Efficient Markets

Performance Evaluation

Lecture 8: Efficient Markets

SAPM [Econ F412/FIN F313]

Ramana Sonti
BITS Pilani, Hyderabad Campus
Semester II, 2014-15

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Lecture 8: Efficient Markets

Ramana Sonti

Efficient Markets

Performance Evaluation

Agenda

1 Efficient Markets

Introduction

2 Performance Evaluation

Context
Performance Attribution
Example
Mutual fund performance

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Lecture 8: Efficient Markets

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Efficient Markets

Performance Evaluation

Introduction

What is market efficiency?

Market efficiency refers to informational efficiency

Efficient market hypothesis (EMH): Prices fully reflect all available

information on the asset

Implications
Prices need not equal intrinsic value at all times
We require that pricing errors, if any, are random, i.e., at every point, a

stock is as likely to be overvalued as undervalued

No profits to be made in excess of a risk-adjusted return on information

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Lecture 8: Efficient Markets

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Efficient Markets

Performance Evaluation

Introduction

Grossman and Stiglitz (1980)

Existence of (perfectly) informationally efficient markets is

impossible
There are a lot of investors in the market. Some trade on information

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(informed traders) and some others are uninformed (trade for liquidity
reasons etc.)
Information is costly to acquire and process
Informed traders work hard to uncover inefficiencies and make a profit
that at least recoups their costs. Paradoxically, the very act of trying to
actively discover inefficiencies drives prices closer to values, i.e.
makes the market more efficient
However, if the market is perfectly efficient, it would drive away all the
informed traders (as they have no incentive to participate), which would
lead the market to be inefficient, which would make them all re-enter
the market, which would make the market more efficient and drive
them all away... and so on...a vicious circle...a state of disequilibrium
The only equilibrium possible is that a market will be efficient to the
extent that informed traders exactly recoup their costs, i.e., we can
never have a 100 % efficient market where price always equals value
Lecture 8: Efficient Markets

Ramana Sonti

Efficient Markets

Performance Evaluation

Introduction

Grossman and Stiglitz (1980) ... 2

The Grossman-Stiglitz argument implies

Since there are so many investors looking for inefficiencies, easy

pickings are rare the market will be efficient to a large degree

The probability of finding inefficiencies in a market increases as the

cost of exploiting inefficiencies increases. Investors who can

acquire/process information at a marginally lower cost than the next
investor will be better positioned to exploit these inefficiencies
The degree of inefficiency of a market depends upon the number of
informed investors in the market who are more closely looking to
exploit any opportunities

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Lecture 8: Efficient Markets

Ramana Sonti

Efficient Markets

Performance Evaluation

Introduction

Versions of the EMH

Weak form efficiency

History of past prices useless in predicting future prices to make extra

profits
Technical analysis is useless

Semi-strong form efficiency

Publicly available information cannot be used to make extra profits
Fundamental analysis is useless

Strong form efficiency

No information (public or private) can be utilized to make extra profits
Insider trading for instance, is useless

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Lecture 8: Efficient Markets

Ramana Sonti

Efficient Markets

Performance Evaluation

Introduction

Issues in testing the EMH

Magnitude
How efficient is the market? Can we observe the magnitude of

inefficiency?

Selection bias
If you could beat the market, would you publicize the fact?

Are fund managers just lucky monkeys?

How do we separate skill from luck?

How do we define risk-adjusted returns

Joint tests of the EMH and the asset pricing model (CAPM, factor

models etc.)

Tests of the EMH

Weak form: Filter rules, Tests of the random walk hypothesis
Semi-strong form: Anomalies, event studies
Strong form: Insider trading

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Lecture 8: Efficient Markets

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Efficient Markets

Performance Evaluation

Introduction

Anomalies: Size
Size effect: Portfolios of small cap stocks earn abnormal returns

(positive alphas), even after (beta) risk is taken into account

!
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Lecture 8: Efficient Markets

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Efficient Markets

Performance Evaluation

Introduction

Anomalies: Value vs. Growth

Book-to-market effect: Portfolios of high Book-to-Market ratio stocks

earn abnormal returns (positive alphas), even after (beta) risk is

taken into account

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Lecture 8: Efficient Markets

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Efficient Markets

Performance Evaluation

Introduction

Volatility: Value vs. Growth

!
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Lecture 8: Efficient Markets

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Efficient Markets

Performance Evaluation

Introduction

Anomalies: Momentum
Portfolios of stocks with high returns in the recent past significantly outperform those
with low returns in the recent past

Returns to momentum strategies cannot be explained by risk measures like standard

deviation or beta

Not explained by FF 3 factor model, and is the most robust anomaly to date

!
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Lecture 8: Efficient Markets

Ramana Sonti

Efficient Markets

Performance Evaluation

Context

Why measure performance?

There is over $1 trillion under active management in the U.S. alone

INR 4-5 trillion in India

Active fund managers typically charge a higher fee than passive

fund managers
Fidelity Magellan (active fund): Annual fee of 0.63%
Fidelity Spartan 500 (index fund): Annual fee of 0.10%
Vanguard 500 (index fund): Annual fee of 0.18%

Assuming an average fee of 0.40%, investors spend >$4 bn on fee

in the U.S. alone

Clearly, there is a need for investigating performance

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Lecture 8: Efficient Markets

Ramana Sonti

Efficient Markets

Performance Evaluation

Performance Attribution

Performance attribution

Step 1: Define benchmark or bogey portfolio, reflecting passive

investment strategy
Step 2: Compare return of active or managed portfolio with

bogey portfolio
Step 3: Attribute difference in return to
Asset allocation
Security selection
Sector allocation
Security allocation

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Lecture 8: Efficient Markets

Ramana Sonti

Efficient Markets

Performance Evaluation

Performance Attribution

Attribution framework
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Lecture 8: Efficient Markets

Ramana Sonti

Efficient Markets

Performance Evaluation

Example

Attribution example

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points?
In particular, how much is portfolio allocation and how much security

selection?

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Lecture 8: Efficient Markets

Ramana Sonti

Efficient Markets

Performance Evaluation

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Example

Asset allocation
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Asset allocation is about being in the right market at the right time
Impact due to asset allocation: 31 bp

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Lecture 8: Efficient Markets

Ramana Sonti

Efficient Markets

Performance Evaluation

Example

Security selection

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Impact due to asset allocation: 106 bp
Can be further split into the part due to sector allocation versus

security allocatio

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Lecture 8: Efficient Markets

Ramana Sonti

Efficient Markets

Performance Evaluation

Mutual fund performance

Mutual fund performance...1

A typical study by Malkiel (Journal of Finance, 1995) of 239 mutual funds during
1971-1991

Average alpha (both pre- and post-expenses is indistinguishable from zero with
Wilshire index

Average alpha (both pre- and post-expenses is negative with S&P500 index
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Lecture 8: Efficient Markets

Ramana Sonti

Efficient Markets

Performance Evaluation

Mutual fund performance

Mutual fund performance...2

A good representative piece of research is by Daniel, Grinblatt, Titman and Wermers
(Journal of Finance, July 1997)

Virtually every mutual fund in existence between 1975 through 1994

Explore benchmark-free Selectivity and Timing measures based on stock
characteristics

These authors find that a number of funds appear to have consistent, abnormally high
returns (pre-expense) relative to CAPM benchmarks, but most of this performance is
due to buying high momentum stocks
Even after controlling for anomalies, including momentum, the average
aggressive-growth fund manager exhibited some selectivity ability; almost all this
outperformance concentrated in first half of sample

!
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Lecture 8: Efficient Markets

Ramana Sonti

Efficient Markets

Performance Evaluation

Mutual fund performance

Mutual fund performance...3

Chevalier and Ellison (1999) show that

There is manager persistence, not fund persistence
Manager characteristics predict future performance
Younger managers better
Managers with MBAs better
Undergraduate institution matters for performance

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Lecture 8: Efficient Markets

Ramana Sonti

Efficient Markets

Performance Evaluation

Mutual fund performance

Why invest in mutual funds?

Diversification benefits
Opportunity costs of keeping up with and monitoring markets
Transaction costs
Hope: The next Magellan fund?

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Lecture 8: Efficient Markets

Ramana Sonti