The CFA Society of the UK, supporting ASIP, CFA and IMC professionals.

 Fri 04 Jul 2008

UK Society of Investment Professionals - CFA Institute

<< BACK

The ICMA Centre, University of Reading

The ICMA Centre has an international reputation for providing quality undergraduate, postgraduate and professional programmes tailored to the capital markets industry. The ICMA Centre’s success is based not only on the integration of applied finance theory and industry specific training but also its considerable professional and academic expertise, and strong links with companies and trade associations in the global finance industry.

If you would like more information about the ICMA Centre, please contact admin@icmacentre.ac.uk or call +44 0118 378 8239

Low-Cost Momentum Strategies

Xiafei Li, Chris Brooks and Joëlle Miffre

Abstract

The article analyses the impact of trading costs on the profitability of momentum strategies in the UK and concludes that losers are more expensive to trade than winners. The observed asymmetry in the costs of trading winners and losers crucially relates to the high cost of selling loser stocks with small size and low trading volume. Since transaction costs severely impact net momentum profits, the paper defines a new low-cost relative-strength strategy by shortlisting from all winner and loser stocks those with the lowest total transaction costs. While the study severely questions the profitability of standard momentum strategies, it concludes that there is still room for momentum-based return enhancement, should asset managers decide to adopt low-cost relative-strength strategies.

http://www.icmacentre.ac.uk/files/pdf/dps/dp2007_12.pdf

Short-Term Returns of UK Share Buyback Activity

Carol Padgett and Zhiqi Wang

Abstract

This paper examines the short-term signalling power of UK open market share repurchases between 1999 and 2004. The 5-day and 11-day abnormal returns centred on the announcement date are statistically significant at 1.13% and 1.21% respectively. However, there is no evidence to support any relationship between the 5-day announcement abnormal returns and characteristics of UK share repurchases, such as the percentage of shares to be repurchased, pre-announcement return, size and lag time. These results are largely in line with results reported by Rees (1996). It seems that UK share repurchases are not primarily motivated by share undervaluation. That is why the signalling hypothesis fails to explain the announcement abnormal returns of the UK open market share repurchases.

http://www.icmacentre.ac.uk/files/pdf/dps/dp_200710.pdf

Global Portfolio Optimization Revisited: A Least Discrimination Alternative to Black-Litterman

Jacques Pézier

Abstract

Global portfolio optimization models rank among the proudest achievements of modern finance theory, but practitioners are still struggling to put them to work. In 1992, Black and Litterman recognized the difficulties portfolio managers have in expanding their personal views about some expected asset returns into full probabilistic forecasts about all asset returns and developed a method to facilitate this task. We propose a more general method based on a least discrimination (LD) principle. It produces a probabilistic forecast that is true to personal views but is otherwise as close as possible to a chosen reference forecast. For this purpose we expand the concept of optimal portfolio to include non-linear pay-offs and derive an economic measure of distance - a generalized relative entropy distance - between probabilistic forecasts. The LD method produces optimal portfolios matching any views, including views on volatility and correlation as well as expected returns, and containing option-like pay-offs, if allowed. It also justifies a simple linear interpolation between reference and personal forecasts, should a compromise need be reached.

http://www.icmacentre.ac.uk/files/pdf/dps/dp2007_07.pdf

Should Defined Benefit Pension Schemes be Career Average or Final Salary?

Charles Sutcliffe

Abstract

There is widespread dissatisfaction amongst employers with defined benefit pension schemes, and many are switching to defined contribution schemes. Career average is a form of defined benefit scheme that has some important advantages over final salary schemes. The comparison of career average and final salary schemes is a neglected area, and this paper offers one of the first in-depth analyses of this topic. It considers the advantages and disadvantages of a cost neutral switch to a career average re-valued earnings (CARE) scheme.

http://www.icmacentre.ac.uk/files/pdf/dps/dp2007_06.pdf

Hedging and Cross-hedging ETFs

(Forthcoming in Journal of Banking and Finance)

Carol Alexander and Andreza Barbosa

Abstract

This paper presents an empirical study of hedging the four largest US index exchange traded funds (ETFs). When hedging each ETF position with its own index futures we find that it is difficult to improve on the naïve 1:1 futures hedge, that hedging is less effective around the time of dividend payments, and that hedged portfolio returns tend to have very large negative skewness and highly significant excess kurtosis. We also investigate the extent to which a long position on one ETF can be offset by a short position on another correlated ETF and consider how best to hedge portfolios of ETFs with one index futures. In these situations minimum variance hedging is clearly preferable to naïve hedging, although it seems to matter little which econometric hedge ratio is used, and the cross-hedged portfolio returns are closer to normality than the futures hedged portfolios. The evaluation focuses on a very large out of sample hedging performance analysis that includes aversion to negative skewness and excess kurtosis as well as effective reduction in variance. Our results should be of interest to hedge funds employing tax arbitrage or leveraged long-short equity strategies. They will also be of interest to ETF market makers since hedging is the most cost effective way of reducing the market risk of inventories, thus hedging enables market makers to reduce bid-ask spreads in a competitive environment.

http://www.icmacentre.ac.uk/files/pdf/dps/DP2007-01.pdf

The Relative Merits of Investable Hedge Fund Indices and of Funds of Hedge Funds in Optimal Passive Portfolios

Jacques Pezier and Anthony White

Abstract

Can the new investable hedge fund indices (IHF) enhance the performance of optimal passive portfolios made of equities and bonds? How do they compare to funds of hedge funds (FoHF) as well as to other alternative investments such as commodities and volatility? The conclusions depend crucially on forecasts of future expected excess returns for all assets as well as a careful conditioning of the data to reflect trading costs and remove unrealistic serial correlations. A naïve forecast based on recent historical performance leads to no allocations to either IHF or FoHF, a result explained by the performance of equities and commodities and limited diversification effects from hedge funds. Yet a forecast based on market equilibrium returns for all main asset classes but hedge funds, which are kept at their historical level, leads to the opposite result with optimal portfolios almost exclusively invested in hedge funds. Both conclusions are unrealistic and unstable. More reasonable allocations are obtained with the Black-Litterman (BL) approach to combining subjective views with equilibrium returns. Then both hedge funds instruments play a significant role in optimal passive portfolios if their expected excess returns are at least 1%. Long volatility positions are also likely to be attractive. However the BL approach can also be criticised.

http://www.icmacentre.rdg.ac.uk/pdf/discussion/DP2006-10.pdf

Better Cross Hedges with Composite Hedging? Hedging Equity Portfoloios Using Financial and Commodity Futures

Fei Chen
Charles Sutcliffe

Abstract

Unless a direct hedge is available, cross hedging must be used. In such circumstances portfolio theory implies that a composite hedge (the use of two or more hedging instruments to hedge a single spot position) will be beneficial. Surprisingly, the study and use of composite hedging has been neglected; possibly because it requires the estimation of two or more hedge ratios. This paper demonstrates a statistically significant increase in out-of-sample effectiveness from the composite hedging of the Amex Oil Index using S&P500 and Nymex crude oil futures. This conclusion is robust to the technique used to estimate the hedge ratios, and to allowance for transactions costs, dividends and the maturity of the futures contracts.

http://www.icmacentre.ac.uk/files/pdf/dps/DP2007-04.pdf

T he S&P 500 Index Effect in Continuous Time: Evidence from Overnight, Intraday and Tick-by-Tick Stock Price Performance

Konstanina Kappou
Chris Brooks
Charles Ward

The advent of index tracking early in the 1970s and the continuous growth of assets tied to the S&P 500 index have enforced perceptions of the importance of becoming an index-member, due to increased demand by index fund participants for the stocks involved in index composition changes. This study focuses on S&P 500 inclusions and examines the impact of potential overnight price adjustment after the announcement of an S&P 500 index change. We find evidence of a significant overnight price change that diminishes the profits available to speculators although there are still profits available from the first day after announcement until a few days after the actual event. More importantly observing the tick-by-tick stock price performance of the key days of the event window for the first time, we find evidence of consistent trading patterns during trading hours over inclusion event. A separate analysis of two different sub-periods as well as of NASDAQ and NYSE listed stocks allows for a detailed examination of the price and volume effect in continuous time.

http://www.icmacentre.ac.uk/files/pdf/dps/DP2007-05.pdf

The Value premium and Time-Varying Unsystematic Risk

Xiafei Li
Chris Brooks
Joelle Miffre

Abstract

Recent research has discussed the possible role of unsystematic risk in explaining equity returns. Simultaneously, but somehow independently, numerous other studies have documented the failure of the static and conditional capital asset pricing models to explain the differences in returns between value and growth stocks. This paper examines the post-1963 value premium by employing a model that captures the time-varying total risk of the value-minus-growth portfolios. In accordance with existing studies, it finds that the static CAPM has no explanatory power for the value premium, and that firm size has only a limited role to play. The results show that the conditional variance specification incorporating time-varying idiosyncratic risk can fully capture the post-1963 value premium and that the value premium is a compensation for exposure to time-varying risk. This conclusion is robust to different characteristics of value and growth stocks and to the country under review (US and UK).

http://www.icmacentre.ac.uk/files/pdf/dps/DP2007-03.pdf

Optimal Hedging with Higher Moments

Chris Brooks
Aleš Cerny
Joëlle Miffre

Abstract

This study proposes a utility-based framework for the determination of optimal hedge ratios that can allow for the impact of higher moments on the hedging decision. The approach is applied to a set of 20 commodities that are hedged with futures contracts. It finds that in sample, the performance of hedges constructed allowing for non-zero higher moments is only very slightly better than the performance of the much simpler OLS hedge ratio. When implemented out of sample, utility-based hedge ratios are usually less stable over time, and can make investors worse off for some assets compared to hedging using the traditional methods. It concludes, in common with a growing body of very recent literature, by suggesting that higher moments matter in theory but not in practice.

http://www.icmacentre.ac.uk/pdf/discussion/DP2006-12.pdf

Momentum Profits and Time-Varying Unsystematic Risk

Xiafei Li
Joëlle Miffre
Chris Brooks

Abstract

This study assesses whether the widely documented momentum profits can be ascribed to time-varying risk as described by a GJR-GARCH(1,1)-M model. Consistent with rational pricing in efficient markets, we reveal that momentum profits are a compensation for time-varying unsystematic risks, common to the winner and loser stocks. It also finds that, because losers have a higher propensity than winners of disclose bad news, negative return shocks increase their volatility more than it increases that of the winners. The volatility of the losers is also found to respond to news more slowly, but eventually to a greater extent, than that of the winners. Following Hong et al. (2000), it interprets this as a sign that managers of loser firms are reluctant to disclosing bad news, while managers of winner firms are eager to releasing good news.

http://www.icmacentre.ac.uk/pdf/discussion/DP2006-09.pdf

Speculative Bubbles in the S&P 500: Was the Tech Bubble Confined to the Tech Sector?

Chris Brooks
Apostolos Katsaris

Abstract

This study assesses whether the widely documented momentum profits can be ascribed to time-varying risk as described by a GJR-GARCH(1,1)-M model. Consistent with rational pricing in efficient markets, we reveal that momentum profits are a compensation for time-varying unsystematic risks, common to the winner and loser stocks. It also finds that, because losers have a higher propensity than winners of disclose bad news, negative return shocks increase their volatility more than it increases that of the winners. The volatility of the losers is also found to respond to news more slowly, but eventually to a greater extent, than that of the winners. Following Hong et al. (2000), it interprets this as a sign that managers of loser firms are reluctant to disclosing bad news, while managers of winner firms are eager to releasing good news.

http://www.icmacentre.ac.uk/pdf/discussion/DP2006-07.pdf

The Stock Performance of America's 100 Best Corporate Citizens

Stephen Brammer
Chris Brooks
Stephen Pavelin

Abstract

This study considers the stock performance of America's 100 Best Corporate Citizens following the annual survey by Business Ethics. It examines both possible short-term announcement effects around the time of the survey's publication, and whether longer-term returns are higher for firms that are listed as good citizens. It finds some evidence of a positive market reaction to a firm's presence in the Top 100 firms that are made public, and that holders of the stock of such firms earn small abnormal returns during an announcement window. Over the year following the announcement, companies in the Top 100 yield negative abnormal returns of around 3%. However, such companies tend to be large and with stocks exhibiting a growth style, which existing studies suggest will tend to perform poorly. Once it allows for these firm characteristics, the poor performance of the highly rated firms declines. It also finds companies that are newly listed as good citizens can provide considerable positive abnormal returns to investors, even after allowing for their market capitalisation, price-to-book ratios, and sectoral classification.

http://www.icmacentre.ac.uk/pdf/discussion/DP2006-06.pdf

Corporate Reputation and Stock Returns: Are Good Firms Good for Investors?

Stephen Brammer
Chris Brooks
Stephen Pavelin

Abstract

This paper employs a unique dataset from the UK based on ten years of surveys of company directors and analysts conducted for Management Today to examine the relationship between a firm's reputation and the returns on its shares. It finds that investors who purchase stocks with reputation scores that have risen significantly can make abnormal returns. Also, firms whose scores have fallen substantially still exhibit positive abnormal returns in both the short and long run when the market index is employed as a benchmark. However, when a more appropriate comparator is used, evidence of out-performance entirely disappears.

http://www.icmacentre.ac.uk/pdf/discussion/DP2006-05.pdf

A false perception? The relative riskiness of AIM and listed stocks

John Board
Alfonso Dufour
Charles Sutcliffe
Stephen Wells

Abstract

This research examines the perception that the AIM market is riskier than the Official List market in comparable stocks. The empirical analysis uses high frequency data for January 2000 to December 2004 on 533 AIM stocks and 264 comparable Official List stocks. Risk is measured in a variety of ways. At a superficial level AIM stocks appear riskier than comparable Official List stocks. However, as the analysis is refined to ensure the comparison focuses purely on the effects of being listed on different markets, the additional AIM risk shrinks and finally disappears. This conclusion concurs with the current market practitioner view that there is no significant risk differential.

http://www.icmacentre.rdg.ac.uk/pdf/discussion/DP2006-01.pdf

The UK code of corporate governance: link between compliance and firm performance

Carol Padgett
Amama Shabbir

Abstract

Listed companies in the UK are required to comply or give reasons for non-compliance with the recommendations of the UK code of corporate governance called 'The Combined Code'. Our results suggest that for today's informed and discerning investors, compliance matters, not just as a box ticking exercise, but as a real change in the governance of large listed companies, for which they are willing to pay a premium.

http://www.icmacentre.rdg.ac.uk/pdf/discussion/DP2005-17.pdf

Is minimum variance hedging necessary for equity indices? A study of hedging and cross-hedging exchange traded funds (ETF)

Carol Alexander
Andreza Barbosa

Abstract

The basis risk on US equity indices is now extremely low and there is no evidence that minimum variance hedge ratios outperform a naïve 1:1 futures hedge, either for individual ETFs or for portfolios of ETFs. Where minimum variance hedge ratios are useful is for the netting of long-short positions prior to placing a futures hedge. Also hedging of an ETF portfolio with just one index future can be almost as effective as hedging with all the relevant index futures. The results should be of interest to tax arbitrage investors in ETFs and their market makers, who often face large and heterogeneous creation and redemption demands on different ETFs.

http://www.icmacentre.rdg.ac.uk/pdf/discussion/DP2005-16.pdf

Investment reputation index: family firms vs. non-family firms in the UK

Suranjita Mukherjee
Carol Padgett

Abstract

Family firm researchers have found a host of characteristics that are unique to family firms. We build an Investment Reputation Index that measures the reputation of a family firm as an investment opportunity. Understanding 'How family is the family firm?' is important from an investor's point of view as it highlights the good practices of some family firms. An investor instead of grouping all family firms into one category can now differentiate between 'good' and 'bad' family firms with the help of the Investment Reputation Index.

http://www.icmacentre.rdg.ac.uk/pdf/discussion/DP2005-15.pdf

Asymmetries and volatility regimes in the European equity markets

Carol Alexander
Emese Lazar

Abstract

This paper provides and empirical examination of four European equity indices between 1991 and 2005. We investigate the ability of fifteen different GARCH models to capture the characteristics of historical daily returns effectively and generate realistic implied volatility skews. Using many different model selection criteria we conclude that a normal mixture GARCH model with two volatility components, two sources of asymmetry and endogenous time-varying conditional higher moments provides the best fit overall. Also, its parameters provide information on the likelihood of a crash and the return and volatility behaviour, the leverage effect and the persistence of volatility during the normal and crash market regimes.

http://www.icmacentre.rdg.ac.uk/pdf/discussion/DP2005-14.pdf

Joined-up pensions policy in the UK: An asset-liability model for simultaneously determining the asset allocation and contribution rate

John Board
Charles Sutcliffe

Abstract

The trustees of funded defined benefit pension schemes must make two vital and inter-related decisions - setting the asset allocation and the contribution rate. These decisions are usually taken separately, but this paper develops a model in which the decisions can be taken jointly. This model is then applied to one of the largest UK pension schemes - the Universities Superannuation Scheme.

http://www.icmacentre.rdg.ac.uk/pdf/discussion/DP2005-11.pdf

Merging schemes: An economic analysis of defined benefit pension scheme merger criteria

Charles Sutcliffe

Abstract

The conditions under which pension schemes merge is an important issue that has been under-researched. Mergers can affect the strength of the sponsor's covenant and the balance of power between the trustees and the sponsor, as well as the scheme funding ratio. This paper sets out two financial criteria to be met by any pension scheme merger:- no profit or loss on merging with another scheme; and no dilution of the funding ratio. After defining a merger basis for valuing the assets and liabilities, and allowing for adjustments to the funding ratio via side receipts and payments; it is shown that, whether or not these criteria are met, depends on the state of the financial markets.

http://www.icmacentre.rdg.ac.uk/pdf/discussion/DP2005-09.pdf

Detecting switching strategies in equity hedge funds

Carol Alexander
Anca Dimitriu

Abstract

Equity hedge funds are thought to operate market timing effectively by implementing switching strategies conditional on market circumstances. In this paper, only the reported monthly returns on a set of funds are used to infer which switching strategies, if any are followed, as well as their switching times. A set of regime-switching models for each equity hedge fund's returns against various benchmarks are estimated; subsequently we answer the following general questions: What proportion of equity funds seem to have switching strategies in place? Which are the most popular instruments for switching strategies? And what is the relationship between the switching times of different funds? The general methodology applied in this paper may be useful to investors that wish to detect, from only from their reported returns, whether and when a particular fund has been timing the market.

http://www.icmacentre.rdg.ac.uk/pdf/discussion/DP2005-07.pdf

The spider in the hedge

Carol Alexander
Andreza Barbosa

Abstract

This paper provides an empirical study of the effectiveness of hedging the spider, a passive exchange traded fund (ETF) that replicates the S&P500 index. The spider is by far the largest ETF in the world: trading on the spider has grown so much during the past few years that it is now amongst the few most traded securities in the AMEX. The large net daily creation and redemption orders of recent years pose a problem to the market makers in the spider, as the orders may be too large to execute in the cash market. They face a decision about whether to hedge spider positions on their own book; and if so, how should they hedge? We have employed several sophisticated minimum variance estimates for the future hedge ratio, including OLS regression, an ECM to account for maturity effects and the cointegration of the spot and the future prices and, to the ECM residuals we apply EWMA and number of bivariate GARCH models to account for time-variation in the hedge ratio. The efficiency of hedging the spider is superior to that of the index and the spider hedged portfolios have significantly lower volatility than the spot index hedged portfolios.

http://www.icmacentre.rdg.ac.uk/pdf/discussion/DP2005-05.pdf

The extremes of the P/E effect

Keith Anderson
Chris Brooks

Abstract

Investigations into value-based 'anomalies' such as the P/E effect sort shares into quintiles, or at most deciles. These are blunt instruments. We test whether most of the extra value to be found in the lower end of the P/E spectrum is to be found in the very lowest P/E shares and whether the worst investments are in the few shares with the highest P/E. Using a long-term definition of earnings, and attributing influences on the P/E to company size and sector, we find that a handful of value shares give returns of 40%+ per annum, while a handful of glamour shares give returns less than the risk-free rate.

http://www.icmacentre.rdg.ac.uk/pdf/discussion/DP2005-04.pdf

Decomposing the P/E ratio

Keith Anderson
Chris Brooks

Abstract

The price-earnings effect has been a challenge to the idea of efficient markets for many years. The P/E used has always been the ratio of the current price to the previous year's earnings. However, the P/E is partly determined by outside influences, such as the year in which it was measured, the size of the company, and the sector in which the company operates. Looking at all UK companies since 1975, we determine the power of these influences, and find that the sector influences the P/E in the opposite direction to the others. We use a regression to weight the influences according to their power in predicting returns, reversing the sector influence so that it works for us and not against us. The resulting weighted P/E widens the gap in annual returns between the value and glamour deciles by 8%, and identifies a value decile with average returns of 32%.

http://www.icmacentre.rdg.ac.uk/pdf/discussion/DP2005-03.pdf

The long-term P/E ratio

Keith Anderson
Chris Brooks

Abstract

The P/E effect has been thoroughly documented and widely studied around the world. However, it has always been calculated on the basis of the previous year's earnings. This paper shows that the power of the effect has until now been seriously underestimated, due to taking too short-term a view of earnings. All UK companies since 1975 are examined, and using the traditional P/E ratio the difference in average annual returns between the value and glamour deciles is found to be 6%, similar to other authors' findings. That gap is almost doubled by calculating P/E ratios using earnings averaged over the last eight years. Averaging, however, implies equal weights for each past year. The gap is further widened by optimising the weights of the past years of earnings in the P/E ratio.

http://www.icmacentre.rdg.ac.uk/pdf/discussion/DP2005-02.pdf


<< BACK