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FACULDADE DE ECONOMIA



Second Case:
BETA MANAGEMENT COMPANY












Finance
Fall 2006-2007

1) Based on the first three paragraphs of the case, explain Beta Management
Company's (BMC) investment strategy. Is it compatible with market efficiency
theories?
BMCs Investment Strategy

To enhance returns and reduce risks is a general objective of risk-averse investors and
shouldnt be considered an investment strategy proper.

BMC follows a market timing investment strategy based on two portfolios: the Vanguard
Index and money market (i.e., short-term) instruments. When BMC expects the market to
rise, it transfers its assets from the money market to the Index (up to a maximum of 99%
of total assets), seeking to obtain capital gains; when BMC expects the market to fall, it
transfers back the assets from the Index to the money market instruments (down to a
minimum of 50%), so as to avoid capital losses.

By setting a floor of 50% on the investment on the Index, BMC endeavours to maintain
at all times a return spread so as to enhance returns, while seeking to partly capitalize
on unpredicted rises (at the cost of losses if the market behaves as predicted). By setting a
very high ceiling for the investment in the Index (99%), BMC is willing to take on extra
risk to try to fully capitalize on predicted rises. The investment strategy has thus some
aggressive elements in it. The objective of risk reduction might better accomplished by
setting both a lower ceiling and, particularly, a lower floor.

Advantages of the Vanguard Index:

- Low transaction costs (important in a market timing strategy, which involves frequent
transactions).
- Well-diversified portfolio and good proxy for the S&P 500 Index, which is itself a
proxy for the market portfolio.

Compatibility with Market Efficiency:

Under market efficiency asset prices reflect, every moment in time, all the available
information. Market efficiency implies one cannot systematically obtain excessive profits
if one does not possess a larger information set than the market. A possible exception is
the case were efficiency arises exclusively from arbitrage, in which situation a case can
be made for a scenario where very good arbitragers may repeatedly beat the market
(especially if there are ingenuous players in the market).

Market efficiency can be presented in three forms: weak, semi-strong and strong.

Weak form efficiency: BMC cannot obtain unusual profits based on the
information contained in past prices, because unexpected variations on a stocks
price follow a random walk and cannot therefore be predicted. In this case, it is
fairly irrelevant the timing of BMCs stock selling and buying what determines

expected return is the average level of stock held throughout time. Unusual profits
would require BMC to have and properly use a larger information set that goes
beyond past prices.

Semi-strong form and strong forms: as these forms incorporate the weak form, the
same basic conclusions stated above must apply. The conditions for consistently
obtaining unusual returns are even more stringent: in the semi-strong form BMC
would need to have access to private information (which does not seem to be the
case), and in the strong form such returns would not be possible at all, whatever
information set BMC holds.

So, in conclusion, how could BMC have apparently beaten the market in the past?
- BMC might just have been lucky;
- BMC may be one of the very good arbitragers;
- In case of the weak and semi-strong forms, BMC might have a larger information
set than the market (this does not seem probable);
- The market efficiency theory does not apply.


2) Based on the following paragraphs of the case, explain how BMC sought to
enhance its investment strategy. Does it seem like a good approach?

BMC decided to add individual stocks to its equity portfolio. It preferred to pick smaller
companies, reasoning that (i) larger and high-liquidity stocks are thoroughly analysed and
so, because of efficient arbitrage, the probability of making excess profits is lower and
(ii) smaller companies offer better diversification as BMC was already exposed to big
companies through the Vanguard Index.

Reason (ii) makes good sense in a risk-averse world. Regarding reason (i), it must be
taken into account that even a small number of strong players in the market may be
enough to annul high returns. Also, smaller companies may be more risky.

BMC focused initially on acquiring shares of one of the two following stocks, reasoning
that they were underpriced:

California REIT, whose stock price BMC considered to be unduly depressed due
to the World Series earthquake. However, it should be noted that the earthquake
affected mainly the state of California which only represents 30% of California
REITs portfolio.

Brown Group, Inc.. Regarding this group, BMC remarks that its stock prices are
somewhat sensitive to movements in the stock market, implying a beta that is
positive to some significant degree. However, BMC also expects the companys
sales to perform well in a recession, which implies, somewhat incongruently, a
low beta.


One must also take into account that underpriced stocks may take some time to correct or
even plunge further in the meantime.

Also, the fact that an individual stock bounces around in price much more than the
market is neither unusual nor relevant, as we are not interested in the stocks variance,
but in their contribution to the risk of the Vanguard Index portfolio (i.e., its beta).

In conclusion, it seems that the strongest reason that has lead BMC to acquire small
companies stock is a marketing reason that is, to present a more sophisticated image
of investment management to some of its potential clients.
3) Evaluate the risk of the Vanguard Index.
We will take the Vanguard Index as the market portfolio as it is a well-diversified
portfolio and good proxy for the S&P 500 Index, which is itself a proxy for the market
portfolio.

There are two measures of risk that we may be interested in: the standard deviation and
the beta. The standard deviation is a measure of risk for a security considered
individually, and the beta is the measure of risk for a security in the context of a well-
diversified portfolio.

As the beta of the market portfolio is, by definition, equal to one, we will only look at the
standard deviation of the index.

By applying the usual formula,

,
1
) (
Variance deviation Standard
1
2

= =
T
t
t
T
r r


we get that the unbiased estimation of the standard deviation of the Vanguard Index,
obtained from the 24-month return time series, is 4,6063 percentage points (p.p.).


4) Evaluate the risk of the new securities. Which one is riskiest?

The appropriate measure of risk for a well diversified portfolio (which is our case) is the
beta of the securities.

The betas, obtained from the regression of the individual securities on the market
portfolio, are:


y = 0,1474x - 0,0243
-0,4000
-0,3000
-0,2000
-0,1000
0,0000
0,1000
0,2000
-0,1000 -0,0500 0,0000 0,0500 0,1000 0,1500
Vanguard Index
C
a
l
i
f
o
r
n
i
a

R
E
I
T


y = 1,1633x - 0,0195
-0,2000
-0,1000
0,0000
0,1000
0,2000
-0,1000 -0,0500 0,0000 0,0500 0,1000 0,1500
Vanguard Index
B
r
o
w
n

G
r
o
u
p


Betas
California REIT 0,1474
Brown Group, Inc. 1,1633

Conclusion: Brown is riskiest as it has a higher beta.


5) Calculate the standard deviation of a portfolio composed of 99% invested in
Vanguard and 1% invested in California REIT. Do the same for a 1% investment in
Brown Group. What do you conclude? Explain the result.

The standard deviation of the return of a portfolio composed of securities A and B, with
respective weights w
A
and w
B
, is given by the following formula:

)) , ( 2 ) ( ) ( ) (
2 2
B A B A B B A A B B A A r w r w
r r Cov w w r Var w r Var w r w r w Var SD
B B A A
+ + = + =
+


where
1
) )( (
) , (
1


=

=
T
r r r r
r r Cov
T
t
B B A A
B A
.

SD
1%California+99%Vanguard
=4,5680 p.p. <4,6063 p.p. =SD
Vanguard

SD
1%Brown+99%Vanguard
=4,6143 p.p. >4,6063 p.p. =SD
Vanguard


We conclude that it is possible to diversify away part of the risk of the Vanguard Index
by adding the California security to the portfolio. As the beta of the security is lower than
one, it was to be expected that, for some weights of the California stock, the risk will be
diversified. We have not determined, however, what is the optimal weight for reducing
total risk - it could be higher or lower than 1%.

We also conclude that if we include the Brown security, the overall risk of the portfolio
increases. This is to be expect for all possible positive weights, as the beta of the security
is greater than one.


6) Estimate the SML assuming the CAPM holds. Explain the results you have
obtained.

One could try to estimate the CAPM based on the idea that, in equilibrium, both stocks
and the index must belong to the SML. The necessary data would be (expected returns
calculated based on the 24-month time series):

Security Expect Return Beta
California -2,27% 0,1474
Brown -0,67% 1,1633
Vanguard 1,1% 1



SML
-2,50%
-2,00%
-1,50%
-1,00%
-0,50%
0,00%
0,50%
1,00%
1,50%
0 0,2 0,4 0,6 0,8 1 1,2 1,4

E
x
p
e
c
t
e
d

R
e
t
u
r
n
Vanguard
Brown
California


The three assets do not lie simultaneously on the same line. Therefore, the CAPM implies
that at least one of the assets is not priced correctly.

We can try to drop one of the securities and see which SML we obtain.

If we drop the Vanguard Index, we get the yellow SML. However, it is incorrect
to drop the Index itself, as this is the asset with the highest probability of being
correctly priced.

If we drop the Brown security, we obtain the red SML. However, this SML
cannot be correct as it implies a negative nominal risk-free rate (nominal interest
rates cannot be negative).

If we drop the California security, we obtain the green SML. However, this SML
is negatively slopped, and that is not possible because markets recognize a trade-
off between systematic risk and return.

So, in conclusion, none of the two securities is correctly priced according to the CAPM.

Also, the fact that they show positive betas along with negative returns is inconsistent
with the model. A security can have a negative expected return and still be correctly
priced according to the CAPM, but that would always imply a negative beta in these
cases the security would act as an insurance policy.


A number of reasons can be advanced for explaining this apparent failure of the CAPM,
some of which are:

- The time series are too short. We would need longer ones to determine the true
expected returns (and the other parameters).
- The economy is facing a recession and, again, we would need longer time series for the
market portfolio. In fact, the American economy was indeed under a recession during the
period.
- We could be facing a downturn period in the industry cycle of the individual securities.
Longer time series would be needed for these.
- Past returns do not reflect the agents expectations regarding future returns.
- Breakdown of other assumptions of the CAPM, such as homogenous expectations or the
existence of a market portfolio.
- The CAPM does hold, but securities are overpriced and in the process of correcting.

NOTE: if one were trying to estimate the SML using historical data for the risk-free rate or
the risk premium, one would have to work in monthly terms, to be consistent with the
data for the exercise.

7) Which stock would you recommend adding to the portfolio and why? Can BMC
increase returns by adding either stock to its portfolio? Please explain.

As we have not been able to properly price the securities, it is difficult to commit to a
recommendation. In last the paragraph of the case, it is said that BMCs manager is
worried about maintaining risk under control, which may point to adding California
REIT as, taking into account the results in 5), California can reduce the overall risk of the
portfolio, whereas Brown increases it. However one must also note that California
REITs expected return is more negative than Browns.

If the true reasons for adding individual securities are the marketing reasons alluded to,
then the company might as well add both. Otherwise, it should consider adding none,
because of their negative expected values.

The CAPM is an equilibrium model (i.e., assets are correctly priced) based on the betas
of the securities (which shouldnt change too much, nor too often), and is therefore more
in line with a buy and hold investment strategy (i.e., just acquire a well-diversified
portfolio and keep it for a certain period). In this case, it is not possible to increase
expected returns by adding securities with negative expected returns. It is however
possible to increase returns with an efficacious market timing strategy (which allows for
returns even in a recession).

Finally, as we have seen previously, one must bear in mind that the expected returns we
have calculated are likely not the true expected returns.



Daniel Pereira Monteiro
Fall 2006/2007