2102013 Apurv Jain Capital Markets Group MSFT Definitions Systematic Risk Something that affects everyone the whole economy Can explain this in a factor model framework like CAPM as the market portfolio ID: 580919
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Slide1
What does your portfolio say about you?
2/10/2013
Apurv Jain
Capital Markets Group
MSFTSlide2
Definitions
Systematic Risk
Something that affects everyone- the whole economy
Can explain this in a factor model framework like CAPM as the market portfolio
Idiosyncratic Risk
Something particular to an individual (company)
Investing
Expecting rewards for bearing “systematic risk”
Speculation
Expecting to win by bearing “non systematic risk”
Beta
I AM WITH THE CROWD
Investing in one asset class or type of risk every time
Alpha
I AM SPECIAL and BETTER THAN YOU
Beating the market consistently but not taking any one direction in one asset consistently
Rest as we go alongSlide3
What do we know?
Taking
risk has generally been rewarded
Triumph of the optimists
Linear relationship according to most asset pricing models
Usually
No free lunch
No Arbitrage can be used to get to Black Scholes
Not easy to beat the market
i.e. predict short term returns and beat transaction costs
Market efficiency studies (
Fama
1970)
Diversification generally helpsSlide4
What we sort of know
Central banks matter
Asset
volatility is higher than macroeconomic volatility
Different periods in Business cycles produce different returns
Value stocks and small stocks outperform the market
Blindly
trusting equations can blow you
up
“good traders” can help avoid that…
Human being have many cognitive biases…
models can help you avoid those….Slide5
What I believe
Collecting various kind of risk premium is smart
You can beat the market but it is hard
Always ask what the “edge” is?
Structural Factors can be big edges
People overpay for leverage
Pension funds invest in suboptimal portfolios due to regulation
Growth, inflation and credit creation can help think about what asset classes to invest in
Growth high
Growth Low
Inflation High
Commodities
Real Estate
IL Bonds
Inflation Low
Stocks
Credit
Nominal BondsSlide6
What is the debate about?
Physics => Laws
Finance => Generalizations!
Finance is a noisy social science but it
matters
There is no perfect agreement on anything in finance
Unlike Physics humans don’t follow laws when it comes to consumption
vs.
Statistical significance vs. Economic Significance
16 years of data to know if stocks STATISTICALLY (at 95% confidence level) outperform bonds
Economic significance of a winning portfolio is big! A 4.5% higher return over 16 years means doubling your money!Slide7
Investing choices we will talk about
Stock Mutual Funds
With active management
Passive management
Bond Managers
Govt. Bonds
Corporate Bonds
CTA
Trend Followers
Hedge FundsAbsolute return
Exotic beta types
Global Macro
Private EquityVenture CapitalReal EstateSlide8
Summarizing Investors
Characteristics
Capital
Risk Tolerance
Investing Horizon
Sophistication
Market BeliefsSlide9
Stock Mutual Fund
If you invest in actively managed stock mutual fund- GENERALLY
Reasonable risk tolerance
Longer investing horizon
Are Naïve
Have NOT taken a finance course since you are OVERPAYING
Believe your manager can beat the market => do NOT know how to run regressions!*
Optimistic
Low fee Index Funds
sophisticated
*Some managers do beat the market consistently but it more style predicated so if you don’t know much don’t give them your money!
*It may also be harder to get into their funds at lower cost if you are not an institutional investorSlide10
Bond Managers
Characteristics
Older
Lower risk tolerance
Known liabilities
Market Beliefs
Pessimistic on growth (nominal and inflation linked bonds)
Optimistic on inflation (For Inflation linked bonds)
Optimistic on low defaults if buying corporate bondsSlide11
CTA
Characteristics
Richer than simply mutual fund investor
Short/long time horizon
Moderate risk tolerance (around 10%
vol
but may have jump losses)
Market Beliefs
Believe “Trend Following” works
Believe in “Technical Analysis”
Price and volume contain information about the future prices
My Comments
Momentum trading does seem to help outperform with stocks but have to be careful about small , illiquid stocksMomentum and trends also work on FX, commodities and most markets. Could it be something to do with human nature? My current research topicSlide12
Hedge Funds
Characteristics
Rich
Risk Taking
Sophisticated investor or Naïve rich fool?
If you are paying 2 and 20 for beta you are naïve
If you got into a top hedge fund that has an edge, then sophisticated
Have a good network
Market Beliefs
Believe that markets have inefficiencies
Micro inefficiencies @ Absolute return funds
Macro inefficiencies @ Global Macro Funds
Mispriced risk
premia @ exotic beta fundsSlide13
Absolute Return Hedge Funds
Equity Market Neutral, Fixed Income
Arb
Really believe in your manager
Likely overpaying for illiquidity beta (more likely) or unknown
beta
Really have a manager that has a better mousetrap (less likely but possible
)
Believe market is inefficient and can be consistently exploited
Crowded
positions is a big riskSlide14
Exotic Beta generating Hedge Funds
Believe bearing complex risks have more reward
Merger Arbitrage, Convertible Arbitrage, Emerging Markets
Be careful that returns are not only coming from lack of mark to market accounting
Exposure to illiquidity
Naïve if paying 2 and 20
Can do exotic beta cheaper
Hopefully not paying for fund of funds type of structure
An organization I know invests in 100 hedge funds! That basically delivers the market portfolioSlide15
Private Equity
Characteristics
Rich
Risk taking
Long horizon (money locked in for years)
Market Beliefs
Believe that public markets force management to make suboptimal decisions (esp. on restructuring)
=> better alignment of interest between investor board and management by taking the company private
Adding debt enforces manager discipline
Useful to invest in something illiquid due to accounting treatmentSlide16
Venture Capital
Characteristics
Rich
Risk taking
Long horizon (money locked in for years)
“Adventurous”/”Futurist”/ Seek to invest in innovation
Market Beliefs
Complex technologies can be better valued by experts
The best return is taking on the option like risk of new technologies until the public market values them
Beyond that they become growth companies! Slide17
Real Estate
Characteristics
Many types of real estate investing
Ordinary people buy it for consumption (or a substitution for rent) or easiest way to get leverage on something illiquid
Big investors buy it for inflation hedge or to own their land
Long time horizon
Decent risk tolerance
i
f investing
Beliefs about the market
Inflation likely to happen
Easy to borrow money =>Levering up is a good idea
Have information about land use change or expect population to growSlide18
Are these beliefs true? A look at performanceSlide19
Hedge Funds have done well since 1990 but post 2004 has been more challenging Slide20
Hedge Fund Performance 2004 to today (CS TASS Database)Slide21
Private Equity and VC vs. index correlations have been risingSlide22
Like in most specialized things top guys continue to do wellSlide23
Conclusion
Know yourself
What are my characteristics
Try to know the market
Do your research on the market and see what you believe
Questions
What is my edge?
What is the person to whom I am handing over the money’s edge?
This is a really cool problem so hopefully some of you
wil do research on it!Slide24
Common Beliefs about Asset Classes