FINANCIAL INVESTMENTS Faculty:Bernard DUMAS

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Université de Lausanne Master of Science Spring
2008

• FINANCIAL INVESTMENTSFaculty Bernard DUMAS
• Introduction The Role of Financial Markets. The
  Role of the Asset Management Industry
• session 1-1

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Overview

• The roles of financial markets
• The role of primary markets sources of financing
  for firms
• Secondary markets
• The organization of exchanges
• The quality of stock prices information
  efficiency
• What is Asset Management?
• Two approaches to Asset Management
• How you measure performance
• About the market efficiency doctrine
• Course calendar

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The roles of financial markets

• Primary markets
• new issues of securities by firms
• Provide financing
• Pooling of funds permits financing of very large
  firms
• Secondary markets
• risks are tradable on a daily basis in the
  secondary markets
• Households can maintain diversified portfolios
• diversification of risks
• pooling of risks. Example pensions
• Financial markets indicate a price every day
  (secondary market)
• The price reflects/aggregates the bits of
  information collected by all investors. Useful
  for corporate decision makers their role is to
  maximize that price

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The role of primary markets
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The financing role of financial markets
Investment banks
Households
Non financial assets (tangible and intangible )
Stocks, bonds and other financial markets
Firms
Loans
Commercial banks
Asset management firms
Savings Investments
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Sources of financing for firms
Source Corbett, J. and T. Jenkinson, 1997, How
is Investment Financed? A Study of Germany,
Japan, the United Kingdom and the United States,
Manchester School, 65, pp. 69-93. And private
communication with Tim Jenkinson, Oxford
University.
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Evolutions
Private communication with Tim Jenkinson, Oxford
University.
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Evolutions (2)
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Secondary markets
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The organization of exchanges

• Auction markets order driven markets
• All orders are channeled through auctioneer or
  specialist
• Orders are posted (the book)
• Market clearing price
• Note in effect the specialist is a dealer
• Example NYSE, Euronext
• Members form a partnership

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The organization of exchanges

• Dealer markets price-driven markets
• Dealer trade on their own account, posting bid
  and ask prices
• Market is more fragmented
• Following scandal, regulation has forced
  comparative posting of quotes
• Example NASDAQ, EASDAQ etc.

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The quality of stock prices information
efficiency of markets
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Market efficiency

• Definition
• A market is efficient relative to a given set of
  information if that set of information is
  rationally incorporated into stock prices
• Price is present discounted value of expected
  future cash flows
• Implications
• Prices should not be predictable
• Prices should be less volatile than cash flows

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The volatility of stock prices

• Robert Shiller (1981)
• Actual stock price behavior compared to present
  discounted value of dividends
• Stock prices are too volatile to be justified
  by subsequent dividends

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Is the stock market a sideshow?

• I shall show you later that it is connected to
  the business cycle
• Right now, let me show that it is probably
  connected to pension assets and demographics

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Dependency ratio
Source Arnott and Cascells
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Consequence for the stock market

• Conclusion in the years ahead, almost surely,
  expected returns will be lower than they have
  been
• There could even be a stock market crash in 2012
  (when I retire)

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Scary picture
Source J. Poterba, 2004, The Impact of
Population Aging on Financial Markets, NBER,
working paper 10851.
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What is Asset Management?
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What is Asset Management?

• Asset management firms sell a service
• They manage mutual funds short horizon, no
  liabilities, performance measured relative to a
  benchmark
• Passive pure market-index risk
• Active
• Varying amount of trading act on signals
• Varying degree of specialization or tilt value
  vs. growth
• They manage pension fund assets long horizon/
  liabilities
• They manage hedge funds short horizon,
  long/short, absolute performance
• They manage endowments longer horizon,
  liabilities
• Advisors (sub-management) vs. consultants
• Banks and Insurance companies
• They manage their own assets and client assets.
• They have liabilities
• Private banks asset management client services

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What is asset management?
The fi-nancial market

• Institutionals
• Mutual funds
• Pension funds
• Insurance companies
• Endowments

Passive investing (index funds)
Retail
Alter-na-tive in-vestmen-ts
Active investing (hedge funds or tilted funds)
HNW
(private bankers)
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What is Asset Management?

• Three markets
• Retail market
• Mostly reached by mutual funds, many of them
  offered by commercial banks
• And (truly) Independent Financial Advisors
• Institutional clients (themselves intermediaries,
  not final clients)
• pension funds
• other mutual funds (or funds of funds)
• Insurance companies
• Private banks
• High net worth individuals
• Mostly reached by private bankers
• And family offices

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What is Asset Management? Marketing

• Pricing management and other fees
• Mostly function of AuM
• Sometimes based on performance
• Distribution network
• Direct mostly bank branches
• In Continental Europe, commercial bank
  distribution entails an extremely heavy cost.
  Actual management fee is a small fraction of fee
  paid by final customer.
• Third party mostly independent financial
  advisors and brokers
• Varying degrees of open architecture
• Packaging Can one separate manufacturing from
  distribution?
• Not when asset management services are bundled
  with other financial services
• In principle, it would be beneficial to separate
  the two
• Alpha transport

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Two approaches to asset management
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Two approaches to asset management

• Securities analysis Bottom up
• Stock picking, i.e. security selection based on
  analysis (also called research)
• Asset allocation Top down
• Choose allocation to asset classes
• Strategic asset allocation
• If clients risk/return preference is identical
  to the risk/return trade-off offered by the
  market hold the market portfolio
• If various asset classes have returns in a
  risk/return trade-off/pattern that differs from
  clients preferences (because of his/her investor
  characteristics, see above) hold a tilted
  portfolio

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The top-down vs. bottom-up approaches to
equities investment
Peter Lynch quote One way is to tell yourself,
I want to have 8 in autos, because you have a
hunch that autos are going to do well. You can
close your eyes and throw darts at a list of auto
stocks, and buy a few. Another way is to analyze
each company on a case-by-case basis. In the
first instance, the 8 weighting in autos is
deliberate and the choice of companies is
incidental in the second, the choice of
companies is deliberate and the weighting is
incidental.
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What is an asset class?

• Bewildering array of investment opportunities
• Classify assets into a few asset classes. On what
  basis?
• By nature of asset? Stocks, bonds, industry etc..
• The risks that assets are exposed to
• Price risk
• Country
• Industry
• Interest rate risk
• Credit risk
• Tail risk or risk of ruin
• ?Most important classification device
• Statistical correlation
• Modeled as common factors and exposures thereto
• quasi-arbitrage opportunities (convergence
  trades) LTCM
• Pitfalls of correlations they move over time

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How you measure performance
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The tyranny of the benchmarks

• Overall (stock?) market benchmark
• CAPM theoretical support
• In practice, mostly used for passive or active
  stock funds
• Different benchmarks for different investment
  strategies?
• Growth vs. value stocks classified by
  Book/Market ratio
• Value outperforms growth most of the time
• Episodes during which it is the opposite
• Large-caps vs. small caps classified by log of
  Market cap.
• Small caps outperform large caps most of the time
• Episodes during which it is the opposite
• Depends on technology cycle ?
• Industry indexes, Country indexes, Bond indexes
  etc..
• The choice of the benchmark is a large part of an
  asset management firms investment-philosophy
  definition

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Risk management/Performance measurement

• Risk management is the process of measuring
  exposures to various dimensions of risk,
• to the benchmark in particular
• The benchmark(s) serves simultaneously
• to estimate risk exposures (pure statistical
  step)
• and to measure performance (asset-pricing step)
• (link if risk exposures were all reduced to
  zero, the return of a portfolio should be the
  riskless rate)

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Do we need benchmarks?

• Industry trend towards less emphasis on
  benchmarks
• What is truly important for asset allocation is
  return on assets compared to
• Client needs Ultimate benchmark should be the
  satisfaction of client spending needs
• Risks of changes in the value of liabilities
• Does the concept of absolute return abolish
  benchmarks?
• Long/short investing permits hedging (elimination
  of exposures to common factors)
• In that case, any return above interest rate
  (absolute return) is pure value added (alpha)

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About the market efficiency doctrine
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Is Asset Management Useful?

• The proportion of mutual funds beating their
  benchmark is lower than 50 and falling
• Coval et al. reading indicates, however, that a
  few individuals are successful investors
• Is there room for asset management services in an
  efficient market?
• Or should everyone just hold an index (i.e.,
  passive) fund?

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About the market efficiency doctrine

• Dont view market efficiency as an all-or-nothing
  proposition. The market is (or is not) efficient
  relative to a particular bit of information
• The markets need people who gather/process
  information
• If the market were fully efficient relative to
  all forms of information, there would be no
  incentive to go out and gather information
• In equilibrium, even if everyone is rational,
  some level of inefficiency must exist in
  financial markets. The inefficiency is needed to
  pay the information gatherers.
• Like in any line of business, there is
  competition you can turn out to be better or
  worse than others in gathering and processing
  information
• In this business, however, competition is
  becoming worldwide (as opposed to local)

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About the market efficiency doctrine

• In addition, there is evidence of irrational
  behavior on the part of the general public
• One more form of inefficiency
• This opens trading opportunities for professional
  traders
• This shows that the general public needs advice
• For asset management to be successful, there has
  to exist some form of market inefficiency
• The job of asset managers is to detect the
  patterns of market inefficiency that can be
  exploited
• This will result,
• in the short run, in superior performance and,
• in the long run, in a larger amount of assets
  under management
• One goal of this course is to categorize the
  inefficiencies

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Conclusion

• What you will have learnt by the time you finish
  this class
• Who makes decisions about capital allocation in
  the financial market individual investors,
  investment banks, private banks, hedge funds,
  pension funds etc.
• How they make these decisions
• How their performance is measured
• How they manage the level of risk they take

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Course calendar
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