10/6/2014

1
IAPM
PGP17
1
Day7
TwopartargumentofAPT
Tellsushowtogofromthemultifactormodeltorisk
premiums
Twowelldiversifiedportfolioswiththesame
shouldhavethesameexpectedreturn
Arbitrage: Exploitation of asset mispricing in such a way
that risk-free profits can be earned that risk free profits can be earned
Conclusion:Expectedreturnonwelldiversified
portfoliosmustlieonthestraightlinefromtherisk
freeasset(SML)
2
10/6/2014
2
APT
Theriskreturnrelationcanbeextendedfromwell Theriskreturnrelationcanbeextendedfromwell
diversifiedportfoliostoindividualassets.
Asimilarargumentisusedtoestablishthemultifactor
SML.
TheriskpremiumsinamultifactorSMLarecoming
fromfactorportfolios.
Connections between the two equations in the first slide: Is
the airline stock over priced or under priced?
3
Fama andFrenchandthethreefactor
model
ResearchersEugeneFama andKenFrenchhavedone ResearchersEugeneFama andKenFrenchhavedone
extensiveresearchinthisarea
Foundfactorsdescribingvalueandsizetobethe
mostsignificantfactors,outsideofmarketrisk,for
explainingtherealizedreturnsofpubliclytraded
stocks(1992)
To represent these risks, they constructed two factors: SMB
Small Minus Big (firm size) to address size risk and HML
High Minus Low (book-to-market ratio) to address value risk
4
10/6/2014
3
Fama French
SMBisdesignedtomeasuretheadditionalreturn SMBisdesignedtomeasuretheadditionalreturn
investorshavehistoricallyreceivedbyinvestingin
stocksofcompanieswithrelativelysmallmarket
capitalization.Thisadditionalreturnisoftenreferred
toasthesizepremium.
In practice, the SMB monthly factor is computed as the
average return for the smallest 30% of stocks minus the average return for the smallest 30% of stocks minus the
average return of the largest 30% of stocks in that month.
A positive SMB in a month indicates that small cap stocks
outperformed large cap stocks in that month.
5
HML
HML,whichisshortforHighMinusLow,hasbeen HML,whichisshortforHighMinusLow,hasbeen
constructedtomeasurethevaluepremiumprovided
toinvestorsforinvestingincompanieswithhigh
booktomarketvalues
Constructed in a fashion similar to that of SMB, HML is
computed as the average return for the 50% of stocks with
the highest B/M ratio minus the average return of the 50% of the highest B/M ratio minus the average return of the 50% of
stocks with the lowest B/M ratio each month.
6
10/6/2014
4
Fama French
Aretheseriskfactors? Aretheseriskfactors?
Whatdoesthe3factorSMLlooklike?
7
ClassifyingFundsintoStyleBuckets
The3factormodelprovidesawaytocategorizemutualfundsbythe
sizeandvalueriskstowhichitsportfolioisexposed,andthusthe
returnpremiumsexpected.
8
10/6/2014
5
Fundevaluationinpractice(usingCAPM)
Isagivenperformancehigherthanthebenchmark? Isagivenperformancehigherthanthebenchmark?
TheLMVPfundreturned27.3%annuallyfrom
September1998toDecember2002whilethemarket
onlyreturned21.6%.
The fund manager might claim the excess returns were due to
her exceptional ability at picking stocks.
9
UseofSCL
Usinghistoricalmonthlyvaluesforr
A
,r
M
andr
f
,we Usinghistoricalmonthlyvaluesforr
A
,r
M
andr
f
,we
candeterminethevaluesofandusingtheSCL.
Using r
A
r
f
for the y-values and r
M
r
f
for the x-values in a
regression, the following coefficients are returned:
= 0.93
= 0.46% per month
i.e. the fund manager was able to add 46 basis points to the
funds return on a monthly basis or about 5.5% per year above
the return expected from a portfolio with a beta of .93.
Is this higher than benchmark return?
10
10/6/2014
6
Thetstatisticassociatedwithalphais2.37,indicating Thet statisticassociatedwithalphais2.37,indicating
thatachievingsuchreturnswithoutskillwouldbe
extremelyunlikely
11
Fundevaluationinpractice(usingFama
French)
Wenowhaveanothertoolwithwhichtoscrutinizethe Wenowhaveanothertoolwithwhichtoscrutinizethe
managersclaim
Utilize historic monthly values to build a regression using r
A
,
r
M
, r
f
, SMB, and HML . Regress r
A
r
f
against r
M
r
f
, SMB
and HML to determine the estimates of ,
M
,
S
and
V
In this particular case, the following coefficients result:
0 22 = 0.22

M
= 0.99

S
= 0.36

V
= 0.22
t-statistic for = 1.1
12
10/6/2014
7
Fundevaluationinpractice
Therelativelylowtstatisticof1.1,however,underminesthe y
managersclaimandindicatesthatthealphawasmore
likelytohavehappenedbychance(i.e.itisnotstatistically
differentfromzero)
A high R
2
(0.92 in this case) tells us that the three factors explain all
but 8% of the variation in historical returns, further lending
credence to the findings.
13
Upshot:ApositivealphaobservedinaCAPMregression
couldmerelybearesultofexposuretoeitherHMLorSMB
factors,ratherthanactualmanagerperformance.
(Courtesy:KentWomacksteachingnote)