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Student Investment Management Fund

Financial Theory Implementation

Undergraduate Student Investment Management Fund

Fall 2016 Presentation

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Student Investment Management Fund

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Student Investment Management Fund

Student Investment Management Fund

Financial Theory ImplementationFinancial Theory Implementation

Alex Glenn

Gregory Nowicki

Ernest Dela Cruz

Charles Goode Ryan Hebel Sanketh Macha Caleb Boehnlein Michael Muscheid

Hamza Amjad Madeline Osadjan Paige Weisman Junci Zhao

Stephen McAleer

Gregory Goulder

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Daniel Martin

Fund Managers

Fund Analysts

Student Investment Management Fund

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Student Investment Management Fund

Student Investment Management Fund

Financial Theory Implementation

IVOL Background

Financial Theory Implementation

1964 1968 1986 2006 2015

Levy

Merton

CAPM

Ang et al

Stambaughet al

Idiosyncratic Risk

Is not priced

Is priced and has a positive returns

Found a negative premium

Mispricing & Arbitrage Constraints

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Financial Theory Implementation

Mispricing Anomalies

Profitability AccrualsNet Stock

IssuesMomentum Asset Growth

Financial Theory Implementation

Arbitrage Asymmetry and the Idiosyncratic Volatility PuzzleStambaugh, Yu, and Yuan (2015)

O-Score Probability

Composite Equity Issues

Net Operating Assets

Return on Assets

Investment-to-Assets

Financial Distress

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Student Investment Management Fund

Financial Theory Implementation

MispricingArbitrage Asymmetry and the Idiosyncratic Volatility Puzzle

Stambaugh, Yu, and Yuan (2015)

Financial Theory Implementation

Overpriced Security Underpriced Security

High Accruals Low Accruals

High Asset Growth Low Asset Growth

Negative Momentum Positive Momentum

Unprofitable

High Net Stock Issuance

Profitable

Low Net Stock Issuance

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Financial Theory Implementation

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Arbitrage Constraints• Securities with higher IVOL have higher constraints to arbitrage

• Mispricing not completely eliminated by arbitrage

Margin Calls Closing Short Positions

Size correlated with IVOL

Redemption Risk

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Student Investment Management Fund

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Financial Theory ImplementationFinancial Theory Implementation

-6%

-4%

-2%

0%

2%

4%

6%

8/29 9/09 9/20 10/01 10/12 10/23 11/03 11/14

AEIS IWV

-6%

-4%

-2%

0%

2%

4%

6%

8/29 9/09 9/20 10/01 10/12 10/23 11/03 11/14

OMI IWV

AEIS vs IWV Returns OMI vs IWV Returns

Arbitrage Constraints

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Student Investment Management Fund

Financial Theory Implementation

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Arbitrage Constraints

Price Shares Short Sale ValueInitial Margin

Requirement (50%)Total Margin Posted

AEIS $44.09 227 $10,008 $5,004 $15,012

OMI $33.93 295 $10,009 $5,004 $15,014

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Student Investment Management Fund

Student Investment Management Fund

Financial Theory ImplementationFinancial Theory Implementation

Arbitrage ConstraintsPrice Short Sale Value

Maintenance Margin (40%)

Total Margin Required

Margin Posted Margin to

Spare

8/29 $44.09 $10,008.43 $4,003.37 $14,011.80 $15,012.65 $1,000.84

9/8 $45.53 $10,335.31 $4,134.12 $14,469.43 $15,012.65 $543.21

9/19 $45.47 $10,321.69 $4,128.68 $14,450.37 $15,012.65 $562.28

9/28 $46.77 $10,616.79 $4,246.72 $14,863.51 $15,012.65 $149.14

10/7 $47.80 $10,850.60 $4,340.24 $15,190.84 $15,012.65 ($178.19)

8/29 $33.93 $10,009.35 $4,003.74 $14,013.09 $15,014.03 $1,000.94

9/8 $34.18 $10,083.10 $4,033.24 $14,116.34 $15,014.03 $897.69

9/19 $33.72 $9,947.40 $3,978.96 $13,926.36 $15,014.03 $1,087.67

9/28 $34.89 $10,292.55 $4,117.02 $14,409.57 $15,014.03 $604.46

10/7 $33.83 $9,979.85 $3,991.94 $13,971.79 $15,014.03 $1,042.24

AEI

SO

MI

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Financial Theory Implementation

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$9,000

$10,000

$11,000

$12,000

$13,000

$14,000

$15,000

8/29 9/5 9/12 9/19 9/26 10/3 10/10 10/17 10/24

OMI Margin Requirements

Short Sale Value Total Margin Required Margin Posted

$9,500

$10,500

$11,500

$12,500

$13,500

$14,500

$15,500

8/29 9/5 9/12 9/19 9/26 10/3 10/10 10/17 10/24

AEIS Margin Requirements

Short Sale Value Total Margin Required Margin Posted

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Financial Theory Implementation

Arbitrage Risk• Limits of arbitrage restrict ability of investors to enter and/or hold profitable short position

• Higher IVOL suggests difficulty in maintaining short position

Financial Theory Implementation

1

3

5

0%5%

10%15%20%

1 2 3 4 5

Short Leg IVOL

Long Leg IVOL

Arbitrage Asymmetry and the Idiosyncratic Volatility Puzzle

Probability of a Margin Call

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Financial Theory Implementation

Arbitrage Asymmetry• Arbitrage eliminates more underpricing than

overpricing

• Greater amount of arbitrage capital in long positions versus short positions

• The negative IVOL effect among overpriced stocks is greater than the positive IVOL effect among underpriced stocks

Financial Theory Implementation

Arbitrage Asymmetry and the Idiosyncratic Volatility PuzzleStambaugh, Yu, and Yuan (2015)

-2.5

-2

-1.5

-1

-0.5

0

0.5

1

Mo

nth

ly A

bn

orm

al R

etu

rns

(%)

Most Overpriced Least Overpriced

Monthly Abnormal Returns

Highest IVOL

Next 20%

Next 20%

Next 20%

Lowest IVOL

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Financial Theory ImplementationFinancial Theory Implementation

Strategy Implementation

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Financial Theory Implementation

Charter Constraints

Financial Theory Implementation

Firms domiciled in the U.S. Market cap > $1B

Long-only portfolioMaximum of 10% in one

company and 25% in one sector

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Financial Theory Implementation

• Companies with low accruals have a higher expected future return

• Invest in companies with the lowest accrual portion of earnings

• Number of securities: 1,714

AccrualsDo Stock Prices Fully Reflect Information in Accruals

and Cash Flows about Future Earnings?Sloan (1996)

Financial Theory Implementation

Accruals =(ΔCA – ΔCash) – (ΔCL – ΔSTD – ΔTP) – ΔDep)

Average Total Assets

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Financial Theory Implementation

Asset GrowthAsset Growth and the Cross-Section of Stock Returns

Cooper, Gulen, and Schill (2008)

Asset Growth = (Total Assetst−Total Assetst−1)

Total Assetst−1

Financial Theory Implementation

• Firms that have high asset growth are less likely to perform well in future

• Invest in firms with low asset growth

• Number of securities: 2,212

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Financial Theory Implementation

Momentum• “Winners continue to win and losers continue to lose.”

• Ranked on compounded monthly returns during September 2015 to September 2016

• Number of securities: 2,757

Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency

Jegadeesh and Titman (1993)

Momentum = (Rt-1)(Rt-2)...(Rt-13) - 1

Financial Theory Implementation

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Financial Theory Implementation

Gross Profitability• Firms with high gross profit are expected to generate abnormally high future returns

• Invest in companies with high profitability

• Number of securities: 1,642

Financial Theory Implementation

The Other Side of Value: The Gross Profitability Premium Novy-Marx (2013)

Gross Profitability = (Revenue − Cost of Goods Sold)

Total Assets

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Financial Theory Implementation

Net Issuance• Management tends to repurchase shares when stock is undervalued

• Invest in companies with lower net issuance

• Number of securities: 2,592

Net Issuance = ln(Adj. Shares Outstanding)t - ln(Adj. Shares Outstanding)t-11

Financial Theory Implementation

Share Issuance and Cross-Sectional ReturnsPontiff and Woodgate (2008)

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Financial Theory Implementation

Aggregate Ranking Construction• Found the individual percentile ranking of each anomaly for every security

• Took the average of percentiles to find the total average mispricing percentile for every security

• Sorted securities based on the average percentile ranking

• Selected the top decile of securities based on mispricing anomaly ranking

Financial Theory Implementation

Ticker Accruals Asset Growth Momentum Net Issuance Profitability Aggregate

Company A 10% 20% 30% 30% 10% 20%

Company B 20% 30% 20% 20% 30% 24%

Company C 30% 10% 10% 10% 20% 16%

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Financial Theory Implementation

Idiosyncratic Volatility (IVOL)• High IVOL indicates high expected returns

• Calculated for 60 trading days from August 26, 2016 to November 17, 2016

• Number of securities: 2,843

Arbitrage Asymmetry and the Idiosyncratic Volatility Puzzle

Stambaugh, Yu, and Yuan (2015)

Financial Theory Implementation

R=𝞪i+𝞫i(Rmkt- Ri)+𝟄i IVOL=∑(𝟄i)2

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Financial Theory Implementation

Portfolio Construction

Financial Theory Implementation

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0%

10%

20%

30%

40%

50%

60%

70%

0% 5% 10% 15% 20% 25% 30% 35% 40%

IVO

L R

anki

ng

Aggregate Ranking

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Financial Theory Implementation

Portfolio Construction

Financial Theory Implementation

Comprised of 44 securities

Security Weighting: 50 bps floor / 5% ceiling

Market-cap weighted

Excluded firms with pending M&A activity and performed

news checks on each individual security

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Financial Theory Implementation

Portfolio By Market Cap

Financial Theory Implementation

3%7%

19%

31%

40%

Russell 3000

50M-300M 300M-2B 2-10B 10B-200B +200B

10%

70%

20%

IVOL Portfolio

1.2-2B 2-10B 10B-200B

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Student Investment Management Fund

Financial Theory Implementation

20%

5%

11%

3%

24%

25%

12%

IVOL Portfolio

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Portfolio By Sector

12%

8%

7%

13%

12%18%

3%

16%

4%4%

3%

Russell 3000ConsumerDiscretionaryConsumer Staples

Energy

Health Care

Industrials

InformationTechnology

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Financial Theory Implementation

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ReturnsPortfolio Return: 0.75%IWV Return: 0.23%

Notable Securities:CLF Return: 19.92%IGT Return: -10.04%

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Financial Theory Implementation

Thank you. We will now welcome questions.

Financial Theory Implementation

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Financial Theory Implementation

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Anomaly Correlations