1

BM410: Investments

Portfolio Construction 2:

Market Anomalies

and Portfolio Tilts

2

Objectives

A. Understand different market anomalies B. Review active versus passive investingC. Understand portfolio tilts

3

• What is a market anomaly?• A market anomaly refers to price behavior that

differs from the behavior predicted by the efficient market hypothesis.

• An anomaly discussed means it is known

• It is less like to do the same next time because others will be watching for it as well.

• Are there known anomalies?

A. Understand Market Anomalies

4

Anomalies (continued)

Price Earnings Effect

• Portfolio’s of low P/E stocks have exhibited higher average risk-adjusted returns than higher P/E Stocks

• Investors prefer cheaper stocks to more expensive stocks even if risk levels are the same.

Small Firm Effect

• Smaller firms generally earn higher returns

• May be tied to fact that ownership of smaller firms is left to smaller investors who require a higher return to invest.

5

Small Firm Effect

Source: Ibbotson Associates 2000

6

Anomalies (continued)

January Effect

• Stocks tend to exhibit a higher return in January than any other month (higher for smaller stocks)

• May be tied to tax-loss selling or window dressing at year-end

Neglected Firm Effect

• Firms not followed by analysts tend to perform better than those followed

• Because costs are higher to analyze smaller firms, investors require a higher rate of return to invest in less liquid stocks

7

Anomalies (continued)

Liquidity Effect

• Less liquid stocks sometimes perform better than more liquid stocks

• Investors may require a higher return premium to compensate for lower liquidity

Market to Book Ratios

• Stocks with lower price to book ratios (or higher book to market ratios) perform better

• Investors prefer to invest in cheaper stocks (in reference to their assets) than more expensive stocks

8

Book to Market Ratios

9

Anomalies (continued)

Reversals

• Extreme stock market performance tends to reverse itself, i.e. reversion to the mean.

• Losers rebound and winners fall Value Line Enigma

• Stocks rated highly by Value Line perform better

• Investors may actually read Value Line

10

Anomalies (continued)

Post-Earnings Announcement Drift

• The effect of earnings announcements continue for many days after the announcement

• May be due to trading costs, particularly for smaller companies

• In addition, this drift shows consistency

• If a company consistently has above market expectations, the market learns it

11

Anomalies (continued)

Market Anomalies are due to:

• Risk Premia

• Are we accounting for all the appropriate risk factors, such as in an multifactor framework? (there may be more factors than just market portfolio)

• Behavior - Irrational or rational

• Investors prefer to purchase large and growth stocks and neglect small and value stocks.

• Data Mining

• By chance, some criteria will appear to predict returns. Is it logical? If not, don’t bet on it!

12

Anomalies (continued)

Over-fitting the S&P 500: Butter Production in Bangladesh and the United States, United States Cheese Production, and Sheep Population in Bangladesh and the United States. R2=.99

Source for all the S&P 500 data mining graphs is: David Leinweber’s “Data-Snooping Biases in Tests of Financial Asset Pricing Models.”

13

Questions

Do you understand the market anomalies?

14

B. Review Active versus Passive Investing

• What is Active Portfolio Management?• Trading to earn more than a “market” return for

time and risk• It is using publicly available data to actively

manage a portfolio in an effort to consistently beat the benchmark after all costs, taxes, management, and other fees (not just from luck)

What is passive management?• Not trading to earn a market return for time and

risk.• The process of buying a diversified portfolio

which represents a broad market index (or benchmark) without any attempt to outperform the market

15

Active versus Passive (continued)

What does active management require?• Active management requires a competitive

advantage in at least one of three categories:

• 1. Information. You should have information not widely available and not already reflected in stock prices

• 2. Trading costs. You should have a lower cost to trade, possibly helped by being a dealer or floor trader

• 3. Analysis. You should have the ability to convert public data into private knowledge about value that is not fully reflected in current prices.

16

Active versus Passive (continued)

Does it have to be one or the other?• Why not use a combined approach

• Index when that is perceived to add value• Actively manage when you can add value there

• What about in-between?• What about enhanced-indexing?

• It is often called risk-controlled active funds or hybrid active-passive strategies

• For example, you could have a bond and equity index funds, and you could dynamically market time by varying your allocations in each fund (i.e. asset allocation)

17

C. Understand Index-tilt Strategies

What is an index-tilt strategy?• It is the process of using an index as a performance

benchmark and departing from the exact index weighting in order to overweight assets or sectors you expect to outperform

Are their different types of “tilts?”• There are a number of them

• Interestingly, most are bets on the persistence of so-called long run market anomalies discussed earlier

18

Index-tilt Strategies (continued)

What is the key question for anomaly-tilt strategy?• Will the market anomaly continue?• Can the excess returns from the tilt cover the

additional costs in research, trading costs and fees, and taxes?

• Is the additional return sufficient to justify the increase in fees for the active strategy?

19

Index-tilt Strategies (continued)

What are some variations on index-tilting?• Suppose you want excess returns from your U.S.

portfolio. You decide on an 80% passively managed portfolio with a 20% actively managed portfolio.

• This strategy would give you the stability of the index fund (i.e. risk reduction and close to benchmark returns)

• In addition, it would give the opportunity to earn higher than benchmark returns if you do well on your actively managed portion of your portfolio

20

Index-tilt Strategies (continued)

• The 20% might include:• Stocks not in the index

• Purchase assets from other asset classes that have higher than the expected returns from your benchmark

• Industry tilts • Overweighting more attractive industries

that you expect to add value above the benchmark

• Size tilts • Overweight (underweight) smaller

companies if you expect their returns to be higher (lower)

21

Index-tilt Strategies (continued)

• Anomaly tilts• Invest in market anomalies that you expect to

continue, i.e., low PE or high book to market stocks

• Risk tilts • Increase (decrease) the beta if you expect is

market forecast is for higher (lower) returns• Tax tilts

• Increase (decrease) investments in high dividend (taxed at 15%) stock companies versus bonds (taxed at marginal tax rates) if your forecast for market returns is higher (lower)

22

Index-tilt Strategies (continued)

• What is the key to portfolio construction?• The key is to build that optimal portfolio to help

you achieve your goals the quickest

• There are distinct advantages for active, passive, and hybrid strategies

• Understand your goals

• Understand what you want to accomplish, and

• Understand the tools that can help you achieve them

23

Review of Objectives

A. Do you understand different market anomalies?

B. Do you understand active versus passive investing?

C. Do you understand portfolio tilts?