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Global Finance WHERE DATA FINDS DIRECTION Global Finance WHERE DATA FINDS DIRECTION

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CFA Level I Exam Companion

This edition first published 2012. Š 2012 John Wiley & Sons Ltd. Registered office John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex, PO19 8SQ, United Kingdom For details of our global editorial offices, for customer services and for information about how to apply for permission to reuse the copyright material in this book please see our website at www.wiley.com/finance. The right of the author to be identified as the author of this work has been asserted in accordance with the Copyright, Designs and Patents Act 1988. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, except as permitted by the UK Copyright, Designs and Patents Act 1988, without the prior permission of the publisher. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. Designations used by companies to distinguish their products are often claimed as trademarks. All brand names and product names used in this book are trade names, service marks, trademarks or registered trademarks of their respective owners. The publisher is not associated with any product or vendor mentioned in this book. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold on the understanding that the publisher is not engaged in rendering professional services. If professional advice or other expert assistance is required, the services of a competent professional should be sought.

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Study Session 1 Ethics

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Equity Asset Valuation

Equity Asset Valuation 2nd Edition Jerald E. Pinto, Elaine Henry, Thomas R. Robinson and John D. Stowe with a foreword by Abby Cohen 978-0-470-57143-9 • Hardback • 464 pages • March 2010 £65.00 / €76.00 £45.50 / €53.20

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Chapter 1

Equity Valuation: Applications and Processes LEARNING OUTCOMES After completing this chapter, you will be able to do the following: • Define valuation and intrinsic value and explain two possible sources of perceived mispricing. • Explain the going - concern assumption, contrast a going concern to a liquidation value concept of value, and identify the definition of value most relevant to public company valuation. • List and discuss the uses of equity valuation. • Explain the elements of industry and competitive analysis and the importance of evaluating the quality of financial statement information. • Contrast absolute and relative valuation models and describe examples of each type of model. • Illustrate the broad criteria for choosing an appropriate approach for valuing a particular company.

1. INTRODUCTION Every day, thousands of participants in the investment profession — investors, portfolio managers, regulators, researchers — face a common and often perplexing question: What is the value of a particular asset? The answers to this question usually 4


Equity Valuation: Applications and Processes

determine success or failure in achieving investment objectives. For one group of those participants — equity analysts — the question and its potential answers are particularly critical, because determining the value of an ownership stake is at the heart of their professional activities and decisions. Valuation is the estimation of an asset’s value based on variables perceived to be related to future investment returns, on comparisons with similar assets, or, when relevant, on estimates of immediate liquidation proceeds. Skill in valuation is a very important element of success in investing. In this introductory chapter, we address some basic questions: What is value? Who uses equity valuations? What is the importance of industry knowledge? How can the analyst effectively communicate his analysis? This chapter answers these and other questions and lays a foundation for the remainder of this book. The balance of this chapter is organized as follows: Section 2 defines value and describes the various uses of equity valuation. Section 3 examines the steps in the valuation process, including a discussion of the analyst’s role and responsibilities. Section 4 discusses how valuation results are communicated and provides some guidance on the content and format of an effective research report. Section 5 summarizes the chapter, and practice problems conclude it.

2. VALUE DEFINITIONS AND VALUATION APPLICATIONS Before summarizing the various applications of equity valuation tools, it is helpful to define what is meant by value and to understand that the meaning can vary in different contexts. The context of a valuation, including its objective, generally determines the appropriate definition of value and thus affects the analyst’s selection of a valuation approach. 2.1. What Is Value? Several perspectives on value serve as the foundation for the variety of valuation models available to the equity analyst. Intrinsic value is the necessary starting point, but other concepts of value — going - concern value, liquidation value, and fair value — are also important. 2.1.1. Intrinsic Value A critical assumption in equity valuation, as applied to publicly traded securities, is that the market price of a security can differ from its intrinsic value. The intrinsic value of any asset is the value of the asset given a hypothetically complete understanding of the asset’s investment characteristics. For any particular investor, an estimate of intrinsic value reflects his or her view of the “true” or “real” value of an asset. If one assumed that the market price of an equity security perfectly reflected its intrinsic value, valuation 5


Equity Asset Valuation

would simply require looking at the market price. Roughly, it is just such an assumption that underpins traditional efficient market theory, which suggests that an asset’s market price is the best available estimate of its intrinsic value. An important theoretical counter to the notion that market price and intrinsic value are identical can be found in the Grossman - Stiglitz paradox. If market prices, which are essentially freely obtainable, perfectly reflect a security ’ s intrinsic value, then a rational investor would not incur the costs of obtaining and analyzing information to obtain a second estimate of the security ’ s value. If no investor obtains and analyzes information about a security, however, then how can the market price reflect the security’s intrinsic value? The rational efficient markets formulation (Grossman and Stiglitz 1980) recognizes that investors will not rationally incur the expenses of gathering information unless they expect to be rewarded by higher gross returns compared with the free alternative of accepting the market price. Furthermore, modern theorists recognize that when intrinsic value is difficult to determine, as is the case for common stock, and when trading costs exist, even further room exists for price to diverge from value (Lee, Myers, and Swaminathan 1999). Thus, analysts often view market prices both with respect and with skepticism. They seek to identify mispricing. At the same time, they often rely on price eventually converging to intrinsic value. They also recognize distinctions among the levels of market efficiency in different markets or tiers of markets (for example, stocks heavily followed by analysts and stocks neglected by analysts). Overall, equity valuation, when applied to market – traded securities, admits the possibility of mispricing. Throughout this book, then, we distinguish between the market price, P, and the intrinsic value (“value” for short), V. For an active investment manager, valuation is an inherent part of the attempt to produce investment returns that exceed the returns commensurate with the investment’s risk; that is, positive excess risk - adjusted return. An excess risk - adjusted return is also called an abnormal return or alpha. (Return concepts are more fully discussed in Chapter 2.) The active investment manager hopes to capture a positive alpha as a result of his efforts to estimate intrinsic value. Any departure of market price from the manager’s estimate of intrinsic value is a perceived mispricing (a difference between the estimated intrinsic value and the market price of an asset). These ideas can be illuminated through the following expression that identifies two possible sources of perceived mispricing: 1 VE – P = (V – P) + (VE – V)

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Equity Valuation: Applications and Processes

where VE = estimated value P = market price V = intrinsic value This expression states that the difference between a valuation estimate and the prevailing market price is, by definition, equal to the sum of two components. The first component is the true mispricing, that is, the difference between the true but unobservable intrinsic value V and the observed market price P (this difference contributes to the abnormal return). The second component is the difference between the valuation estimate and the true but unobservable intrinsic value, that is, the error in the estimate of the intrinsic value. To obtain a useful estimate of intrinsic value, an analyst must combine accurate forecasts with an appropriate valuation model. The quality of the analyst’s forecasts, in particular the expectational inputs used in valuation models, is a key element in determining investment success. For an active security selection to be consistently successful, the manager’s expectations must differ from consensus expectations and be, on average, correct as well. Uncertainty is constantly present in equity valuation. Confidence in one’s expectations is always realistically partial. In applying any valuation approach, analysts can never be sure that they have accounted for all the sources of risk reflected in an asset’s price. Because competing equity risk models will always exist, there is no obvious final resolution to this dilemma. Even if an analyst makes adequate risk adjustments, develops accurate forecasts, and employs appropriate valuation models, success is not assured. Temporal market conditions may prevent the investor from capturing the benefits of any perceived mispricing. Convergence of the market price to perceived intrinsic value may not happen within the investor’s investment horizon, if at all. So, besides evidence of mispricing, some active investors look for the presence of a particular market or corporate event (catalyst) that will cause the marketplace to re-evaluate a company’s prospects. 2.1.2. Going - Concern Value and Liquidation Value A company generally has one value if it is to be immediately dissolved and another value if it will continue in operation. In estimating value, a going - concern assumption is the assumption that the company will continue its business activities into the foreseeable future. In other words, the company will continue to produce and sell its goods and services, use its assets in a value - maximizing way for a relevant economic 7


Equity Asset Valuation

time frame, and access its optimal sources of financing. The going - concern value of a company is its value under a going – concern assumption. Models of going - concern value are the focus of these chapters. Nevertheless, a going - concern assumption may not be appropriate for a company in financial distress. An alternative to a company’s going - concern value is its value if it were dissolved and its assets sold individually, known as its liquidation value. For many companies, the value added by assets working together and by human capital applied to managing those assets makes estimated going - concern value greater than liquidation value (although a persistently unprofitable business may be worth more dead than alive). Beyond the value added by assets working together or by applying managerial skill to those assets, the value of a company’s assets would likely differ depending on the time frame available for liquidating them. For example, the value of non-perishable inventory that had to be immediately liquidated would typically be lower than the value of inventory that could be sold during a longer period of time, in an orderly fashion. Thus, concepts such as orderly liquidation value are sometimes distinguished. 2.1.3. Fair Market Value and Investment Value For an analyst valuing public equities, intrinsic value is typically the relevant concept of value. In other contexts, however, other definitions of value are relevant. For example, a buy – sell agreement among the owners of a private business — specifying how and when the owners (e.g., shareholders or partners) can sell their ownership interest and at what price — might be primarily concerned with equitable treatment of both sellers and buyers. In that context, the relevant definition of value would likely be fair market value. Fair market value is the price at which an asset (or liability) would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell. Furthermore, the concept of fair market value generally includes an assumption that both buyer and seller are informed of all material aspects of the underlying investment. Fair market value has often been used in valuation related to assessing taxes. In a financial reporting context — for example, in valuing an asset for the purpose of impairment testing — financial reporting standards reference fair value , a related (but not identical) concept. 2 Assuming the marketplace has confidence that the company’s management is acting in the owners’ best interests, market prices should tend, in the long run, to reflect fair market value. In some situations, however, an asset is worth more to a particular buyer (e.g., because of potential operating synergies). The concept of value to a specific buyer taking account of potential synergies and based on the investor’s requirements and expectations is called investment value. 8


Equity Valuation: Applications and Processes

2.1.4. Definitions of Value: Summary Analysts valuing an asset need to be aware of the definition or definitions of value relevant to the assignment. For the valuation of public equities, an intrinsic value definition of values is generally relevant. Intrinsic value, estimated under a going concern assumption, is the focus of this equity valuation book. 2.2. Applications of Equity Valuation Investment analysts work in a wide variety of organizations and positions; as a result, they apply the tools of equity valuation to address a range of practical problems. In particular, analysts use valuation concepts and models to accomplish the following: • Selecting stocks. Stock selection is the primary use of the tools presented in these chapters. Equity analysts continually address the same question for every common stock that is either a current or prospective portfolio holding, or for every stock that they are responsible for covering: Is this security fairly priced, overpriced, or under-priced relative to its current estimated intrinsic value and relative to the prices of comparable securities? • Inferring (extracting) market expectations. Market prices reflect the expectations of investors about the future performance of companies. Analysts may ask: What expectations about a company’s future performance are consistent with the current market price for that company’s stock? What assumptions about the company’s fundamentals would justify the current price? (Fundamentals are characteristics of a company related to profitability, financial strength, or risk.) These questions may be relevant to the analyst for several reasons: o The analyst can evaluate the reasonableness of the expectations implied by the market price by comparing the market’s implied expectations to his own expectations. o The market’s expectations for a fundamental characteristic of one company may be useful as a benchmark or comparison value of the same characteristic for another company. o To extract or reverse - engineer a market expectation, the analyst selects a valuation model that relates value to expectations about fundamentals and is appropriate given the characteristics of the stock. Next, the analyst estimates values for all fundamentals in the model except the fundamental of interest. The analyst then solves for that value of the fundamental of interest that results in a model value equal to the current market price.

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Equity Asset Valuation

• Evaluating corporate events. Investment bankers, corporate analysts, and investment analysts use valuation tools to assess the impact of such corporate events as mergers, acquisitions, divestitures, spin - offs, and going - private transactions. (Merger is the general term for the combination of two companies. An acquisition is also a combination of two companies, with one of the companies identified as the acquirer, the other the acquired. In a divestiture, a company sells some major component of its business. In a spin - off, the company separates one of its component businesses and transfers the ownership of the separated business to its shareholders. A leveraged buyout is an acquisition involving significant leverage [i.e., debt], which is often collateralized by the assets of the company being acquired.) Each of these events affects a company’s future cash flows and thus the value of its equity. Furthermore, in mergers and acquisitions, the company ’ s own common stock is often used as currency for the purchase; investors then want to know whether the stock is fairly valued. • Rendering fairness opinions. The parties to a merger may be required to seek a fairness opinion on the terms of the merger from a third party, such as an investment bank. Valuation is central to such opinions. • Evaluating business strategies and models. Companies concerned with maximizing shareholder value evaluate the effect of alternative strategies on share value. • Communicating with analysts and shareholders. Valuation concepts facilitate communication and discussion among company management, shareholders, and analysts on a range of corporate issues affecting company value. • Appraising private businesses. Valuation of the equity of private businesses is important for transactional purposes (e.g., acquisitions of such companies or buy - sell agreements for the transfer of equity interests among owners when one of them dies or retires) and tax reporting purposes (e.g., for the taxation of estates) among others. The absence of a market price imparts distinctive characteristics to such valuations, although the fundamental models are shared with public equity valuation. An analyst encounters these characteristics when evaluating initial public offerings, for example. An initial public offering (IPO) is the initial issuance of common stock registered for public trading by a company whose shares were not formerly publicly traded, either because it was formerly privately owned or government-owned, or because it is a newly formed entity. • Share - based payment (compensation). Share - based payments (e.g., restricted stock grants) are sometimes part of executive compensation. Estimation of their value frequently depends on using equity valuation tools.

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Equity Valuation: Applications and Processes

EXAMPLE 1 - 1 Inferring Market Expectations On 21 September 2000, Intel Corporation (NASDAQ - GS: INTC) 3 issued a press release containing information about its expected revenue growth for the third quarter of 2000. The announced growth fell short of the company ’ s own prior prediction by 2 to 4 percentage points and short of analysts ’ projections by 3 to 7 percentage points. In response to the announcement, Intel ’ s stock price fell nearly 30 percent during the following five days — from $ 61.50 just prior to the press release to only $ 43.31 five days later. To assess whether the information in Intel’s announcement was sufficient to explain such a large loss of value, Cornell (2001) estimated the value of a company’s equity as the present value of expected future cash flows from operations minus the expenditures needed to maintain the company ’ s growth. (We discuss such free cash flow models in detail in Chapter 4.) Using a conservatively low discount rate, Cornell estimated that Intel’s price before the announcement, $ 61.50, was consistent with a forecasted growth rate of 20 percent a year for the subsequent 10 years and then 6 percent per year thereafter. Intel’s price after the announcement, $ 43.31, was consistent with a decline of the 10 - year growth rate to well under 15 percent per year. In the final year of the forecast horizon (2009), projected revenues with the lower growth rate would be $ 50 billion below the projected revenues based on the preannouncement price. Because the press release did not obviously point to any changes in Intel ’ s fundamental long - run business conditions (Intel attributed the quarterly revenue growth shortfall to a cyclical slowing of demand in Europe), Cornell ’ s detailed analysis left him skeptical that the stock market ’ s reaction could be explained in terms of fundamentals. Assuming Cornell’s methodology was sound, one interpretation is that investors’ reaction to the press release was irrational. An alternative interpretation is that Intel ’ s stock was overvalued prior to the press release, and the press release was “a kind of catalyst that caused movement toward a more rational price, even though the release itself did not contain sufficient long - run valuation information to justify that movement” (Cornell 2001, 134). How could one evaluate these two possible interpretations? Solution: To evaluate whether the market reaction to Intel’s announcement was an irrational reaction or a rational reduction of a previously overvalued price, one could compare the expected 20 percent growth implicit in the preannouncement stock price to some benchmark — for example, the

11


Equity Asset Valuation

company’s actual recent revenue growth, the industry’s recent growth, and/or forecasts for the growth of the industry or the economy. Finding the growth rate implied in the company’s stock price is an example of using a valuation model and a company’s actual stock price to infer market expectations. Note: Cornell (2001) observed that the 20 percent revenue growth rate implied by the pre-announcement stock price was much higher than Intel ’ s average growth rate during the previous five years, which occurred when the company was much smaller. He concluded that Intel’s stock was overvalued prior to the press release.

Example 1-1 describes the market reaction to an earnings release by Intel in 2000. A retrospective on Intel eight years later (in September 2008, the company ’ s share price was around $ 20) illustrates the difficulty of equity valuation and the risk to growth stocks from disappointing results as compared to optimistic previous expectations. This example also illustrates that differences between market price and intrinsic value sometimes persist, offering opportunities for the astute investment manager to generate alpha. Continued…

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References 1. Derived as VE _ P _ VE _ P _ V _ V _ (V _ P ) _ (VE _ V ). 2. Accounting standards provide specific definitions of fair value. As of late 2008, the International Accounting Standards Board (IASB) is seeking to develop a single International Financial Reporting Standard on fair value measurement (see www.iasb.org for more information). The IASB is explicitly considering in its work the requirements of Statement of Financial Accounting Standards (SFAS) 157, which states (paragraph 5): “Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” 3. In this book, the shares of real companies are identifi ed by an abbreviation for the stock exchange or electronic marketplace where the shares of the company are traded, followed by a ticker symbol or formal acronym for the shares. For example, NASDAQ-GS stands for “Nasdaq Global Select Market,” and INTC is the ticker symbol for Intel Corporation on the NASDAQ-GS. (Many stocks are traded on a number of exchanges worldwide, and some stocks may have more than one formal acronym; we usually state just one marketplace and one ticker symbol.)

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CFA Level I Exam Companion

CFA Level I Exam Companion The 7city/Wiley study guide to getting the most out of the CFA Institute Curriculum 7city Learning 978-1-1183-6605-9 • Paperback • 334 pages • August 2012 £125.00 / €150.00 £87.50 / €105.00

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S TUDY S E SS ION 1

ETHICS

Chapter 1

Study Session 1 - Ethics Ethics

CFA Institute Professional Conduct Program

Code of Ethics

Standards of Professional Conduct

Topic:

Global Investment Performance Standards

Ethics

Weight: Study session(s): Readings:

The big picture T HE BIG PIC TURE Just as ethics are an important part of investment management, analysis, and research, Just they as ethics important part part of management, analysis, and research, they arealong an important areare an an important ofinvestment the CFA examination and curriculum. Included with part ethics of the CFA examination and curriculum. Included along with ethics are the Global Investment Performance are the Global Investment Performance Standards (GIPS), which are principles Standards (GIPS), which are principles detailing how performance results are measured and reported. detailing how performance results are measured and reported. The ethics section is 15% of the syllabus by weighting, yet is often overlooked by The ethics section is 15% of the syllabus by weighting, yet is often overlooked by delegates who focus on the delegates focus on the later in themostly syllabus. It isthe a purely written section calculations laterwho in the syllabus. It iscalculations a purely written section testing CFA Institute professional mostly testing Institute professional butbe the questions practice handbook, butthe theCFA questions are usually scenario practice based and handbook, as such can often quite tricky. are 14 ethics comprises 15% of the Level I exam, it is 10% of the Level II and Level III exams. In other Whereas words, the effort expended to learn about the Code of Ethics, the Standards of Professional Conduct, and GIPS is well worth it – because you will see it again. And again.


Study Session 1 Ethics

usually scenario based and as such can often be quite tricky. Whereas ethics comprises 15% of the Level I exam, it is 10% of the Level II and Level III exams. In other words, the effort expended to learn about the Code of Ethics, the Standards of Professional Conduct, and GIPS is well worth it – because you will see it again. And again.

Code of Ethics and Standards of Professional Conduct Candidates are responsible for not only being able to recite the Code of Ethics and the Standards of Professional Conduct [keywords: describe, state, explain] but also for understanding how the Code and Standards are applied in investment management and research [keywords: demonstrate, distinguish, recommend]. Be sure to practice the application of these to different situations. Whereas the Code of Ethics provides the broad framework for conduct, the Standards are more specific with respect to how the Code is operationalized for CFA Institute members and CFA candidates. For example, the Code of Ethics states “Place the integrity of the investment profession and the interests of clients above their own personal interests,” and the Standards expand on “III. Duties to Clients” with explanations on “Loyalty, Prudence, and Care,” “Fair Dealing,” “Suitability,” “Performance Presentation,” and “Preservation of Confidentiality.” The key to the Code and Standards is to remember: • • • •

The Code and Standards apply to both CFA Institute members and CFA candidates Always put the client, the profession, and one’s employer ahead of oneself Be professional, knowledgeable, and objective Comply with securities laws

GIPS The basic idea of GIPS is to facilitate the comparison of investment performance. The beneficiaries of GIPS are investors and investment management firms, with the benefits arising primarily from the clear, understandable, and comparable results. Investment management firms comply on a voluntary basis, but they can also employ a third party to verify their claim on compliance to GIPS. A key element of GIPS is that they form the ethical principles of performance reporting.

15


CFA Level I Exam Companion

Code of Ethics and Standards of Professional Conduct Study Session 1 Reading 1

Learning outcome statements Application LOS

Knowledge LOS 1a Describe the structure of the CFA Institute Professional Conduct Program and the process for the enforcement of the Code and Standards 1b State the six components of the Code of Ethics and the seven Standards of Professional Conduct 1c Explain the ethical responsibilities required by the Code and Standards, including the multiple subsections of each Standard

Knowledge learning outcome statements 1a Describe the structure of the CFA Institute Professional Conduct Program and the process for the enforcement of the Code and Standards The program is fundamental to the values of the CFA Institute. The key points to note are: • The program is a model for measuring the ethics of investment professionals globally • All members and candidates must abide by the Code and Standards • They are encouraged to notify their employer of this responsibility Violations of the Code and Standards may result in disciplinary sanctions by the CFA Institute. Sanctions include: • Revocation of membership • Revocation of candidacy in the CFA program • Revocation of right to use the CFA designation

1b State the six components of the Code of Ethics and the seven Standards of Professional Conduct The Code of Ethics “Members of CFA Institute and candidates for designation must: • Act with integrity, competence, diligence, respect, and in an ethical manner with 16


Study Session 1 Ethics

• •

• • •

the public, clients, prospective clients, employers, employees, colleagues in the investment profession, and other participants in the global capital markets Place the integrity of the investment profession and the interests of clients above their personal interests Use reasonable care and exercise independent professional judgment when conducting investment analysis, making investment recommendations, taking investment actions, and engaging in other professional activities Practice and encourage others to practice in a professional and ethical manner that will reflect credit on themselves and on the profession Promote the integrity of and uphold the rules governing capital markets Maintain and improve their professional competence and strive to maintain and improve the competence of other investment professionals”

Standards of Professional Conduct i. Professionalism a. Knowledge of the Law b. Independence and Objectivity c. Misrepresentation d. Misconduct ii. Integrity of Capital Markets a. Material Non-public Information b. Market Manipulation iii. Duties to Clients a. Loyalty, Prudence, and Care b. Fair Dealing c. Suitability d. Performance Presentation e. Preservation of Confidentiality iv. Duties to Employers a. Loyalty b. Additional Compensation Arrangements c. Responsibilities of Supervisors v. Investment Analysis, Recommendations, and Actions a. Diligence and Reasonable Basis b. Communication with Clients and Prospective Clients c. Record Retention vi. Conflict of Interest a. Disclosure of Conflicts b. Priority of Transactions 17


CFA Level I Exam Companion

vii.

c. Referral Fees Responsibilities as a CFA Institute Member or CFA Candidate a. Conduct as Members and Candidates in the CFA Program b. Reference to the CFA Institute, the CFA Designation, and the CFA Program

1c Explain the ethical responsibilities required by the Code and Standards, including the multiple sub-sections of each Standard This simply requires knowledge of the Standards and the Code, ready to apply to scenarios in Reading 2. Reading 1 sample question (Answers on p. 297 of full book) The Standard covering “Communication with client and prospective clients� is least likely to require that: A. Analysts distinguish between fact and opinion in their reports B. Clients must be informed promptly about any changes to the investment process C. Analysts always show at least ten years of historic information in their reports

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Study Session 1 Ethics

Guidance for Standards I窶天II Study Session 1 Reading 2

Learning outcome statements Application LOS

Knowledge LOS

2a Demonstrate a thorough knowledge of the Code of Ethics and Standards of Professional Conduct by applying the Code and Standards to situations involving issues of professional integrity 2b Distinguish between conduct that conforms to the Code and Standards and conduct that violates the Code and Standards 2c Recommend practices and procedures designed to prevent violations of the Code of Ethics and Standards of Professional Conduct

Application learning outcome statements 2a Demonstrate a thorough knowledge of the Code of Ethics and Standards of Professional Conduct by applying the Code and Standards to situations involving issues of professional integrity 2b Distinguish between conduct that conforms to the Code and Standards and conduct that violates the Code and Standards 2c Recommend practices and procedures designed to prevent violations of the Code of Ethics and Standards of Professional Conduct The emphasis in this reading is on applying the Standards to situations that members face, rather than being able to recite the Standards from the handbook. As such, spend your review time here with the case studies and examples that are shown throughout the handbook rather than learning the names and numbers of each Standard. Within each Standard there are several examples of how the Standard would be applied in specific situations. Make sure you understand each example and the rationale for the conclusions reached. There are then plenty of practice questions at the end of the reading that you should complete. Reading 2 sample question (Answers on p. 297 of full book) 19


CFA Level I Exam Companion

A discretionary fund manager of an equities fund invests new cash received in T-bills. Is this necessarily a breach of the Code and Standards? A. Yes, as it is an equities fund B. No, as the T-bills may be a temporary investment C. No, as the fund manager is only guided towards, not legally bound to, equity investments

Introduction to the Global Investment Performance Standards Study Session 1 Reading 3

Learning outcome statements Application LOS

Knowledge LOS 3a Explain why the GIPS standards were created, which parties the GIPS standards apply to, and who is served by the standards 3b Explain the construction and purpose of composites in performance reporting 3c Explain the requirements for verification

Knowledge learning outcome statements 3a Explain why the GIPS standards were created, which parties the GIPS standards apply to, and who is served by the standards Why were the GIPS standards created? Global Investment Performance Standards were devised for the following reasons: • The investment community had great difficulty making meaningful comparisons on the basis of accurate investment performance data • Misleading practices hinder comparability • Representative accounts • Reporting only top-performing accounts • Survivorship bias (i.e. ignoring performance of funds that no longer exist) • Presenting an “average” performance history 20


Study Session 1 Ethics

• • • • •

Excluding poor-performing portfolios Varying time periods Selecting time periods to favour results Practitioner-driven set of ethical principles Establish a standardized, industry-wide approach for calculating and presenting historical investment results • Help avoid misrepresentation of performance by investment firms Who can claim compliance? • Any investment management firm may choose to comply with GIPS o Voluntary compliance o Not typically required by legal or regulatory authorities • Investment firm o Must manage assets • Plan sponsors and consultants o Cannot make a claim of compliance o Can claim to endorse the GIPS • Software vendors o Cannot be compliant • Firm-wide process o Cannot be achieved on a single product or composite • Two options: o Comply or do not comply Who benefits from compliance? Benefits two main groups: 1. Investment management firms 2. Prospective clients • Provide reassurance to prospective clients about track record of the investment management firm o Record is complete and fairly presented o Allows global competition for compliant firms o Investors have a greater level of confidence in integrity of performance management o Can more readily compare firms 3b Explain the construction and purpose of composites in performance reporting 21


CFA Level I Exam Companion

Composites Key concepts: • Required use of composites o An aggregation of discretionary portfolios into a single group that represents a particular investment objective or strategy o Must include all actual, fee-paying discretionary portfolios managed in accordance with the same investment objective or strategy • Firms cannot choose portfolios to include or exclude • Establish criteria on an ex-ante basis (before the fact, not after) 3c Explain the requirements for verification Verification • Firms are responsible for their claim of compliance and for maintenance of the claim • Firms self-regulate • Firms may voluntarily hire an independent third party to verify claim • Primary purpose • Provide assurance that a firm has adhered to the GIPS on a firm-wide basis • Verification • Entire firm; not on specific composites • Has the firm complied with all the composite construction requirements of GIPS on a firm-wide basis? • Are the firm’s processes and procedures designed to calculate and present performance results in compliance with the GIPS standards? • Performed only by qualified independent third parties

Reading 3 sample question (Answers on p. 297 of full book) Abraham Management was established five years ago and has complied with GIPS in presenting information about the performance of its assets under management for this time. The firm has commissioned its internal audit department to test whether the firm has complied with composite construction criteria firm-wide and has the policies and procedures to calculate performance in accordance with GIPS. It put a note on its marketing materials stating “Abraham Management have complied with GIPS standards and have had the compliance verified.” 22


Study Session 1 Ethics

Abraham Management is: A. in full compliance with GIPS B. in violation of GIPS because it has not presented at least ten years’ information C. in violation of GIPS because the firm cannot provide its own verification

Introduction to the Global Investment Performance Standards Study Session 1 Reading 4

Learning outcome statements Application LOS

Knowledge LOS 4a Describe the key characteristics of the GIPS standards and the fundamentals of compliance response when the GIPS standards and local regulations conflict 4b Describe the scope of the GIPS standards, with respect to an investment firm’s definition and historical performance record 4c Explain how the GIPS standards are implemented in countries with existing standards for performance reporting, and describe the appropriate response when the GIPS standards and local regulations conflict 4d Describe the nine major sections of the GIPS standards

Knowledge learning outcome statements 4a Describe the key characteristics of the GIPS standards and the fundamentals of compliance response when the GIPS standards and local regulations conflict 4b Describe the scope of the GIPS standards, with respect to an investment firm’s definition and historical performance record 4c Explain how the GIPS standards are implemented in countries with 23


CFA Level I Exam Companion

existing standards for performance reporting, and describe the appropriate response when the GIPS standards and local regulations conflict 4d Describe the nine major sections of the GIPS standards Note that the examinable portion of Reading 4 is actually very short. There is a large optional section, denoted with blue lines, that is not examinable. The key to this reading is to memorize the main components of the GIPS framework. These are listed in detail in the early part of the reading before the optional section. Following the optional section is a set of sample disclosures – these provide an excellent interactive way of committing the GIPS rules to memory.

Reading 4 sample question (Answers on p. 297 of full book) Ames Capital is a global financial services firm incorporated in the United States of America. Each overseas branch of the firm operates through separate legal entities under the name Ames Capital except for in Europe where the company operates through a single subsidiary called Europa Wealth. Europa Wealth has head offices in Geneva but branches in 15 other European countries. For the purposes of GIPS compliance the definition of the firm includes: A. all legal entities called Ames Capital only B. all legal entities called Ames Capital and the head office of Europa Wealth C. all legal entities called Ames Capital, the head office of Europa Wealth and all of Europa Wealth’s branches

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Study Session 1 Ethics

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25


How the Trading Floor Really Works

How the Trading Floor Really Works Terri Duhon 978-1-1199-6295-3 • Hardback • 368 pages • September 2012 £29.99 / €36.00 £20.99 / €25.20

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Chapter 1

What Are Financial Markets? This chapter will provide the financial markets foundation, terminology and context to discuss the dynamics of the trading floor. The first step is to realize that every time a financial transaction occurs between two or more parties it has ramifications in the financial markets. Parties on one side of the transaction may include individuals investing in their pensions, saving up for a rainy day or buying insurance. Most of this retail activity gets funneled through larger financial companies such as pension funds, banks, insurance companies and asset managers, which are the main investors in the financial markets. On the other side of many financial transactions are the entities that need money and raise it either by borrowing (debt markets) or by selling part of their company (equity markets). These are generally referred to as the “issuers.” Extrapolate from there and the foundation of the financial markets becomes clear. It is where people with money (investors) meet people who need money (issuers). The place where the buyers and the sellers meet or where the issuers and the investors meet is called the “financial market” and the transfer itself often occurs via a bank trading floor. In other words, the buyers and sellers don’t physically meet in order to trade; they use the trading floor instead. Throughout this discussion, the broad role of banks as intermediators will become clear. This chapter will also answer questions such as: Who needs money? What is private equity vs. public equity? Why do banks give out loans and how are they different from bonds? Why do derivatives exist?

26


What Are Financial Markets?

When I was a senior at MIT, I started doing interview rounds with Wall Street banks for a position in sales and trading. My first interview was conducted by an options trader from a boutique trading company. After a very brief introduction, the trader said, “Make me a market for this pencil.” I literally had no idea what he had just said. So the trader says, “OK, let’s play a game. I’m going to roll a die. Whatever number comes up, I’ll pay you that amount in dollars. If I roll a one, I’ll pay you one dollar. If I roll a two, I’ll pay you two dollars, etc. How much will you pay me to play that game?” I still couldn’t understand what he was trying to get me to say. What did it mean to pay someone to play a game? The trader said, “OK, whatever I roll, you’ll at least get a dollar, right? Will you pay me a dollar to play this game?” I immediately said, “Yes.” The trader then said, “Will you pay me two dollars to play this game?” I said “yes” again. The trader then said, “Will you pay me three dollars to play this game?” I said “yes” again. I now knew how to get to the right answer but the trader was clearly irritated and was asking rapid-fire questions so I had no time to think. He then said, “Will you pay me four dollars to play this game?” I said “yes” without thinking. The trader said, “Why?” At this point I knew I had made a mistake, but I was so frazzled and nervous that I couldn’t think of a good answer. I decided to brazen it out and said, “I feel lucky?” Needless to say, the interview was immediately over and I didn’t get the job.

The financial markets encompass everything from shares to derivatives to commodities. They are as broad and diverse in what they offer and who participates as any supermarket is. This seems a daunting space to then try to classify and explain; however, there is one primary driver of the financial markets that is a good framework on which to base an understanding. The financial markets are primarily driven by the supply of issuers and the demand of investors. Or in other words, the financial markets are a place where entities who need money meet with entities that have money. Where do banks and in particular trading floors come into this? They sit in the middle. They facilitate the meeting of the supply and the demand. Within the broader world of financial markets, this particular space is called capital markets, where capital refers to cash in any currency and the focus of these capital markets is capital raising by the issuers and investing by the investors. Who are the entities who need money? Doesn’t everyone need money? Yes, at some point or another, everyone generally comes to the capital markets to raise some money. Figure 1.1 shows the position of banks in the capital markets.

27


How the Trading Floor Really Works

FIGURE 1.1 Banks as intermediators in the capital markets. Capital - cash

Capital - cash Issuers need money: Individuals (retail) Corporates Banks Insurance Companies Pension Funds Asset Managers Government Entities Debt or Equity

Financial Intermediaries: Banks

Investors have money: Individuals (retail) Corporates Banks Insurance Companies Pension Funds Asset Managers Government Entities Debt or Equity

Capital moves from the investors to the issuers via banks acting as financial intermediators. Before going into details of who each of these entities is and what exactly they do in the capital markets, it is important to first distinguish between the equity capital markets and the debt capital markets. All issuers who need money must first decide whether they need equity capital or debt capital. Throughout this book, there are references to the price of a financial product in the financial market. A market is where buyers and sellers meet. Think supermarket, flower market, flea market . . . Some of these are places which have fixed prices and others are places where a buyer and seller come to an agreement. In the latter case, the price is determined by the number of buyers compared to the number of sellers. This is no different in the financial market. Supply and demand are the drivers of the price of every financial product, such as equity and debt. We generally say the price of a financial product is where it recently traded unless some bit of financial news would have likely affected that price since the last trade. The key point to understand about financial products is that their price generally moves all day, every day based on new information. This information can be about the performance of a particular retailer, which will affect their equity or bond price or the state of a particular economy, which will affect financial products in that economy. However, while that information might give general direction of the price (in other words whether the price might go up or down), supply and demand determine the actual price. Debt Markets Almost all companies borrow money, or in other words issue debt. The easiest way to explain this is by using an example of a young couple buying a home. They don’t have the money to buy the entire house, but they have savings which allow them to 28


What Are Financial Markets?

spend up to 30% of the house price, called “equity,” and they are able to borrow the rest via a mortgage, called “debt.” They also have an income that allows them to pay off the mortgage debt (plus the interest) over the years. In theory, over time, as the couple pay down the mortgage, their equity in the house increases until they eventually have 100% equity in their house and no debt. Most companies on the other hand almost never pay down their debt entirely. Instead, they continue to borrow more and more as they grow their business. Companies borrow for a number of reasons. For example, they want to expand their business or they want to buy a competitor. It is exactly the same as an individual going to the bank and asking for a loan. The lender wants to know why the borrower needs the money and how the borrower is going to pay the money back. If the lender doesn’t believe the borrower will be able to pay the money back, the lender won’t lend. Governments borrow money the same way and for the same reasons that companies do. For example, they borrow to build infrastructure such as roads or they borrow to expand their defensive capabilities. The lender asks the same questions to governments as to companies as to individuals. Why is the money needed and how will it be paid back? Years ago, debt and equity were pieces of paper much like paper money is today. Whoever is holding paper money is the owner of it. It was the same with debt and equity. There are stories of people finding boxes of often worthless shares (another term for equity) or bonds (another term for debt) in their attics. They looked like a certificate. Some were very elaborate; others were very simple. Today, there is a legal contract for equities and debt which details the terms and conditions of them, but the ownership is not a function of who is physically holding the contract itself. The ownership is mostly listed in electronic registers. What is debt? Very simply, in the financial markets debt is either a bond or a loan which represents an obligation of one party to make a payment to another party. It is a financial product which gives the borrower (generally called the issuer) an amount of money (called the principal amount) and in exchange requires the issuer to pay a coupon (also called interest) every year and then to repay the entire principal amount at maturity. The maturity can be anywhere from 1 day to 100 years, but most company debt has a maturity of between two and seven years. As mentioned above, most issuers re-borrow their debt rather than pay it down. This means that if a corporate borrows $100 million for five years, the corporate is still required to pay the $100 million back to the investors at maturity in five years, but he will often do this by borrowing another $100 million. Box 1.1 summarizes the main aspects of debt.

29


How the Trading Floor Really Works

Box 1.1 Debt summary • Bonds and loans are the two primary types of debt (Figures 1.2 and 1.3). • Debt is borrowed money and needs to be paid back at maturity. • Debt has a coupon (also called an interest payment) which is due until the principal is paid back. • The maturity of debt can be overnight out to 50 or 100 years but is generally two to seven years.

The coupon on a bond or loan is where the term fixed income originates. We talk about the debt markets vs. equity markets but we also use the term “fixed income markets vs. equity markets.” Very broadly, the terms “debt” and “fixed income” are the same. The term fixed income is meant to distinguish between a coupon on a bond (Figure 1.2) or loan (Figure 1.3) in contrast to a dividend payment in equity that is an unknown amount and may or may not be paid to shareholders, which we will explore later in this chapter. What is the difference between a bond and a loan? Historically, bonds are bought by investors and loans are given and held by banks. Generally, bonds are considered public financial products while loans are considered private financial products. A bond might have several hundred different investors, while a loan will often only be owned by the bank that originally gave the loan in the case of individuals and small companies or by a handful of banks in the case of larger companies. Table 1.1 compares bonds and loans. In Figure 1.2, the bank facilitates the issuance of a bond by finding the investors in the bond. If Supermart needs to borrow $100 million, the bank needs to find enough investors that add up to $100 million. The bank manages both the relationship with the issuers (in this case Supermart) as well as with the investors. The bank facilitates this matchmaking between its issuer clients and its investor clients.

30


What Are Financial Markets?

FIGURE 1.2 Example of a bond. Supermart, a large supermarket chain, borrows $100 million for five years in the bond market with a coupon of 3% per year. • The principal of the bond is $100 million. • The coupon on the bond is 3% per year or $3 million per year. • Supermart gets the principal of $100 million on day one from investors who buy the bond. • Supermart pays the investors $3 million each year for five years and in five years also pays back the $100 million. Cashflow timeline for an investor who buys $20 million of the Supermart bond $600,000 Investor receives 3% every year from Supermart $600,000

Investor pays $20 million to Supermart on day one

initial payment

$600,000

$600,000 $600,000

timeline

$20 million At maturity, the investor receives the last coupon payment and the principal back from Supermart

5 years

$20 million

Another distinction that can generally be made between bonds and loans is that the larger the issuer, the more likely the issuer will use the bond market. This is a function of how familiar investors are with the issuer. While an entity such as a car manufacturer, like Ford or Toyota, can easily borrow in the form of bonds from investors, a small entity such as a coffee shop will likely need to go to its bank where it has a relationship and borrow in the form of a loan. Over time if the coffee shop expands and becomes a recognized brand nationally or internationally, such as Starbucks, it may eventually have access to the bond markets.

31


How the Trading Floor Really Works

FIGURE 1.3 Example of a loan. Supermart, a large supermarket chain, borrows $100 million for five years from its bank at a rate of 3% per year. • The principal of the loan is $100 million. • The coupon or the interest rate on the loan is 3% per year or $3 million per year. • Supermart gets the principal of $100 million on day one from its bank which gives out the loan. • Supermart pays its bank $3 million each year for five years and in five years also pays back the $100 million principal. Cashflow timeline for a bank who lends $100 million to Supermart Cashflow timeline for a bank who lends $100 million to Supermart Cashflow timeline for a bank who lends $100 million to Supermart

$3,000,000 $3,000,000 Bank receives 3% every year from Supermart Bank receives 3% every year from Supermart $3,000,000 $3,000,000 $3,000,000 $3,000,000 $3,000,000 $3,000,000 $3,000,000 $3,000,000

Bank pays $100 Bank million pays to $100 Supermart million on day one to Supermart on day one

Initial payment Initial payment

Timeline Timeline

$100 million $100 million

At maturity, the bank receives the last the bank At maturity, coupon payment receives the lastand thecoupon principal back and payment 5 years the principal back 5 years

$100 million $100 million

TABLE 1.1 Comparison of a Bond and a Loan Bonds Bonds Bonds are arranged by bank Bonds are arranged by bank Banks distribute the bonds to their Banks clients distribute the bonds to their investor investor clients A bank intermediates between the A bank issuer and intermediates the investor between the issuer and the investor There are thousands of investors are thousands of investors in There some bonds in some bonds

32

Loans Loans Loans are arranged by banks Loans are arranged by banks Banks may distribute loans may distribute loans to Banks other banks to other banks Banks will retain some or all of Banks a loanwill retain some or all of a loan Loans generally have one to a handful generally have one to a handful of Loans investors of investors


What Are Financial Markets?

There is another distinction we make in the debt markets. It is between the two types of coupons debt can have: fixed and floating. The first is an interest rate that is fixed for the life of the bond or loan, for example a borrower issues a bond with a fixed rate of 3% per year for five years. The second is an interest rate that is reset with a set frequency based on where current interest rates are. For example, if the coupon is reset annually the interest changes every year. On day one, the borrower knows what his interest is for the first year but has to wait till the end of the first year to know what his interest cost will be for the next year and so on. These are both considered fixed income as defined above because in both cases there is definitely an interest payment to be made as opposed to dividends in the equity markets, which are unknown in both amount and whether they will be paid or not. Why borrowers choose fixed over floating interest payments is not always a case of their choosing as opposed to a case of what the investors are interested in buying at the time. Many borrowers are advised by their bank on what type of debt will be best received by the investors and will thus try to choose what they believe will be the cheapest for them. “Cheapest” means the one with the lowest interest cost. One generalization we can make however is that loans are generally floating rate and bonds are split evenly between fixed rate and floating rate coupons. The role of the banks is crucial in the debt markets. They are either lending money to borrowers or facilitating (also called intermediating) the debt issuance to the appropriate investor base. “Appropriate” means that for some smaller borrowers they are only able to borrow from investors in their jurisdiction or region, for example a regional supermarket chain in the United States is likely only to have US investors, whereas a global brand such as a car manufacturer will have global investors. To be clear, the crucial role that banks play in the debt markets applies to the individual who needs a loan, a mortgage or a credit card, through to the largest corporate who needs to do a debt issuance. In fact, one could say that, historically, a bank’s main role, other than taking in deposits, was to lend money or facilitate the borrowing of money. Figure 1.4 illustrates how a bank intermediates access to capital.

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How the Trading Floor Really Works

FIGURE 1.4 Bank intermediating access to capital in the loan market. Cash

Cash

Banks lend money to clients: Individuals (retail) Corporates Banks Insurance companies Pension funds Asset managers Government Entities

Loans

Financial Intermediaries: Banks

Banks borrow money from investors: Individuals (retail) Corporates Banks Insurance companies Pension funds Asset managers Government Entities OR Banks use client deposits Debt or Deposits

There is an old saying in the banking world in London. Traditionally, bankers were the individuals who gave out loans. The rest of the financial community in London used to say that they operated on the “3_6_3 rule”: bankers borrowed money at 3%, lent money at 6% and went home by 3 p.m. Another big difference between the bond and loan market is what happens after the bond or loan is issued. The bond will change hands (in other words trade) over time, while the loan generally won’t. Once the bank has found the initial investors in the new issue bonds (called the primary market), the bank continues to play a crucial role in the debt markets because many investors don’t keep the bonds for the full life of the bond. They will sell their bond investments for a variety of reasons, which include the price of the bond going up, which means the initial investor made a profit, or the price of the bond going down because the issuer was not performing very well or because the investor no longer liked the sector in which the company operated. All trading activity in that bond after the bank first sold it to its investors is called the secondary market (Box 1.2). Because loans are often given to smaller issuers who are less well known in the financial markets, once a bank has lent the money, it is not as easy to sell a loan even to other banks. In other words, there is very little secondary market trading in loans compared to bonds. Table 1.2 compares the primary and secondary markets.

34


What Are Financial Markets?

Box 1.2 Reasons for trading in secondary markets • An investor who purchased his bonds when they were first issued at a price of 100% sees that the price has gone up to 101%. He decides to sell them and make a profit. • An investor who didn’t purchase the debt when it was first issued has decided that he would like to invest in the Supermart bonds. • An investor who purchased his bonds when they were first issued has a limit to how much the price of his bonds can change. They are now trading at 95% and he bought them at 100%. He is required to sell them now.

When an investor wants to sell a bond, he will ask a bank to buy it from him. He will not necessarily ask the bank that originally sold it to him. TABLE 1.2 Comparison of Primary and Secondary Markets Primary Market

Secondary Market

The first transaction of a new issue debt or equity

All trades in a product after the first

The arranging bank sells the new issue debt or equity to an investor for the first time

The investor of a new issue sells the new issue back to the arranging bank or to another bank

The investor buys the shares at the issue price and the debt at 100%

The trade price is likely different from the issue price

He can go to a different bank. A bank’s job is to determine the price where the bank can sell it to another investor. The bank will often buy the bond without knowing exactly to whom it will sell the bond but knowing that it has enough investor clients that it will be able to sell the bond to one of its clients. The price where debt trades is expressed as a percentage of the principal, for example 100% or 101% or 98%. Normally, a bond is originally issued at 100% (a bond price of 100% is called par) and over time _ based on supply and demand, the performance of the issuer, the performance of the economy and interest rate changes _ that price will move up and down. The key relationship in fixed income is between the price of the bond and how interest rates have changed since the bond was issued. If interest rates go up, the bond price will go down and vice versa. The idea is that if interest rates for five years are 35


How the Trading Floor Really Works

currently at 4% and a 5-year bond has a 3% coupon, investors will want to pay less for that bond because it is not paying 4%. This is explained in more detail in later chapters.

Trading debt • An investor buys $50 million of a bond at a price of 100% of the principal amount. Thus the cash price is $50 million. • The bond price moves up to 101% of the principal amount, which is $50.5 million. • The investor sells the bond and makes a profit of 1%. The cash exchange for a $50 million trade is: o -$50 million (to buy the bond) + $50.5 million (to sell the bond) = $0.5 million profit

Continued…

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36


What Is Behavioral Finance?

Behavioral Finance and Wealth Management How to Build Optimal Portfolios That Account for Investor Biases 2nd Edition Michael Pompian 978-1-1180-1432-5 • Hardback • 324 pages • January 2012 £50.00 / €60.00 £35.00 / €42.00

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Part 1

What is Behavioral Finance? People in standard finance are rational. People in behavioural finance are normal. —Meir Statman, PhD, Santa Clara University

At its core, behavioral finance attempts to understand and explain actual investor and market behaviors versus theories of investor behavior. This idea differs from traditional (or standard) finance, which is based on assumptions of how investors and markets should behave. Wealth managers from around the world who want to better serve their clients have begun to realize that they cannot rely solely on theories or mathematical models to explain individual investor and market behavior. As Meir Statman’s quote puts it, standard finance people are modeled as “rational,” whereas behavioural finance people are modeled as “normal.” This can be interpreted to mean that “normal” people may behave irrationally—but the reality is that almost no one (actually, I will go so far as to say absolutely no one) behaves perfectly rationally, and dealing with normal people is what this book is all about. We will delve into the topic of the irrational behaviors of markets at times; however, the focus of the book is on individual investor behavior. Fundamentally, behavioral finance is about understanding how people make financial decisions, both individually and collectively. By understanding how investors and markets behave, it may be possible to modify or adapt to these behaviors in order to improve financial outcomes. Inmany instances, knowledge of and integration of 37


Behavioral Finance and Wealth Management

behavioral finance may lead to better than expected results for both advisors and their clients. But advisors cannot view behavioral finance as a panacea or “the answer” to problems with clients. Working with clients is as much an art as it is a science. Behavioral finance can add many arrows to the art quiver. We will begin this chapter with a review of the prominent researchers in the field of behavioral finance, all of whom promote a deeper understanding of the benefits of the behavioral finance discipline. We will then review the key differences debate between standard finance and behavioral finance. By doing so, we can establish a common understanding of what we mean when we say behavioral finance, which will in turn permit us to understand the use of this term as it applies directly to the practice of wealth management. This chapter will finish with a summary of the role of behavioral finance in dealing with private clients and how the practical application of behavioural finance can enhance an advisory relationship.

BEHAVIORAL FINANCE: THE BIG PICTURE Behavioral finance, commonly defined as the application of psychology to finance, has become a very hot topic, generating credence with the rupture of the tech-stock bubble inMarch of 2000, and has been pushed to the forefront of both investors’ and advisors’ minds with the financial market meltdown of 2008–2009. While the term behavioral finance is bandied about in books, magazine articles, and investment papers, many people lack a firm understanding of the concepts behind behavioral finance. Additional confusion may arise from a proliferation of topics resembling behavioral finance, at least in name, including: behavioral science, investor psychology, cognitive psychology, behavioral economics, experimental economics, and cognitive science, to name a few. Furthermore, many investor psychology books that have entered the market recently refer to various aspects of behavioral finance but fail to fully define it. This section will try to communicate a more detailed understanding of the term behavioral finance. First, we will discuss some of the popular authors in the field and review the outstanding work they have done (not an exhaustive list), which will provide a broad overview of the subject.We will then examine the two primary subtopics in behavioural finance: behavioral finance micro and behavioral finance macro. Finally, we will observe the ways in which behavioral finance applies specifically to wealth management, the focus of this book.

38


What Is Behavioral Finance?

Key Figures in the Field In Chapter 2 we will review a history of behavioral finance. In this section, we will review some key figures in the field who have more recently contributed exceptionally brilliant work to the field of behavioral finance. Most of the people we will review here are active academics, but many of them have also been applying their work to the “real world,” which makes them especially worthy of our attention. While this is clearly not an exhaustive list, the names of the people we will review are: Professor Robert Shiller, Professor Richard Thaler, Professor Meir Statman, Professor Daniel Kahnemann, and Professor Vernon Smith.

FIGURE 1.1 Robert Shiller, former president of the Eastern Economic Association and best-selling author. The first prominent figure we will discuss is Professor Robert Shiller (Figure 1.1). Some readers may be familiar with the work Irrational Exuberance, by Yale University professor Robert Shiller, PhD. Certainly, the title resonates; it’s a reference to a nowfamous admonition by Federal Reserve Chairman Alan Greenspan during his remarks at the Annual Dinner and Francis Boyer Lecture of the American Enterprise Institute for Public Policy Research in Washington, D.C., on December 5, 1996. In his speech, Greenspan acknowledged that the ongoing economic growth spurt had been accompanied by low inflation, generally an indicator of stability. “But,” he posed, “how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?”1 In Shiller’s Irrational Exuberance, which hit bookstores only days before the 1990s’ market peaked, Professor Shiller warns investors that stock prices, by various historical measures, have climbed too high. He cautions that the “public may be very disappointed with the performance of the stock market in coming years.”2 39


Behavioral Finance and Wealth Management

It was reported that Shiller’s editor at Princeton University Press rushed the book to print, perhaps fearing a market crash and wanting to warn investors. Sadly, few heeded the alarm. Mr. Greenspan’s prediction came true, and the bubble burst. Though the correction came earlier than the Fed Chairman had foreseen, the damage did not match the aftermath of the collapse of the Japanese asset price bubble (the specter Greenspan raised in his speech). More recently, Professor Shiller has been active in indentifying the next bubble— in the U.S. housing market. Together with researcher Karl E. Case, Shiller has been collecting data on housing, which is now known as the S&P/Case-Shiller U.S. National Home Price Index. This is a composite of single-family home price indices for the nine U.S. Census divisions. As early as 2004, Shiller and Case asked, “Is there a bubble in the housing market?” They were early, but they were also quite correct. Mr. Shiller is an active commentator on news programs and is someone to whom, in my opinion, we should listen closely.

FIGURE 1.2 Richard Thaler, PhD, renowned behavioral finance theorist. Another high-profile behavioral finance researcher, Professor Richard Thaler, PhD (Figure 1.2), of the University of Chicago Graduate School of Business, penned a classic commentary with Owen Lamont entitled “Can the Market Add and Subtract? Mispricing in Tech Stock Carve-Outs,”3 also on the general topic of irrational investor behavior set amid the tech bubble. The work relates to 3Com Corporation’s 1999 spin-off of Palm, Inc., and argues that if investor behavior was indeed rational, then 3Com would have sustained a positive market value for a few months after the Palm Pilot spin-off. In actuality, after 3Com distributed shares of Palm Pilot to shareholders in March 2000, Palm Pilot traded at levels exceeding the inherent value of the shares of the original company. “This would not happen in a rational world,” Thaler notes. Professor Thaler is 40


What Is Behavioral Finance?

also the author of the book Advances in Behavioral Finance, which was published in 1993. More recently, Professor Thaler, in conjunction with Professor Cass Sunstein, wrote Nudge: Improving Decisions About Health, Wealth, and Happiness. In this work, Thaler and Sunstein support the idea that by “tilting” people’s decision making in a positive direction, everyone can make society a better place. The following is an interesting and insightful excerpt from an interview Amazon.com did with Thaler and Sunstein.4 I particularly like the reference to choice architecture. Amazon.com: What do you mean by “nudge” and why do people sometimes need to be nudged? Thaler and Sunstein: By a nudge we mean anything that influences our choices. A school cafeteria might try to nudge kids toward good diets by putting the healthiest foods at front. We think that it’s time for institutions, including government, to become much more user-friendly by enlisting the science of choice to make life easier for people and by gentling nudging them in directions that will make their lives better. Amazon.com: Can you describe a nudge that is now being used successfully? Thaler and Sunstein: One example is the Save More Tomorrow program. Firms offer employees who are not saving very much the option of joining a program in which their saving rates are automatically increased whenever the employee gets a raise. This plan has more than tripled saving rates in some firms, and is now offered by thousands of employers. Amazon.com: What is “choice architecture” and how does it affect the average person’s daily life? Thaler and Sunstein: Choice architecture is the context in which you make your choice. Suppose you go into a cafeteria. What do you see first, the salad bar or the burger and fries stand? Where’s the chocolate cake? Where’s the fruit? These features influence what you will choose to eat, so the person who decides how to display the food is the choice architect of the cafeteria. All of our choices are similarly influenced by choice architects. The architecture includes rules deciding what happens if you do nothing; what’s said and what isn’t said; what you see and what you don’t. Doctors, employers, credit card companies, banks, and even parents are choice architects. We show that by carefully designing the choice architecture, we can make dramatic improvements in the decisions people make, without forcing anyone to do anything. For example, we can help people save more and invest better in their retirement plans, make better choices when picking a mortgage, save on their utility bills, and improve the environment simultaneously. Good choice architecture 41


Behavioral Finance and Wealth Management

can even improve the process of getting a divorce—or (a happier thought) getting married in the first place! Amazon.com: You point out that most people spend more time picking out a new TV or audio device than they do choosing their health plan or retirement investment strategy? Why do most people go into what you describe as “auto-pilot mode” even when it comes to making important long-term decisions? Thaler and Sunstein: There are three factors at work. First, people procrastinate, especially when a decision is hard. And having too many choices can create an information overload. Research shows that in many situations people will just delay making a choice altogether if they can (say by not joining their 401(k) plan), or will just take the easy way out by selecting the default option, or the one that is being suggested by a pushy salesman. Second, our world has gotten a lot more complicated. Thirty years ago, most mortgages were of the 30-year fixed-rate variety, making them easy to compare. Now mortgages come in dozens of varieties, and even finance professors can have trouble figuring out which one is best. Since the cost of figuring out which one is best is so hard, an unscrupulous mortgage broker can easily push unsophisticated borrowers into taking a bad deal. Third, although one might think that high stakes would make people pay more attention, instead it can just make people tense. In such situations some people react by curling into a ball and thinking, well, err, I’ll do something else instead, like stare at the television or think about baseball. So, much of our lives is lived on auto-pilot, just because weighing complicated decisions is not so easy, and sometimes not so fun. Nudges can help ensure that even when we’re on auto-pilot, or unwilling to make a hard choice, the deck is stacked in our favor. Another prolific contributor to behavioral finance is Meir Statman, PhD, of the Leavey School of Business, Santa Clara University (Figure 1.3). Statman has authored many significant works in the field of behavioural finance, including an early paper entitled “Behavioral Finance: Past Battles and Future Engagements,”5 which is regarded as another classic in behavioural finance research. His research posed decisive questions: What are the cognitive errors and emotions that influence investors? What are investor aspirations? How can financial advisors and plan sponsors help investors? What is the nature of risk and regret? How do investors form portfolios? How important are tactical asset allocation and strategic asset allocation? What determines stock returns? What are the effects of sentiment? Statman produces insightful answers 42


What Is Behavioral Finance?

FIGURE 1.3 Meir Statman, PhD, Glenn Klimek Professor of Finance at the Leavey School of Business, Santa Clara University. to all of these points. Professor Statman has won the William F. Sharpe Best Paper Award, a Bernstein Fabozzi/Jacobs Levy Outstanding Article Award, and two Graham and Dodd Awards of Excellence. More recently, Professor Statman has written a book entitled What Investors Really Want.6 According to Statman, what investors really want is three kinds of benefits from their investments: utilitarian, expressive, and emotional. Utilitarian benefits are those investment benefits that drop to the bottom line: what money can buy. Expressive benefits convey to us and to others an investor’s values, tastes, and status. For example, Statman contends that hedge funds express status, and socially responsible funds express virtue. Emotional benefits of investments express how people feel. His examples are: insurance policies make people feel safe, lottery tickets and speculative stocks give hope, and stock trading gives people excitement. Perhaps the greatest realization of behavioral finance as a unique academic and professional discipline is found in the work of Daniel Kahneman and Vernon Smith, who shared the Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel in 2002. The Nobel Prize organization honored Kahneman for “having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty.” Smith similarly “established laboratory experiments as a tool in empirical economic analysis, especially in the study of alternative market mechanisms,” garnering the recognition of the committee.7

43


Behavioral Finance and Wealth Management

FIGURE 1.4 Daniel Kahneman, Prize winner in Economic Sciences 2002. Source: Jon Roemer. Š The Nobel Foundation. Professor Kahneman (Figure 1.4) found that under conditions of uncertainty, human decisions systematically depart from those predicted by standard economic theory. Kahneman, together with Amos Tversky (deceased in 1996), formulated prospect theory. An alternative to standard models, prospect theory provides a better account for observed behaviour and is discussed at length in later chapters. Kahneman also discovered that human judgment may take heuristic shortcuts that systematically diverge from basic principles of probability. His work has inspired a new generation of research, employing insights from cognitive psychology to enrich financial and economic models.

FIGURE 1.5 Vernon L. Smith, Prize winner in Economic Sciences 2002. Š The Nobel Foundation. Vernon Smith (Figure 1.5) is known for developing standards for laboratory methodology that constitute the foundation for experimental economics. In his own experimental 44


What Is Behavioral Finance?

work, he demonstrated the importance of alternative market institutions, for example, the rationale by which a seller’s expected revenue depends on the auction technique in use. Smith also performed “wind-tunnel tests” to estimate the implications of alternative market configurations before such conditions are implemented in practice. The deregulation of electricity markets, for example, was one scenario that Smith was able to model in advance. Smith’s work has been instrumental in establishing experiments as an essential tool in empirical economic analysis.

Behavioral Finance Micro versus Behavioral Finance Macro As we have observed, behavioral finance models and interprets phenomena ranging from individual investor conduct to market-level outcomes. Therefore, it is a difficult subject to define. For practitioners and investors reading this book, this is a major problem, because our goal is to develop a common vocabulary so that we can apply to our benefit the very valuable body of behavioral finance knowledge. For purposes of this book, we adopt an approach favored by traditional economics textbooks; we break our topic down into two subtopics: behavioral finance micro and behavioral finance macro. 1. Behavioral finance micro (BFMI) examines behaviors or biases of individual investors that distinguish them from the rational actors envisioned in classical economic theory. 2. Behavioral finance macro (BFMA) detects and describe anomalies in the efficient market hypothesis that behavioral models may explain. As wealth management practitioners and investors, our primary focus will be BFMI, the study of individual investor behavior. Specifically, we want to identify relevant psychological biases and investigate their influence on asset allocation decisions so that we can manage the effects of those biases on the investment process. Each of the two subtopics of behavioral finance corresponds to a distinct set of issues within the standard finance versus behavioral finance discussion. With regard to BFMA, the debate asks: Are markets “efficient,” or are they subject to behavioral effects? With regard to BFMI, the debate asks: Are individual investors perfectly rational, or can cognitive and emotional errors impact their financial decisions? These questions are examined in the next section of this chapter; but to set the stage for the discussion, it is critical to understand that much of economic and financial theory is based on the notion that individuals act rationally and consider all available information in the decision-making process. In academic studies, researchers have documented 45


Behavioral Finance and Wealth Management

abundant evidence of irrational behavior and repeated errors in judgment by adult human subjects. Finally, one last thought before moving on. It should be noted that there is an entire body of information available on what the popular press has termed the psychology of money. This subject involves individuals’ relationship with money—how they spend it, how they feel about it, and how they use it. There are many useful books in this area; however, this book will not focus on these topics.

Continued…

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References 1. The Federal Reserve Board, www.federalreserve.gov/boarddocs/speeches/1996/19961205.htm. 2. Robert Shiller, Irrational Exuberance (New Haven, CT: Yale University Press, 2000). 3. Owen A. Lamont and Richard H. Thaler, “Can the Market Add and Subtract? Mispricing in Tech Stock Carve-Outs,” Journal of Political Economy 111(2) (2003): 227–268. 4. www.amazon.com/Nudge-Improving-Decisions-Health-Happiness/dp/014311526X/ref=sr_1_1?ie=UT F8&qid=1315651564&sr=8-1 5. This paper can be found on Meir Statman’s home page at http://lsb.scu.edu/finance/faculty/Statman/ Default.htm. 6. Meir Statman, What Investors Really Want: Discover What Drives Investor Behavior and Make Smarter Financial Decisions (New York: McGraw Hill, 2011). 7. Nobel Prize web site: http://nobelprize.org/economics/laureates/2002/.

46


Basic Principles

The Complete Guide to Portfolio Construction and Management Lukasz Snopek 978-1-1199-7688-2 • Hardback • 310 pages • January 2012 £50.00 / €60.00 £35.00 / €42.00

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Chapter 1

Basic Principles 1.1 INVESTORS Before beginning our analysis, it is worthwhile noting that this book ultimately aims to help a particular type of individual: investors. These individuals, who have capital to invest deriving from various sources (savings, inheritance, proceeds from the sale of real estate, etc.), are those most concerned by what follows. They want to invest this sum of money so it yields a profit, thereby increasing their capital over time. So investors look first and foremost for a return, which may take the form of regular income, capital gains, or both at once. At this stage, it should be noted that the expected return for the given time horizon must be positive in order to achieve the desired growth. It must also be higher than average inflation so that investors can preserve their purchasing power over time, and therefore their real wealth. Furthermore, net return – that is return after tax – should ideally be taken into account. So, along with the risk of capital loss, inflation is one of the two greatest risks for investors, as it can seriously affect their capital over time. As such, it is worth defining more precisely.

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The Complete Guide to Portfolio Construction and Management

1.2 INFLATION Inflation can be defined as an increase in general price level, with the chief consequence of a decrease in consumer purchasing power. Conversely, deflation is defined as a decrease in general price level. Salaries, retirement pensions and other social security benefits are generally indexed to inflation, thus enabling consumers to maintain their purchasing power over time. As Marc Faber suggests, “to explain inflation to your children, buy a $100 US bond and frame it, then watch its value diminish to almost nothing over the next 20 years”.1 As shown by the graph below (Figure 1.1), inflation can indeed strongly affect the value of assets over time. Excluding any investment generating annual interest and considering an inflation rate of only 2%, the capital’s value is halved in about 35 years. With an inflation rate of 3%, this period drops to 23 years and at a rate of 4%, “only” 17 years are necessary to halve the initial capital. The importance of investing money at a rate which covers at least that of inflation is obvious. 4

The Complete Guide to Portfolio Construction and Management Impact of inflation on capital 1 200 000

Capital

1 000 000 800 000

Inflation 2% Inflation 3% Inflation 4%

600 000 400 000 200 000 0

0

5

10

15

20

25

30

35

40

45

50

Years

Figure 1.1

Impact of inflation over time with an interest rate of 2%, 3% and 4%.

Figure 1.1 Impact of inflation over time with an interest rate of 2%, 3% and 4%. rate of 3%, this period drops to 23 years and at a rate of 4%, “only” 17 years are necessary to halve the initial capital. The importance of investing money at a rate which covers at

The objective by central banks for inflation is around 2%. However, in least thatgenerally of inflation fixed is obvious. absolute terms, this figure should be revised upwards from an investor’s point of view, The objective generally fixed by central banks for inflation is around 2%. However, in considering the product categories most relevant to consumers in the price index. absolute terms, this figure should be revised upwards from an investor’s point of view, Indeed, considering when focusing on price increases for food, housing, energy or health-related the product categories most relevant to consumers in the price index. Indeed, when focusing on price increases for food, housing, energy or health-related spending, the spending, the average rate of inflation appears to be much higher. average rate of inflation appears to be much higher. In general, a market basket is used to calculate price changes. This basket includes In general,selection a market basket is used and to calculate price changes. Thisby basket includes a reprea representative of goods services consumed private households. It is sentative selection of goods and services consumed by private households. It is subdivided subdivided into various categories of expenditure, and each main category is weighted into various categories of expenditure, and each main category is weighted according to the share represents household expenditure. The following examplesThe are following of the consumer according to itthe share itinrepresents in household expenditure. examples price index calculation for Switzerland2 and England3 (Table 1.1). 2 3 are of the consumer price index calculation for Switzerland and England (Table 1.1). Table 1.1 Allocation of items to IPC and CPI divisions in 2010

48

Items Food and non-alcoholic beverages Alcohol and tobacco Clothing and footwear Housing and household services Furniture and household goods

IPC weight

CPI weight

11.063% 1.784% 4.454% 25.753% 4.635%

10.8% 4.0% 5.6% 12.9% 6.4%


when focusing on price increases for food, housing, energy or health-related spending, the average rate of inflation appears to be much higher. In general, a market basket is used to calculate price changes. This basket includes a reprePrinciples sentative selection of goods and services consumed by private households. It is Basic subdivided into various categories of expenditure, and each main category is weighted according to the share it represents in household expenditure. The following examples are of the consumer price index calculation for Switzerland2 and England3 (Table 1.1).

Table 1.1 Allocation of items to IPC and CPI divisions in 2010 Table 1.1 Allocation of items to IPC and CPI divisions in 2010 Items Food and non-alcoholic beverages Alcohol and tobacco Clothing and footwear Housing and household services Furniture and household goods Health Transport Communication Recreation and culture Education Restaurants and hotels Miscellaneous goods and services 2 Source: 3 Source:

IPC weight

CPI weight

11.063% 1.784% 4.454% 25.753% 4.635% 13.862% 11.011% 2.785% 10.356% 0.669% 8.426% 5.222%

10.8% 4.0% 5.6% 12.9% 6.4% 2.2% 16.4% 2.5% 15% 1.9% 12.6% 9.7%

www.bfs.admin.ch. www.statistics.gov.uk.

Ultimately, the impact of inflation depends on the category of the population being considered and its type of consumption. In light of this, an interesting tool has been made available in the UK. Individuals can make use of a personal inflation calculator4 to calculate inflation specifically based on their own personal expenditure, which can then be compared to national inflation. Generally speaking, an annual rate of 2% is the minimum conceivable threshold and a rate of 3% is more realistic. By setting a target rate of return of 2%, investments may only just cover inflation, while a target of 3% will begin to generate a certain level of growth. It is interesting to note that Graham, in his work written in the 1950s, already believed “that it is reasonable for an investor [ . . . ] to base his thinking and decisions on a probable (far from certain) rate of future inflation rate of, say, 3% per annum”.5 So investors must bear in mind that their final return, which we will call the real rate, should be calculated in the following way: Real rate = nominal rate − inflation rate Example: Nominal interest rate of a savings account = 2.5% Inflation = 2% Final (real) rate = 2.5% − 2% = 0.5% Our Advice Given that periods of deflation also exist, we ultimately suggest allowing for an average inflation rate of 2%. The important thing is to take this minimum threshold into account in the investment process. 49


The Complete Guide to Portfolio Construction and Management

1.3 CHOICES FOR INVESTORS IN TERMS OF INVESTMENTS Investors may choose to invest in an asset with virtually no risk. This investment, commonly known as a risk-free rate investment, offers a very low return, usually only partially covering inflation, except of course during periods of deflation. However, a feature of this type of investment is that it is always positive, generating capital growth which, though modest, is stable over time. Some investors settle for this type of low return investment, even though their purchasing power may be affected over time. For other investors, a risk-free rate investment is not enough. Investment in other asset classes must therefore be considered in order to improve returns and avoid capital being affected by inflation in the long term. As we will see further on, domestic stocks (national firms), for example, provide good protection against inflation. Investors can turn to risky assets such as stocks, bonds or real estate. They certainly generate higher returns than risk-free rates, but they may be either positive or negative. Because of fluctuations in their price over time, the possibility of capital loss is the main risk for investors here. It is now time to begin our analysis by examining how this risk is defined in finance, and determining how well this is adapted to reality.

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References 1. Marc Faber. Interview with Tom Dannet. “Five Books: Marc Faber on Investment.� 23.10.2009 (www.fivebooks. com/interviews/marc-faber-on-investment). 2. www.bfs.admin.ch. 3. www.statistics.gov.uk. 4. www.statistics.gov.uk. 5. Graham, p. 50.

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Introduction

Expected Returns An Investor’s Guide to Harvesting Market Rewards Antti Ilmanen 978-1-1199-9072-7 • Hardback • 592 pages • February 2011 £45.00 / €54.00 £31.50 / €37.80

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Chapter 1

Introduction • This book covers the general topic of expected returns on investments. The traditional paradigm among institutional investors focuses too much on historical performance and too narrowly on asset class allocation. This book argues that investment decision making should be broadened beyond the asset class perspective and a wider set of inputs should be used for assessing expected returns. • The book considers in detail a wide range of return sources: major asset classes (stocks, bonds, and alternative investments) and strategy styles (value, carry, momentum, and so forth) as well as risk factors (such as growth, inflation, and liquidity). • The main inputs—beyond discretionary views—for investors to judge expected returns are (1) historical performance, (2) theories, and (3) forwardlooking indicators. A better understanding of these inputs and a better balance among them is needed. • Well-known evidence of historical asset returns include the significant longrun outperformance of stocks over bonds (less so in the 19th and 21st century than in the 20th century) as well as more moderate rewards for bearing interest rate risk and credit risk. 51


Expected Returns

• Less familiar historical findings include the pervasive success of value, carry, and momentum strategy styles in several markets as well as the tenuous relation between volatility and average returns. This book highlights the low long-run returns of the most volatile assets within each asset class, a finding that may reflect risk-seeking (‘‘lottery-playing)’’ behavior by investors, or that may be explained by leverage constraints. • Finance theories have changed dramatically over the past 30 years, away from the restrictive theories of the single-factor CAPM, efficient markets, and constant expected returns. Current academic views are more diverse, less tidy, and more realistic. Expected returns are now commonly seen as driven by multiple factors. Some determinants are rational (risk and liquidity premia), others irrational (psychological biases such as extrapolation and overconfidence). Expected returns on all factors may vary over time. • A central insight from academic finance theories is that required asset returns have little to do with an asset’s standalone volatility and more to do with when losses can be expected to occur. Investors should require high-risk premia for assets that fare poorly in bad times, whereas safe haven assets (that fare well in bad times and less well in good times) can justify low or even negative risk premia. Strategies that resemble selling financial catastrophe insurance— steady small gains punctuated by infrequent but large losses—warrant especially high risk premia because their losses are so highly concentrated in the worst times. • Forward-looking indicators such as valuation ratios have a better track record in forecasting future asset class returns than rear-view mirror measures. The practice of using historical average returns as best estimates of future returns is dangerous when expected returns vary over time. Recall stock markets in 1999–2000. • Long-run expected returns for any investment tend to be especially high following adverse events. For example, equity markets tend to have predictably higher returns after recessions, and nominal bonds after high inflations. • Investors can try to boost expected returns by taking risks that produce attractive rewards for all market participants (beta risks) and/or by skilful active management (alpha) which may involve exploiting regularities and market inefficiencies. This book offers a comprehensive guide for smart harvesting of beta risk premia, covering both long-run exposures to traditional and alternative betas as well as tactical beta timing. However, I concede from the outset that the magic of view-based alpha generation cannot be conveyed in a book. 52


Introduction

• Two visual aids—an elephant and a cube—help the reader keep ‘‘the big picture’’ in mind through the book. • Although I present large amounts of empirical evidence about historical returns and forward-looking indicators, as well as numerous theories in an attempt to make sense of the data, I believe it is important to stress humility. Hindsight bias makes us forget how difficult forecasting is, especially in highly competitive financial markets. Expected returns are unobservable and our understanding of them is limited. Even the best experts’ forecasts are noisy estimates of prospective returns.

It was six men of Hindostan, To learning much inclined, Who went to see the elephant (Though all of them were blind); That each by observation Might satisfy his mind. —J.G. Saxe (to be continued) The traumatic housing and credit crisis that began in 2007 challenged many beliefs about investing and financial markets. The aftershocks of the crisis are still felt in many markets and economies (not least in public finances), but it is no longer necessary or advisable to view the future solely through the prism of this crisis. Instead, this book surveys the landscape of expected returns and long-term investment prospects based on lessons learned over decades. The traditional paradigm of institutional investing focuses on relatively static asset class allocations that are largely determined by historical performance. We must go back to basics and broaden the traditional paradigm in two ways. The inputs used for assessing expected returns should be better balanced and the idea of what constitutes investments should be challenged beyond the asset class perspective.

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Expected Returns

Figure 1.1. The elephant: Shining light on expected returns from different directions.

The foremost need for multi-dimensional thinking is on inputs. When investors make judgments about the expected returns of various investments, they should guard against being blinded by past performance and must ensure that they take all or most of the following considerations into account: • • • •

historical average returns; financial and behavioral theories; forward-looking market indicators such as bond yields; and discretionary views.

Figure 1.1 recalls the parable about several blind men and an elephant, as told by the American poet John Godfrey Saxe (1816–1887), each man describing one part of the elephant from his narrow vantage point. One man is feeling the leg and calling it a tree, another touching the ear and naming it a fan, a third mistaking the tail for a rope, and so on. Each man misses the big picture—and so will investors who study expected returns from a single vantage point. The first approached the elephant, And happening to fall Against his broad and sturdy side, At once began to bawl, ‘‘Bless me, it seems the elephant Is very like a wall.’’ So the challenge is to refine the art of investment decision making in a way that exploits all our knowledge about historical experience, theories, and current market conditions, 54


Introduction

without being overly dependent on any one of these. This book will summarize the state of knowledge on all these aspects, but it focuses on the first three inputs since these are systematic. I have less to say about discretionary views since these are inherently investor specific. However, the approaches described in this book will help readers form such views. Stated differently, investing involves both art and science; a solid background in the science can improve the artist. Figure 1.2. The cube: Three perspectives on investments and their expected returns.

Before turning to these inputs, I address the reasonable question ‘‘Expected returns on what?’’ The traditional paradigm has been to break the complex world of investments into simplified groupings called asset classes. Analyzing, and allocating to, asset classes has been the dominant approach but I argue that studying investments from perspectives other than asset classes can enhance our understanding of return sources and our ability to diversify effectively. This book will add to the asset class perspective the complementary viewpoints of strategy styles and risk factors, as in the threedimensional ‘‘cube’’ in Figure 1.2: • Starting with the asset class perspective, I will cover all traditional asset classes (equities, government bonds, credits) plus many alternative ones (including real estate, commodities, hedge funds, and private equity). I focus on long-run returns but also review tactical market-timing approaches. A broader mindset naturally leads to questioning the traditional 60/40 portfolio which relies excessively on one source of excess returns (the equity premium) and which therefore has highly concentrated risk (more than 90% of portfolio volatility is due to equities). • The strategy style perspective is especially important for understanding the 55


Expected Returns

profit potential of popular active-trading approaches. Value, carry, momentum, and volatility styles have outperformed buy-and-hold investments in many asset classes. Styles can also offer better diversification opportunities than asset classes. • Sophisticated investors are increasingly trying to look beyond asset classes and strategies in order to identify the underlying factors driving their portfolio returns. A factor-based approach is also useful for thinking about the primary function of each asset class in a portfolio (stocks for harvesting growth-related premia, certain alternatives for illiquidity premia, Treasuries for deflation hedging, and so on) as well as for diversifying across economic scenarios. Among underlying risk factors, I opt to focus on growth, inflation, illiquidity, and tail risks (volatility, correlation, return asymmetries). The second, feeling of his tusk, Cried, ‘‘Ho! What have we here So very round and smooth and sharp? To me, ’tis mighty clear This wonder of an elephant Is very like a spear.’’ How can investors deal with the complexity of multiple inputs and perspectives, let alone with the even more bewildering assortment of novel investment products on offer? This book provides a map to investors, giving a bird’s eye view over a rugged terrain and occasionally zooming in to interesting locations (12 case studies), not unlike Google EarthTM. I hope my two visual aids—the elephant and the cube—will help readers keep the forest in sight among the many trees along the way. Next, Sections 1.1–1.4 give an overview on the four perspectives on ‘‘feeling the elephant’’ (i.e., on considerations for judging expected returns). These themes will be expanded on through the book.

1.1 HISTORICAL PERFORMANCE Historical average returns are a common starting point for judging expected returns. The idea is that if expected returns are constant over time, long-run average realized return is a good estimate of expected future return. Unexpected news dominates returns in the short run but the effects of such news tend to cancel out in the long run. Why should you think twice before using historical returns as forecasts of future returns? • Any sample period may be biased—in the sense of not being representative 56


Introduction

of market expectations—so that unexpected returns do not neatly cancel out, especially if the sample starts or ends at times of exceptionally high or low market valuations. Windfall capital gains during a benign sample can boost average returns meaningfully even over multiple decades. Bond indices are a prime example, given the downtrend in bond yields since the 1970s and 1980s when a number of the widely used bond index histories start. • In principle, longer historical windows reduce sample specificity and enable more accurate estimates of average returns. However, distant historical data may be irrelevant due to structural changes, apart from lower data quality. Would we really want to include data from the 1600s even if good-quality returns were available to us? • Expected returns may vary over time in a cyclical fashion, which makes extrapolation of multi-year performance particularly dangerous. Periods of high realized returns and rising asset valuations—think stock markets in the 1990s— are often associated with falling forward-looking returns. • For specific funds and strategies, the historical performance data that investors get to see are often upward biased. This bias is due to the voluntary nature of performance reporting and survivorship bias (so that poor performers are left out of databases or are not marketed by the fund manager). A similar caveat applies to simulated ‘‘paper’’ portfolios because backtests may be overfitted and trading costs ignored or understated. These concerns notwithstanding, this book presents extensive evidence of long-run realized returns, when possible covering 50-to-100-year histories. Several main findings are familiar to most readers: • Stock markets have outperformed fixed income markets during the past century in all countries studied. The compound average real return for global equities between 1900 and 2009 is 5.4%, which is 3.7% (4.4%) higher than that of longterm government bonds (short-dated Treasury bills). Stocks’ outperformance over bonds is 0.5% to 0.8% higher for the U.S. than globally and was even more pronounced before the negative returns in 2000s. The experience of the current investor generation has buried the myth that stocks always beat bonds over 20-year or 30-year horizons. (This myth was never true. Many exceptions to it occurred outside the U.S. in the 20th century and inside the U.S. during the 19th century.) • Among fixed income markets, long-term bonds have outperformed short-dated bonds by 0.5% to 1% and credit-risky corporate bonds have outperformed 57


Expected Returns

comparable government bonds by 0.3% to 1% (low end for investment-grade bonds, high end for high-yield bonds). More surprisingly, the reward for bearing interest rate risk or credit risk is most consistent at short maturities. At the back end of the yield curve and at the low end of the credit spectrum there has been scant long-run benefit for additional risk taking. • Illiquid assets have tended to offer moderately higher long-run returns than their liquid peers. Part of corporate bonds’ excess returns over Treasuries reflects the liquidity disadvantage of corporates, and the same appears true for small-cap stocks over large-cap stocks. Evidence across asset classes is more ambiguous because various reporting biases may overstate published private equity and hedge fund returns. Moreover, average return differences can reflect premia for various risks and not just for illiquidity; disentangling the determinants is quite hard. Other findings are less widely known: • Certain active strategy styles have proved profitable in several asset classes, adding several percentage points to annual average returns. The most prominent styles are value (overweighting assets that appear cheap based on some valuation metrics, while underweighting richly valued peers), carry (overweighting highyielding assets while underweighting low-yielding assets), and momentum (overweighting assets that have outperformed over multiple months while underweighting recent laggards). There wards from simulated active strategies are often overstated due to over fitting or selection biases. Yet the value, carry, and momentum profits have been so prevalent that there is little doubt that these opportunities really existed in the past. The pertinent question is whether these strategies will remain profitable now that they are so well known. If their profits represent (at least in part) risk premia rather than market inefficiencies, it is less likely that future excess returns will be fully competed away. o A flipside of the value effect is that ‘‘growth assets’’—stocks of firms or countries with high past and expected growth rates—often deliver poor long-run returns that can be traced back to their high valuation ratios. One behavioral explanation is that investors over-extrapolate past growth rates and thus overpay for growth assets. No investment is attractive at any price, however fast growing it has been. o Yield seeking has been profitable in many contexts but more so in cross-country trades than in within-country trades. The worst results 58


Introduction

are for complex carry products that may contain hidden costs and risks. o Chasing returns sounds very naive but favoring past winners has not been a bad strategy historically—as long as history lengths to measure past returns are judiciously selected. Details differ across asset classes but most investments exhibit momentum (continuation) tendency over multi-month horizons and a mild reversal tendency over multi-year horizons. • The empirical relation between volatility and expected returns is tenuous. Volatility and long-term average returns are positively related across asset classes. Moreover, a strategy of writing equity index options earns positive long-run returns, a justifiable reward given the inherent riskiness of effectively selling financial catastrophe insurance. However, the most volatile assets within each asset class—high-volatility stocks, 30-year Treasuries, and CCC-rated corporates— tend to offer low long-run returns and even worse risk-adjusted returns. This surprising pattern may reflect investors’ lottery-seeking bias (overpaying for the hope of jackpot returns) as well as leverage constraints (overpaying for inherently volatile assets that give high bang for the buck for naive return seekers). Avoiding the inherently volatile pockets of each market (lottery tickets) and leveraging up inherently stable assets have boosted returns in the past, even before the leverage restrictions were tightened in the aftermath of the 2008 crisis.

Continued…

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CFA Level I Exam Companion

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CFA Institute EIC 2012 Sample Chapter Minibook  

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