funds charge 12b-1 (marketing) fees. 2003 cost = $9.5B

. Operating expenses in 2003 = $38.1B

. Trading costs in 2003 about $16B

Total of $66 Billion represents about 1% of NAV. These

are yearly direct costs.

61

3. Delegated Portfolio Management:

• Turnover Rate of Equity Funds (1974-2010)

Source: ICI

FactBook

2014

Source: ICI

FactBook

2014

3. Delegated Portfolio Management:

63

3. Delegated Portfolio Management:

Open-End Closed-End

Capital structure Open, new shares

issued for subscriptions

Closed, like any

ordinary firm, the nr. of

shares is fixed

Buying / Selling into

fund …

Subscription may

involve sales charge

(load)

From another investor,

like buying/selling a

stock: trading costs but

no loads.

Cost of a share Redemption of

investments is at net

asset value (NAV)

May deviate from NAV.

Two risks: NAV and

changing discount.

Performance is reduced

by fees and

transactions costs

yes yes

• Types of Mutual Funds:

64

3. Delegated Portfolio Management:

• Passive vs. Active Management

Passive: - Aims to track (come as close as possible to) a

fixed portfolio of stocks, such as the S&P500.

- Minimizes costs and trades as little as possible.

Active: - Portfolio manager chooses strategy: “bottom

up”: security analysis; “top down”: asset allocation

Source: ICI

FactBook

2014

65

3. Delegated Portfolio Management:

• Passive vs. Active: Performance

Percentage of active funds below Wilshire 500

66

3. Delegated Portfolio Management:

• “Co-Insurance in Mutual Fund Families,”

by Goncalves-Pinto and Schmidt

67

3. Delegated Portfolio Management:

• Passive vs. Active:

68

• Investing in Equity :

go long (+) go short (-)

directly: buy short-sell

buy on margin

indirectly: mutual funds, pension funds

hedge funds

new: ETFs that replicate

investment classes

“Do-it-Yourself” Portfolio Management:

Source: ICI

FactBook

2014

3. Delegated Portfolio Management:

70

Exchange-Traded Funds (ETFs)

71

Exchange-Traded Funds (ETFs)

• ETFs offer public investors an undivided interest in a pool

of securities and other assets

• Shares can be traded throughout the day on a securities

exchange. ETFs do not sell or redeem at NAV. Financial

institutions purchase and redeem ETF shares directly in

large blocks called "creation units" (in kind, a basket of

securities in the same proportion held by the ETF)

• Many types:

• Indices (ex: SPDRs, Diamonds, Cubes, iShares),

leveraged, short, commodities, etc.

• …

• Other ETFs include value (growth) stocks of all sizes and

all small (large) cap stocks of all sizes.

Exchange-Traded Funds (ETFs)

• Many types:

• Indices (ex: SPDRs, iShares), leveraged, short

• Commodities

• …

http://etf.peacefulgains.com/A-List-of-exchange-traded-funds/

73

Mispricing of ETFs

• “Intraday Pricing Inefficiencies in International-Based

Exchange-Traded Funds,” by Goncalves-Pinto, Chua,

and Stefanescu (2012)

74

Investing directly into Value-Growth & Size

• Ex: iShares are exchange traded funds (ETFs) that

replicate the 9 Morningstar styles

75

Why the Lack of Interest for

ETFs in Singapore?

• Field Study Supervised by Goncalves-Pinto and Zahalka

in 2014:

Client Company: Singapore Exchange (SGX)

Survey Evidence:

- Small range of ETF product offerings

- Lack of knowledge by retail investors

- Home bias investing

- Value opinion of financial advisors highly

76

• Investing in Equity :

go long (+) go short (-)

directly: buy short-sell

buy on margin

indirectly: mutual funds, pension funds

hedge funds

new: ETFs that replicate

investment classes

“Do-it-Yourself” Portfolio Management:

77

3. Delegated Portfolio Management:

• Hedge Funds:

- Growing. Assets may exceed $2Trln (in Q3 2007,

Institutional Investors)

- No legal definition. Generally, a private investment fund open to limited range of qualified/accredited investors

- Invest in more complex and more risky investments (short-selling, derivatives, leverage). Dominate some specialty areas (derivatives, high-yield/distressed bonds, macro strategies)

- Many of these so-called "hedge funds" do not actually hedge their investments!

78

3. Delegated Portfolio Management:

• Hedge Funds:

- Only available to “sophisticated investors”.

– Partnership organization with max # of investors

– Large minimum investment

– Significant minimum holding period

– Performance-based compensation.

- No requirement to register with SEC, unlike open-to-the-public "retail" funds (e.g., U.S. mutual funds)

- Difficult to benchmark. Have a tendency to “blow up”

- Effective Activists

79

3. Delegated Portfolio Management:

• Hedge Fund Activism:

Daniel Loeb

Third Point Management

Carl Ichan

Ichan Enterprises

80

Short-Squeeze Risk and Activist HFs

Honours Thesis by

Gavin Loh (2014),

supervised by Luis

Goncalves-Pinto

81

3. Delegated Portfolio Management:

• Some Well-Known Hedge Fund Companies:

Amaranth Advisors

Citadel Investment Group

D. E. Shaw & Co.

Fortress Investment Group

Goldman Sachs Asset Management

Long Term Capital Management

Renaissance Technologies

Soros Fund Management

…

Hedge Funds: Risk and Return, study by Prof. Burton Malkiel

http://www.cfapubs.org/doi/pdf/10.2469/faj.v61.n6.2775

• For a critical look at hedge fund performance numbers:

82

3. Delegated Portfolio Management:

• Hedge Fund Styles:

Global macro – seeking assets that deviated from some anticipated

relationship. Heavy in bonds, FX and derivatives.

Arbitrage – seeking assets that are mispriced

Convertible arbitrage – (convertible bond vs. equity)

Fixed income arbitrage – (between related bonds)

Risk arbitrage – (between securities whose prices appear

to imply different probabilities for one event)

Statistical arbitrage– (between securities that have deviated

from some statistically estimated relationship)

Derivative arbitrage – (between a derivative and its security)

Long / short equity – hedged investment in equities

Short bias – (emphasizing short positions)

Equity market neutral – (balance long and short positions)

–> “Twice the risk and half the reward”?

-> Ex: George Soros

83

3. Delegated Portfolio Management:

• Hedge Fund Styles:

Event driven –

Distressed securities – (companies close to bankruptcy)

Regulation D – (distressed companies issuing securities)

Merger arbitrage – (between acquiring and target companies)

Other –

Emerging markets- (unhedged long in emerging markets)

Fund of hedge funds – (long only positions in hedge funds)

Quantitative

130-30 funds

-> Bet is on the probability that the merger happens

-> Usually contrarian

84

HF Prospectus

85

HF Prospectus

86

HF Prospectus

87

HF Prospectus

Fees are

• related to fund performance

• large

• option-like

• mostly paid only after the “high water mark” is met

88

To Do (For Next Class)

• Finish reading BKMJ Chapters 3, 4

• Read BKM Chapter 5.4, 5.5. and 5.6. and review

your statistics (Expected values, Standard deviations,

variances, Covariance, correlations) !

• Next class we will assign the case studies to be

presented/discussed by each group – submit your

group formation 4-6 people ASAP!

• People without a group come talk to me and I will

assign them to one!