Chap 5 & 11 - Stratégie de PF: Titres de Participants

Question 1

what are the 3 assumptions from an efficient market ?

Answer 1

An important premise of an efficient market requires a large number of independent profitmaximizing participants who analyze and value securities. A second assumption is that new information regarding securities comes to the market in a random fashion, and the timing of one announcement is generally independent of others. The third assumption is especially crucial: The buy and sell decisions of all those profitmaximizing investors cause security prices to adjust rapidly to reflect the effect of new information.

Question 2

The combined effect of (1) information coming in a random, independent, unpredictable fashion and (2) numerous competing investors adjusting stock prices rapidly to reflect this new information means that prices should be independent and random. This scenario implies that informationally efficient markets require some minimum amount of trading and that more trading by numerous competing investors should cause a faster price adjustment, making the market more efficient.

Question 3

What is the random walk hypothesis ?

Answer 3

Most of the early work related to efficient capital markets was based on the random walk hypothesis, which contended that changes in stock prices occurred randomly.

Question 4

In his original article, Fama (1970) divided the overall efficient market hypothesis (EMH) and the empirical tests into three subhypotheses depending on the information set involved: (1) weak-form EMH, (2) semistrong-form EMH, and (3) strong-form EMH.

Question 5

What is the weak-form EMH ?

Answer 5

The weak-form EMH assumes that current stock prices fully reflect all security market information, including the historical sequence of prices, rates of return, trading volume data, and other market-generated information, such as odd-lot transactions and transactions by market-makers. this hypothesis implies that past rates of return and other historical market data should have no relationship with future rates of return (that is, rates of return should be independent). Therefore, this hypothesis contends that you should gain little from using any trading rule which indicates that you should buy or sell a security based on past rates of return or any other past security market data.

Question 6

What is the semistrong-form EMH ?

Answer 6

The semistrong-form EMH asserts that security prices adjust rapidly to the release of all public information; that is, current security prices fully reflect all public information. The semistrong hypothesis encompasses the weak-form hypothesis, because all the market information considered by the weak-form hypothesis, such as stock prices, rates of return, and trading volume, is public. This hypothesis implies that investors
who base their decisions on any important new information after it is public should not derive above-average risk-adjusted profits from their transactions, considering the cost of trading.

Question 7

What is the stong-form EMH ?

Answer 7

The strong-form EMH contends that stock prices fully reflect all information from public and private sources. This hypothesis assumes that no group of investors has monopolistic access to information relevant to the formation of prices, which implies that no group of investors should be able to consistently derive above-average risk-adjusted rates of return. It emcompasses other 2 hypothesis and extends the assumption of efficient markets to assume perfect markets, in which all information is cost-free and available to everyone at the same tim

Question 8

What are the 2 tests for weak-from hypthesis ?

Answer 8

1- Statistical tests of independence between rates of return :

a) Autocorrelation tests of independence measure the significance of positive or negative correlation in returns over time. Does the rate of return on day t correlate with the rate of return on day t 1, t 2, or t 3?

b) Runs test. Given a series of price changes, each price change is either designated a plus ( ) if it is an increase in price or a minus ( ) if it is a decrease in price. A run occurs when two consecutive changes are the same; two or more consecutive positive or negative price changes constitute one run. When the price changes in a different direction (for example, when a negative price change is followed by a positive price
change), the run ends, and a new run may begin. To test for independence, you would compare the number of runs for a given series to the number in a table of expected values for the number of runs that should occur in a random series.

2- Test of tradings rules, compares risk–return results for trading rules that make investment decisions based on past market information relative to the results from a simple buy-and-hold policy, which assumes that you buy stock at the beginning of a test period and hold it to the end :

a) Evidence from simulations of specific trading rules indicates that most trading rules tested have not been able to beat a buy-and-hold policy. Therefore, the early test results generally support the weak-form EMH, but the results are clearly not unanimous, especially if one considers the current substantially lower commissions.

When the pre-2000 trading costs were considered, all the trading profits
turned to losses. It is possible that using recent lower trading costs (post-2011), the results could be different. Alternatively, trading using larger filters did not yield returns above those of a simple buy-and-hold policy.

Question 9

The trading-rule studies compared the risk–return results derived from trading-rule simulations, including transaction costs, to the results from a simple buy-and-hold policy. Three major pitfalls can negate the results of a trading-rule study:

Answer 9

1. The investigator should use only publicly available data when implementing the trading rule. As an example, the trading activities of some set of traders/investors for some period ending December 31 may not be publicly available until February 1. Therefore, you should not factor in information about the trading activity until the information is public.
2. When computing the returns from a trading rule, you should include all transaction costs involved in implementing the trading strategy because trading rules generally involve many more transactions than a simple buy-and-hold policy.
3. You must adjust the results for risk because a trading rule might simply select a portfolio of high-risk securities that should experience higher returns.

Question 10

Recall that markets should be more efficient when there are numerous investors attempting to adjust stock prices to reflect new information, so market efficiency will be related to trading volume. Alternatively, for securities with relatively few stockholders and limited trading activity, the market could be inefficient simply because fewer investors would be analyzing the effect of any new information. Therefore, using only active, heavily traded stocks when testing a trading rule could bias the results toward finding efficiency.

Question 11

What are the 2 tests for semistrong-from hypthesis ?

Answer 11

Advocates of the EMH contend that it would not be possible to predict future returns using past returns and dvocates of the EMH would expect security prices to adjust rapidly, such that it would not be possible for investors to experience superior risk-adjusted returns by investing after the public announcement and paying normal transaction costs.

1- Return prediction studies : Studies to predict future rates of return using available public information beyond pure market information considered in the weak-form tests. These studies can involve either time-series analysis of returns or the cross-section distribution of returns for individual stocks. Ex: Is it possible to predict abnormal returns over time for the market based on public information such as changes in the aggregate dividend yield or the risk premium spread for bonds?

2- Event studies that examine how fast stock prices adjust to specific significant economic events. These studies test whether it is possible to invest in a security after the public announcement of a significant event (for example, earnings, stock splits, major economic events) and whether they can experience significant abnormal rates of return.

Question 12

What is the theory behind the abnormal rate of return ?

Answer 12

For any test, we have to consider the markets return during the study. If the market had experienced a 10 percent return during an announcement period, the 5 percent return for the stock may be lower than expected.

ARit = Rit - Rmt

where:

ARit is the abnormal rate of return on security i during period t
Rit is the rate of return on security i during period t
Rmt is the rate of return on a market index during period t

Question 13

What is the abormal rate of return of a stock taking into account beta ?

Answer 13

ARit = Rit - E(Rit)

where:

ARit is the abnormal rate of return on security i during period t
Rit is the rate of return on security i during period t
E(Rit) is the expected rate of return for stock i during period t based on the market rate of return and the stock’s normal relationship with the market (its beta)

Question 14

What should the market expect for abormal returns of a stock ?

Answer 14

Over the normal long-run period, you would expect the abnormal returns for a stock to sum to zero. Specifically, during one period the returns may exceed expectations and the next perod they may fall short of expectations.

Question 15

When the two most significant variables—the dividend yield (D/P) and the bond default spread—are high, it implies that investors are requiring a high return on stocks and bonds. In contrast, when dividend yields and yield spreads are small, it implies that investors have reduced their risk premium, required rates of return, and the prices of assets increase; therefore, future returns will be below normal. The studies that support this expectation provide evidence against the EMH because they indicate you can use public information on dividend yields and yield spreads to predict future abnormal returns.

Answer 15

Several studies have considered two variables related to interest rates: (1) a
default spread, which is the difference between the yields on lower-grade and Aaa-rated long-term corporate bonds (this spread has been used in earlier chapters of this book as a proxy for a market risk premium), and (2) the term structure spread, which is the difference between the long-term Treasury bond yield and the yield on one-month Treasury bills. These variables have been used to predict stock returns and bond returns.

Question 16

What is time-series analysis ?

Answer 16

The time-series analysis assumes that in an efficient market the best estimate of future rates of return will be the long-run historical rates of return. Will public information will provide superior estimates of returns for a short-run horizon (one to six months) or a long-run horizon (one to five years).

Question 17

What is an earnings surprise ?

Answer 17

Indicated that there were abnormal stock returns during the 13 or
26 weeks following the announcement of a large unanticipated earnings change—referred to as an earnings surprise. These results indicate that an earnings surprise is not instantaneously reflected in security prices.

Jones, Rendleman, and Latané (1985): 31 percent of the total response in stock returns came before the earnings announcement, 18 percent on the day of the announcement, and 51 percent after the announcement.

These results indicate that the market does not adjust stock prices to reflect the
release of quarterly earnings surprises as fast as expected by the semistrong EMH, implying that earnings surprises and earnings revisions can be used to predict returns.

Question 18

What is The January Anomaly ?

Answer 18

Branch (1977) and Branch and Chang (1985) proposed a unique trading rule for those interested in taking advantage of tax selling. Investors (including institutions) tend to engage in tax selling toward the end of the year to establish losses on stocks that
have declined. After the new year, the tendency is to reacquire these stocks or to buy similar stocks that look attractive. Such a scenario would produce downward pressure on stock prices in late November and December and positive pressure in early January.

Question 19

Risk-adjusted performance measures indicated that low P/E ratio stocks experienced superior risk-adjusted results relative to the market, whereas high P/E ratio stocks had significantly inferior risk-adjusted results. 5 These results are inconsistent with semistrong efficiency. Peavy and Goodman (1983) examined P/E ratios with adjustments for firm size, industry effects, and infrequent trading and likewise found that the risk-adjusted returns for stocks in the lowest P/E ratio quintile were superior to those in the highest P/E ratio quintile.

Answer 19

Assuming an efficient market, all securities should have equal risk-adjusted returns because security prices should reflect all public information that would influence the security’s risk.

Question 20

What is the size effect and the the small-firm effect ?

Answer 20

Banz (1981) examined the impact of size (measured by total market value)
on the risk-adjusted rates of return. The risk-adjusted returns for extended periods (20 to 35 years) indicated that the small firms consistently experienced significantly larger risk-adjusted returns than the larger firms. Reinganum (1981) contended that it was the size, not the P/E ratio, that caused the results discussed in the prior subsection, but this contention was disputed by Basu (1983). It was suggested that
small firm risk was improperly measured because small firms are traded less frequently.

A study by Stoll and Whaley (1983) that examined the impact of transaction costs confirmed the size effect but also found that firms with small market value generally have low stock prices. Because transaction costs vary inversely with price per share, these costs must be considered when examining the small-firm effect.

In summary, small firms outperformed large firms after considering higher risk and realistic transaction costs (assuming annual rebalancing).

Question 21

Arbel and Strebel (1983) considered an additional influence beyond size: attention or neglect. They measured attention in terms of the number of analysts who regularly follow a stock and divided the stocks into three groups: (1) highly followed, (2) moderately followed, and (3) neglected. They confirmed the small-firm effect but also found a neglected-firm effect caused by the lack of information and limited institutional interest.

Answer 21

Beard and Sias (1997), who found no evidence of a neglected firm premium after controlling for capitalization.

Question 22

Studies that have used publicly available ratios to predict the cross section of
expected returns for stocks have provided substantial evidence in conflict with the semistrong-form EMH. Significant results were found for P/E ratios, market value size, and BV/MV ratios. Although the research by Fama and French indicated that the optimal combination appears to be size and the BV/MV ratio, a study by Jensen, Johnson, and Mercer (1997) indicated that this combination only works during periods of expansive monetary policy.

Question 23

What does a stock split study advocate ?

Answer 23

Stock Split Studies Many investors believe that the prices of stocks that split will increase in value because the shares are priced lower, which increases demand for them. In contrast, advocates of efficient markets would not expect a change in value because the firm has simply issued additional stock and nothing fundamentally affecting the value of the firm has occurred.

The classic study by Fama, Fisher, Jensen, and Roll (1969), referred to hereafter as FFJR, support the semistrong EMH because they indicate that investors cannot gain
from the information on a stock split after the public announcement.

Question 24

How can an investor make an abnormal return with Initial Public Offerings (IPOs) ?

Answer 24

Because of uncertainty about the appropriate offering price and the risk involved in underwriting such issues, it has been hypothesized that the underwriters would tend to underprice these new issues.

Considered three sets of questions: (1) How great is the underpricing on average? Does the underpricing vary over time? If so, why? (2) What factors cause different amounts of underpricing for alternative issues? (3) How fast does the market price adjust for the underpricing?

the answer to the first question is an average underpricing of about 14 percent, but it varies over for the total period 1980–2016 and for various subperiods. The major variables that cause differential underpricing seem to be various risk measures, the size of the firm, the prestige of the underwriter, and the status of the company’s accounting firm. Miller and Reilly (1987) and Ibbotson, Sindelar, and Ritter (1994) indicate that the price adjustment to the underpricing takes place within one day after the offering. Therefore, it appears that some underpricing occurs based on the original offering price, but the ones who benefit from this underpricing are basically the investors who receive allocations of the original issue. (Institutional investors captured 70 % of short-term profits).

Question 25

How can an investor make an abnormal return with an Exchange Listing ?

A listing is expected to increase the market liquidity of the stock and add to its prestige (Ex: NYSE).

Answer 25

All the studies agreed that (1) the stocks’ prices increased before any listing announcements, and (2) stock prices consistently declined after the actual listing. The crucial question is: What happens between the announcement of the application for listing and the actual listing (a period of four to six weeks)? A study by McConnell and Sanger (1989) points toward profit opportunities immediately after the announcement that a firm is applying for listing and there is the possibility of excess returns (by selling short) from price declines after the actual listing.

Therefore, evidence of short-run profit opportunities for investors using public information, these studies would not support the semistrong-form EMH.

Question 26

How can an investor make an abnormal return with an Unexpected World Events and Economic News ?

Answer 26

The results of studies that examined the response of security prices to world or economic news have supported the semistrong-form EMH. An analysis of the reaction of stock prices to unexpected world events, such as the Eisenhower heart attack, the Kennedy assassination, and major military events, found that prices adjusted to the news before the market opened or before it reopened after the announcement.

For economic information (money supply, inflation, real economic activity, and the discount rate) Pierce and Roley (1985) determined an impact that did not persist beyond the announcement day. Furtheremore, Jain (1988) did an analysis of an
hourly response of stock returns and trading volume to surprise announcements and found that unexpected information about money supply impacted stock prices within one hour.

Question 27

How can an investor make an abnormal return with an Announcements of Accounting Changes ?

Answer 27

During periods of high inflation, many firms will change their inventory method from first-in, first-out (FIFO) to last-in, first-out (LIFO), which causes a decline in reported earnings but benefits the firm because it reduces the firm’s taxable earnings and, therefore, tax expenses. Advocates of efficient markets would expect positive price changes because of the tax savings. Study results confirmed this expectation.
Therefore, studies such as those by Bernard and Thomas (1990) and Ou and Penman
(1989) indicate that the securities markets react quite rapidly to accounting changes and adjust security prices as expected on the basis of changes in true value.

Supporting EMH because there were no positive price changes following the change.

Question 28

How can an investor make an abnormal return with a Corporate Event ?

Answer 28

Events such as mergers and acquisitions, spin-offs, reorganization, and various security offerings (common stock, straight bonds, convertible bonds) have been examined, relative to two general questions: (1) What is the market impact of
these alternative events? (2) How fast does the market adjust the security prices?

Stock prices react as one would expect based on the underlying economic impact of the action. For example, the reaction to mergers is that the stock of the firm being acquired increases in line with the premium offered by the acquiring firm, whereas the stock of the acquiring firm typically declines because of the concern that they overpaid for the firm. On the question of speed of reaction, the evidence indicates fairly rapid adjustment.

Question 29

Results of Event Studies supported the semistrong-form EMH.

Question 30

What are the 3 tests for strong-from hypthesis ?

Answer 30

Investigators have tested this form of the EMH by analyzing the performance of three
major groups of investors: (1) corporate insiders, (2) security analysts at Value Line and else-where, and (3) professional money managers.

Question 31

What does Corporate Insider Trading advocates for strong-from hypthesis ?

Answer 31

Studies by Chowdhury, Howe, and Lin (1993) and Pettit and Venkatesh (1995) indicated that corporate insiders consistently enjoyed above-average profits, based
on selling prior to low returns and not selling before strong returns. This implies that many insiders had private information from which they derived above-average returns on their company stock.

Question 32

How does The Value Line Enigma Value Line (VL) work ?

Answer 32

The Value Line Enigma Value Line (VL) is a large well-known advisory service that publishes financial information on approximately 1,700 stocks. Included in its report is a timing rank, which indicates Value Line’s expectation regarding a firm’s common stock performance over the coming 12 months. A rank of 1 is the most favorable performance metric and 5 is the worst. This ranking system, initiated in April 1965, assigns numbers based on four factors:

1. An earnings and price rank of each security relative to all others
2. A price momentum factor
3. Year-to-year relative changes in quarterly earnings
4. A quarterly earnings “surprise” factor (actual quarterly earnings compared with VL estimated earnings)

The strongest evidence regarding not being able to benefit from this information is that Value Line’s Centurion Fund, which concentrates on investing in rank-1 stocks, has typically underperformed the market.

Question 33

What do studies say about Analysts’ Recommendations ?

Answer 33

There is evidence in favor of the existence of superior analysts who apparently possess private information. A study by Womack (1996) found that analysts appear to have both market timing and stock-picking ability, especially in connection with relatively rare sell recommendations. In contrast, Jegadeesh et al. (2004) found that consensus recommendations by a group of analysts who follow a stock do not contain incremental information for most stocks beyond available market signals (momentum and volume), but changes in consensus recommendations are useful.

Question 34

What do studies say about Performance of Professional Money Managers ?

Answer 34

If any “normal” set of investors should be able to derive above-average profits, it should be this group because they conduct extensive management interviews and they may have the benefit of input from some superior analysts noted above (whitout having monopolistic access to important new informatio).

Notably, articles acknowledged that some funds were able to outperform their benchmarks, but this superior performance was sporadic, and individual managers were generally not able to outperform consistently. In addition, all the articles noted that the major reasons for the inferior performance were the added cost of active management including personnel (analysts); trading expenses, and the higher management fees. These results support the strong-form EMH and suggest that investors should seriously consider investing in a diversified portfolio of passive index funds.

Question 35

The largest endowments in terms of size experienced superior risk-adjusted performance because of their ability and willingness to consider a wide variety of
asset classes such as venture capital, private equity, unique hedge funds, real estate, and commodities on a global basis.

Question 36

Conclusions Regarding the Strong-Form EMH :

Answer 36

The result for corporate insiders did not support the hypothesis because these individuals apparently have monopolistic access to important information and
use it to derive above-average returns. But, historical performance by professional money managers provided support for the strong-form EMH. Therefore, there is positive support for the strong-form EMH as applied to most investors (because managers don’t have priveliedge information like most investors).

Question 37

Summary on the Semistrong-Form EMH :

Answer 37

The hypothesis receives almost unanimous support from the numerous
event studies on a range of events including stock splits, initial public offerings, world events and economic news, accounting changes, and a variety of corporate finance events. In sharp contrast, the numerous studies on predicting rates of return over time or for a cross section of stocks presented evidence counter to semistrong efficiency. Results for cross-sectional predictors such as size, the BV/MV ratio (when there is expansive monetary policy), and P/E ratios also indicated anomalies counter to market efficiency.

Question 38

What is Behavioral finance ?

Answer 38

Behavioral finance considers how various psychological traits affect how individuals or groups act as investors, analysts, and portfolio managers. As noted by Olsen (1998), behavioral finance advocates recognize that the standard finance model of rational behavior and profit maximization can be true within specific boundaries, but they assert that it is an incomplete model since it does not consider individual behavior.

Question 39

Olsen (1998) behavioral finance définition :

Answer 39

Seeks to understand and predict systematic financial market implications of psychological decisions processes … behavioral finance is focused on the implication of psychological and economic principles for the improvement of financial decision-making.

Question 40

What are some of the humans biases ?

Answer 40

1- The propensity of investors to hold on to “losers” too long and sell “winners” too soon. This aversion is explained by prospect theory, which contends that utility depends on deviations from moving reference points rather than absolute wealth.

2- Belief perseverance, which means that once people have formed an opinion (on a company or stock) they cling to it too tightly and for too long. (reluctant and skeptical of contradictory beliefs).

3- Anchoring, wherein individuals who are asked to estimate something, start with an initial arbitrary (casual) value and then adjust away from it.

4- Overconfidence in forecasts, which causes analysts to overestimate the rates of growth and the duration of this growth for “growth” companies and overemphasize good news and ignore negative news for these firms.

5- Representativeness, which causes them to believe that the stocks of growth companies will be “good” stocks.

6- Confirmation bias, whereby investors look for information that supports prior opinions and decisions they have made.

7- Self-attribution bias where people have a tendency to ascribe any success to their own talents while blaming any failure on “bad luck,” which causes them to overestimate their talent.

8- Hindsight bias, which is a tendency after an event for an individual to believe that he or she predicted it, which causes people to think that they can predict better than they can.

9- Escalation bias, which causes investors to put more money into a failure that they feel responsible for rather than into a success.

Question 41

What is fusion investing ?

Answer 41

According to Charles Lee (2003), fusion investing is the integration of two elements of investment valuation—fundamental value and investor sentiment. In Robert Shiller’s (1984) formal model, the market price of securities is the expected dividends discounted to infinity (its fundamental value) plus a term that indicates the demand from noise traders who reflect investor sentiment.

noise traders : (nonprofessionals with no special information)

Question 42

To summarize this discussion, two factors are required to be a superior analyst: (1) You must be correct in your estimates, and (2) you must be different from the consensus. Remember, if you are only correct and not different, that assumes you were predicting the consensus and the consensus was correct, which implies no surprise and no abnormal price movement.

Answer 42

To be a superior analyst, you must do a superior job of estimating the relevant valuation variables and predicting earnings surprises, which implies that you differ
from the consensus, and you should consistently identify undervalued or overvalued securities. The suggestions for the information that should be used in fundamental analysis are based on the studies that considered the cross section of future returns. Recall that these studies indicated that P/E ratios, market value, size, and the BV/MV ratios were able to differentiate future return patterns with size and the BV/MV ratio appearing to be the optimal combination.

Also neglected firms should be given extra consideration.

Question 43

What are the 3 factors involved in minimizing total transaction costs ?

Answer 43

Three factors are involved in minimizing total transaction costs:

1. Minimize taxes. Methods of accomplishing this objective vary, but it should receive prime consideration.
2. Reduce trading turnover. Trade only to sell overvalued stock out of the portfolio or add undervalued stock while maintaining a given risk level.
3. When you trade, minimize liquidity costs by trading relatively liquid stocks. To accomplish this, submit limit orders to buy or sell several stocks at prices that approximate the market-makers quote. That is, you would put in limit orders to buy stock at the bid price or sell at the ask price. The stock bought or sold first is the most liquid one; all other orders should be withdrawn.

Question 44

In summary, if you lack access to superior analysts, you should do the following:

1. Determine and quantify your risk preferences.
2. Construct the appropriate risk portfolio by dividing the total portfolio between risk-free assets and a risky asset portfolio.
3. Diversify completely on a global basis to eliminate all unsystematic risk.
4. Maintain the specified risk level by rebalancing when necessary.
5. Minimize total transaction costs.

Question 45

Passive Management Strategies:
1. Efficient Markets Hypothesis
Buy and hold
Indexing

     Active Management Strategies: 2. Fundamental Analysis “Top down” (e.g., asset class rotation, sector rotation) “Bottom up” (e.g., stock undervaluation/overvaluation)

3. Technical Analysis
   Contrarian (e.g., overreaction)
   Continuation (e.g., price momentum)
4. Factors, Attributes, and Anomalies
   Security characteristic factors (e.g., P/E, P/B, earnings momentum, firm size)
   Investment style factors (e.g., value, growth, volatility, company quality)
   Calendar effects (e.g., weekend, January)
   Information effects (e.g., neglect)

Answer 45

The realm of active management, however, is one in which managers are effectively betting against markets being perfectly efficient. For convenience, it is characterized that the bets fall into three general categories: (1) fundamental, (2) technical, and (3) factors, security attributes, and market anomalies.

Question 46

The top-down investment process begins with an analysis of broad country and asset class allocations and progresses down through sector allocation decisions to
the bottom level, where individual securities are selected. Alternatively, a bottom-up process simply emphasizes the selection of securities without any initial market or sector analysis. Active equity management based on fundamental analysis can start from either direction, depending on what the manager thinks is mispriced relative to his or her valuation models.

Question 47

What are the 3 themes that active fundemantal managers use ?

Answer 47

1- They can try to time the equity market by shifting funds into and out of stocks, bonds, and T-bills depending on broad market forecasts.

2- They can shift funds among different equity sectors and industries (for example, financial stocks, technology stocks, consumer cyclicals) or among investment styles (for example, large capitalization, small capitalization, value, growth) to catch the
next hot concept before the rest of the market.

3- Equity managers can look at individual issues in an attempt to find undervalued stocks.

Question 48

What is a sector rotation strategy ?

Answer 48

A sector rotation strategy positions the portfolio to take advantage of the market’s next move. Often this means emphasizing or overweighting (relative to the benchmark portfolio) certain economic sectors or industries in response to the
next expected phase of the business cycle.

Question 49

What is contrarian investment strategy ?

Answer 49

A contrarian investment strategy is based on the belief that the best time to buy (sell) a stock is when the majority of other investors are the most bearish (bullish) about it. The contrarian investor will attempt to always purchase the stock when it is near its lowest price and sell it (or even short sell it) when it nears its peak. The belief is that stock returns are mean reverting, indicating that, over time, stocks will be priced so as to produce returns consistent with their risk-adjusted expected (or, mean) returns.

Question 50

What is Factor investing ?

Answer 50

Factor investing:
The main idea underlying a factor-based investment strategy is for the manager to form portfolios that emphasize certain characteristics of a collection of securities—such as firm size, relative valuation, low return volatility, momentum, or company quality—that are believed to produce higher risk-adjusted returns than those in a traditional benchmark that is weighted by the market capitalization of the stocks in the index.

Question 51

As we have just seen, in the world of active equity portfolio management, the concept of momentum investing can mean two things: price momentum and earnings momentum. Hoever, the justifications for these strategies are very different—while price momentum is a technical strategy that is often used in factor investing, earnings momentum is ultimately a fundamental approach to investing—so it should not be surprising that they can lead to forming very different types of portfolios.

Question 52

As we have seen, a portfolio’s tracking error statistic can be used to characterize whether the portfolio manager’s investment style was passive or active in nature. The tracking error measure
does this in an indirect way by looking at the difference in the returns a manager’s portfolio produced compared to those of the benchmark index, with returns closer to those of the benchmark more likely to indicate an index fund. A more direct way to assess how active a manager’s strategy is would be to look directly at the portfolio’s holdings compared to those in the benchmark.

Answer 52

Also, Petajisto (2013) reports that while the average active fund has underperformed its index (produced a lower net-of-expenses return) by about 0.4 percent annually, the most active stock-picking managers—those with an AS score in excess of 90 percent—do beat their benchmarks by an average of more than 1.25 percent per year after fees and expenses.

Question 53

What will a a growth-oriented investor do in search for good stocks ?

Answer 53

1- Focus on the EPS component (the denominator) of the P/E ratio and its economic determinants.

2- Look for companies that he or she expects to exhibit rapid EPS growth in the future.

3- Often implicitly assume that the P/E ratio will remain constant over the near term, meaning that the stock price will rise as forecast earnings growth is realized.

Question 54

What will a a value-oriented investor do in search for good stocks ?

Answer 54

1- Focus on the price component (the numerator) of the P/E ratio; he or she must be convinced that the price of the stock is “cheap” by some means of comparisoné

2- Not care a great deal about current earnings or the fundamental drivers of earnings growth.

3- Often implicitly assume that the P/E ratio is below its natural level and that the market will soon “correct” this situation by increasing the stock price with little or no change in earnings.

Question 55

In summary, a growth investor focuses on the current and future economic “story” of a company, with less regard for share valuation. The value investor focuses on share price in anticipation of a market correction and, possibly, improving company fundamentals.