FIN3102 01 Introduction

FIN 3102
Investment Analysis and

Portfolio Management
Prof. Luis Goncalves-Pinto
Lecture 1:
Introduction
Course Introduction and Syllabus
Overview of Capital Markets

Readings:
BKMJ chapters 2, 3, and 4
2
Luis Goncalves-Pinto (just call me Luis, easy!)
Office hours: Fridays 14.00-16.00
Office: MRB BIZ1 / 7-43 (7th floor of Mochtar Riady
Building)
By appointment (set up after class or by email)
Post questions on https://ivle.nus.edu.sg/
By email: lgoncalv@nus.edu.sg
(If of general interest, your questions will be posted
on IVLE together with my answers)

How to reach me:
3
- Course Introduction:
. What is this class about?
. Syllabus and course details

- Overview of Capital Markets:
. Investing directly: markets and trading
. Delegated portfolio management: mutual
funds
Lecture Outline:
4
What Is This Class About?
Introductory knowledge of portfolio management:
How much should I invest in each asset?
1. Optimal portfolio selection
Whats the trade-off between risk and return?
2. Asset pricing theories
How can I assess my portfolios performance?
3. Performance evaluation
Should I invest beyond equities?
4. Fixed income securities, Derivatives
5
1. Optimal portfolio selection

How do we pick the portfolio (of asset classes or of
individual securities) that maximizes return for a
given level of risk?

How does this allocation depend on our investment
horizon, risk aversion, and existing assets in place?

How can we solve implementation problems
stemming from estimation error, short-sale
restrictions, and portfolio constraints?
Harry Markowitz
(Nobel prize)
unique to every individual; willingness to take risk
6
[Lecture 3]: How Vanguard does it

Source: Vanguard
preview
manage money on behalf of investors
questioniaire to identify the risk averse (score) of individuals
7
[Lecture 3]: How Vanguard does it

Source: Vanguard
preview
8
2. The relation between risk and return

What is the relevant measure of risk in each risk-
return tradeoff?

What expected return should the market demand for
each asset?
CAPM
APT
characteristic-based model

How well does the evidence support these theories?

William Sharpe
(Nobel prize)
return per units of risk
sharpe ration: return per unit of risk invested
(systematic and non-systematic risk)
9
preview
[Lectures 5-6]: Fama-French 3-Factor Model

Three Equity Factors:

. MARKET : Stocks have higher expected returns than bonds
. SIZE: Small caps beat large caps (on average)
. VALUE: Value" stocks beat Growth" stocks (on average)
Source: Dimensional Fund Advisors
10
3. Performance Evaluation

How can a fund managers performance be
measured?

Can we separate skill in picking stocks from skill in
picking sectors?

How do we test the managers ability to time the
market?

11
[Lecture 9]: Performance Evaluation of Fidelity Magellan
(FMAGX in finance.yahoo.com)

hit Profile
preview
12
[Lecture 9]: Performance Evaluation of Fidelity Magellan

hit Performance Details
preview
13
[lecture 9]: Performance Evaluation of Fidelity Magellan

hit Risk Details
preview
14
4. Other Instruments

Fixed Income Securities: [* FIN 3131 *]
- What portfolio of bonds should be purchased to
satisfy a given investment objective?
- What is the relation between prices, interest
rates, and yields? How risky are bonds of
different maturities and issuers?

Options and Futures: [* FIN 3116 *]
- What are the reasons to trade derivatives?
- What is the fair value of a derivative?
15
What This Class Is Not Really About
How to pick stocks (i.e. individual stock selection)
How to trade (trading and exchanges)
How companies invest (capital budgeting)
Banking and financial intermediaries
Focus on equity, will not be thorough examination of:
- fixed income, derivatives, real estate, etc.
16
Syllabus Highlights
Prerequisites
Intro finance course, statistics course, Excel
Readings:
Bodie, Kane, Marcus, and Jain
Investments,
Asia Global Edition
Lecture Notes
Extra Readings (Finance Press)
All course materials will be distributed using IVLE
(http://ivle.nus.edu.sg)
Lecture Notes, Group Assignments,
Supplementary Reading Material

17
Syllabus Highlights
Grading (Continuous Assessment):

- Group Assignments:
. Case Studies and www.stocktrak.com

- Test 1: <Sat, 04 Oct 2014, 10-12, Room TBA>
- Test 2: <Sat, 08 Nov 2014, 10-12, Room TBA>

Test 1 30%
Test 2 20%
Assignments 35% (20% Case, 15% StockTrak)
Class Participation 10%
CFA Ethics Test 5% (Prof. Lee Hon Sing)
implementing of concepts
18
Syllabus Highlights
Student Teams of 4-6 People (Due Next Class: Name,
Composition/Identification, and Photos of Members,
Sample Form on IVLE under Assignments)

Case Studies (1 Case Per 2 Teams, Assigned
Randomly):

1. Gold as a Portfolio Diversifier
2. Warren Buffett
3. Dimensional Fund Advisors
4. Behavioral Finance at JP Morgan
5. Zeus Asset Management

StockTrak

19
Why invest in an asset?
Put cash-flow today in exchange for cash-flow in future

Future cash-flow may be:
- Certain (money market, government bonds)
- Uncertain (stocks, corporate bonds, etc)

What are the issues?
- Time value
- Riskiness of investments
make the problem challenging

1. Overview of Capital Markets:
chapter 2
uncertainty exist
20
Which assets to invest in?

Real vs. financial assets

- Real assets: Assets used to produce goods and
services (ex: factories, land, human capital, etc)

- Financial assets (focus of this class): Claims on real
assets (ex: money, stocks, bonds, etc)

financial assets: funds which real assets need in order to continue produce goods
21
Taxonomy of Financial Assets:
http://online.wsj.com/mdc/public/page/marketsdata.html

- Money Markets
short-term deposits
- Fixed Income Securities
bonds: promises fixed stream of income
- Equity
ownership, claim to funds after all debts
have been paid
- Investment Companies
mutual funds, pension funds, hedge funds
- Derivatives
payoff depends upon values of other assets
2 main purposes: hedging
creation of portfolios, buying of shares in funds companies
and speculative
eg: options, futures/ forwards
22
How do financial asset returns compare?

relationship between return and risk
positive relationship between risk and return
small cap and big cap stocks positive returns
23
Going forward: what happened after 2000?
(type ^RUT in http://finance.yahoo.com/)
Nasdaq
Dow Jones
S&P500
Russsel 2000
dot.com bubble
2008: financial crisis
24
Going forward: the 2007-08 Credit Crisis

25
The long-run picture is still that equity beats bonds!
x-axis
legend:
27
This course: focus on Equity

Equity:
- Future cash-flows are (typically) uncertain
- Maturity is (typically) indefinite
- High risk, variable liquidity

Two main classes of equities:
> Common stocks
> Preferred stocks (more like debt than equity)
2. Equity Markets:
liquidity and equity have a positive relationship
voting rights
no voting rights; pay a constant payoff (dividend) until infinity
28
2. Equity Markets:
Investing in Equity :

go long (+) go short (-)

directly: buy short-sell
buy on margin

indirectly: mutual funds, pension funds
hedge funds
leveraging on position; borrow some cash to buy
buying a security that you think prices will drop in the
future; borrow the security and sell it then buy it at a lower
price in the future to return in
29
How do you buy a stock in a company?

- Buy on the primary market:
New issues to raise capital for firm: IPO (Initial
Public Offering), SEO (Seasoned Offering)

- Buy on the secondary market:
Existing owner sells to another party, does not
raise capital for firm (not involved)
- Organized Exchanges.
- Over-the-Counter (shorthand OTC).
- Electronic Networks.

2. Equity Markets:
30
Types of Orders:

Market orders

Price-Contingent orders:

2. Equity Markets:
limit-buy order: set a limit, if the limit is reach, BUY it (When you expect
the price to decrease further)
Limit-sell order: set a limit, if it is reached, SELL it (when you expect
the price to increase)
eg: current price is $90, limiit is $80. if it is at 80 or below, buy it.
Limit is $93, if it as $93, sell it
Stop-loss order: set a limit, if the limit is reached, sell it
(when you expect the price to decrease)
Stop-buy: set a limit, if the limit is reached, BUY it back
by stopping losses for short position
- for short-sell position; for example, you borrow it at $90 earn a
profit at $90, limit is at $100 any limit above 100 - stop buying the security
31
Costs of Trading

Commission: fee paid to broker for making the
transaction

Spread: cost of trading with dealer/ market
Bid: price dealer will buy from you
Ask: price dealer will sell to you
Spread = Ask - Bid

2. Equity Markets:
if you want to buy, pay the "Ask" price
sell -> "bid" price
32
- Buy on Margin (Margin Purchase):

> The investor borrows part of the purchase
price of a security from his broker

> The interest charged to the investor is the
brokers call money rate plus a service spread

> The securities purchased by the investor are
held by the broker as a collateral on the loan
made (lose voting rights)

2. Equity Markets:
33
2. Equity Markets:
Initial margin is set by the Fed
Currently 50%

Maintenance margin
Minimum equity that must be kept in the margin
account
Margin call if value of securities falls too much

34
- Buy on Margin (Margin Purchase): Example 1

2. Equity Markets:
Share price $100
60% Initial Margin
30% Maintenance Margin
100 Shares Purchased
Initial Position
Stock $10,000 Borrowed $4,000
Equity $6,000
35
- Buy on Margin (Margin Purchase): Example 1

Maintenance Margin

2. Equity Markets:
Stock price falls to $70 per share
New Position
Stock $7,000 Borrowed $4,000
Equity $3,000

Margin% = $3,000/$7,000 = 43% (still some slack!)
value of equity decreases
short position
amount borrowed does not change
36
-Buy on Margin (Margin Purchase): Example 1

Margin Call:

2. Equity Markets:
How far can the stock price fall before a
margin call? Let maintenance margin = 30%
Equity = 100P - $4000
Percentage margin = (100P - $4,000)

/ 100P
(100P - $4,000)

/ 100P = 0.30
Solve to find:
P = $57.14

who decides the maintenance margin?
- Brokers
if unable to pay for the margin call, broker will sell some of the stocks
37
-Buy on Margin (Margin Purchase): Example 2

Downside Risk of Buying on Margin:

P(0)=$100, Margin=$10,000, Loan=$10,000, Interest
rate on the loan: 9%/year
2. Equity Markets:
initial margin: 50%
buying a margin is beneficial if you believes that the price will go up (and it actually goes up)
38
- Buy on Margin (Margin Purchase): A message from FINRA
Financial Industry Regulatory Authority
http://www.finra.org/Investors/ProtectYourself/InvestorAlerts/MarginAndBorrowing/P005973

Investing with Borrowed Funds: No "Margin" for Error
Investor purchases of securities "on margin" have grown dramatically in recent months. The
amount of debt taken on to buy securities has been growing steadily over the past few
months and reached a record high of $321.2 billion in February 2007.

We are re-issuing this Alert because we are concerned that many investors may
underestimate the risks of trading on margin and misunderstand the operation and reason
for margin calls. Investors who cannot satisfy margin calls can have large portions of their
accounts liquidated under unfavorable market conditions. These liquidations can create
substantial losses for investors.

Before you decide to open a margin account, make sure you understand the following risks:

- Your firm can force the sale of securities in your accounts to meet a margin call
- Your firm can sell your securities without contacting you
- You are not entitled to choose which securities or other assets in your accounts are sold
- Your firm can increase its margin requirements at any time and is not required to provide you with
advance notice
- You are not entitled to an extension of time on a margin call
- You can lose more money than you deposit in a margin account
- More advice from the SEC
http://www.sec.gov/investor/pubs/margin.htm
39
- Short Sale:

> Sell something you dont own: selling shares
of a firm not owned by borrowing security, and
later replacing it (cover it)

> A profit is made if the short position is covered
at a price lower than the one at which it was
established

> Short sale proceeds must remain with the
broker and investor is required to deposit a
collateral (to post margin)
2. Equity Markets:
40
2. Equity Markets:
payment of dividend to
the lender of the stock
(firm pays dividend to the
buyer of the stock)
41
- Short Sale: Example (Bearish on Dot-Bomb)

2. Equity Markets:
Dot Bomb 1000 Shares
50% Initial Margin
30% Maintenance Margin
$100 Initial Price

Sale Proceeds $100,000
Margin & Equity $50,000
Stock Owed 1000 shares
42
- Short Sale: Example (Dot Bomb Falls to $70)

2. Equity Markets:
Assets
$100,000 (sale proceeds)
$50,000 (initial margin)

Liabilities
$70,000 (buy shares)
Equity
$80,000

Profit = ending equity beginning equity
= $80,000 - $50,000 = $30,000
= decline in share price x number of shares sold short

earned from selling the stocks
43
- Short Sale: (Margin Call)
2. Equity Markets:
How much can the stock price rise before a margin call
(maintenance margin = 30%)?

($150,000
*
- 1000P) / (1000P) = 30%
P = $115.38

* Initial margin ($50,000) + sale proceeds ($100,000)

1000P = value of shares owed

44
What more to talk about on short-selling?

- Margins/fees

- Naked short-selling

- Dividends / Voting: The short-seller pays the dividend to the
stock lender. The naked short-seller pays the dividend to the
buyer of the promised stock. Vote: holder of record.

- More advice from the SEC
http://www.sec.gov/spotlight/keyregshoissues.htm

- NYSE Top 100 Stocks by short interest
http://www.nyse.com/financials/sitable.html

- Stocks with High Short interest
http://www.highshortinterest.com/

"a promise" to sell the stock to the buyer
(buyer)
therefore buyer has the "right" to the buyer
hence, the short-seller always have to pay dividend (either to the
buyer or lender)
holder of the security
45
Regulating short-selling:
- U.S.: SEC banned for 900 financial firms (lifted Oct 8)
- U.K.: FSA banned for 34 financial stocks (lifted 2009)
- France: AMF banned for bank stocks (Sept 22 for 3 months)

2008 Credit Crisis :
46
2008 Credit Crisis (cont.):
47
The curious case of a short squeeze
48


buy on margin

hedge funds
3. Delegated Portfolio Management:
49
Why do individuals use investment companies (mutual
funds, pension funds, hedge funds)?

- each invests $10,000 individually

- add all classes money and invest collectively
50
U.S. Households Investments In Funds, Bonds, Stocks
Source: ICI
FactBook
2014
51
Why do individuals use investment companies (mutual
funds, pension funds, hedge funds)?

- Investment diversification at lower transaction cost

- Security selection skills (?) or portfolio tailoring to meet
specific objectives

- High liquidity and lower administration costs (record
keeping, reinvesting dividends)

- Sophisticated tax management (?)

more diversified portfolio
52
U.S. Households Financial Assets in Investment Firms
Source: ICI FactBook 2014
53
Some mutual fund management companies:
Independent (Vanguard)
Broker-dealer (Charles Schwab)
Bank (Wells Fargo)
Insurance company (USAA)

Browse http://www.morningstar.com/cover/funds.aspx
Source: ICI FactBook 2014
54
Investment policies for all tastes
- Bonds (fixed income), stocks (equity), or mixed
(balanced). Attractive to investors with different
horizons and levels of sophistication

Source: ICI
FactBook
2014
55
Equity Mutual Funds and Market Returns (96-10)
Source: ICI
FactBook
2014
In down market,
valuation are low, investors
are getting out of the fund.
therefore people SELLing
cheap and buying EXP
(net cash flow NEG)
In up market,
valuation are high, investors
are coming in, therefore
people are buying and selling
Flows can hurt the performance
of fund depending on
the period of time
56
Redemption Rates of Equity Funds (86-10)
liquidation investors used to satisfy
some redemption rate
For example, Fidelity has a house of funds - namely equity, HM and Bonds. Eg, someone wants to put money from Equity to Bonds within Fidelity (money does
not get out of Fidelity) -> example of change in preference. 2nd situation: wants to get cash out of his equity account for consumption (buy a house)
Both situation:
Broad
redemptive
Only liquidation:
Narrow
Source: ICI
FactBook
2014
58
Fees are in the forms of:

- Management and operating expenses (0.4%-3.0%/year)

- Sales load (0%-5% at purchase [front-end load] or sale
[back-end load])

- 12b-1 fees (advertising)

- Incentive fees (for hedge funds, up to 20% of gains)

use FINRA mutual fund expense analyzer:
http://apps.finra.org/investor_Information/ea/1/mfetf.aspx
hedge funds have different classes
59
Funds typically have more than 1 Share Class:

Class A Class B Class C No-Load***
Front-end load 5%* 0% 0% 0%
Back-end load 0% 4%** 1% 0%
12b-1 fees 0.25% 1% 1% 0.5%
Expense Ratio 1% 1% 1% 1%

*: depends on size of investment
**: depends on number of years till sale
***: sold directly by fund sponsor or fund supermarket
60
Fees
. 56% of funds have sales load. Mean = 3.6%. 2003 cost = $2.8B
. 66% of funds charge 12b-1 (marketing) fees. 2003 cost = $9.5B
. Operating expenses in 2003 = $38.1B
. Trading costs in 2003 about $16B

Total of $66 Billion represents about 1% of NAV. These
are yearly direct costs.

net asset value
61
Turnover Rate of Equity Funds (1974-2010)
Source: ICI
FactBook
2014
Source: ICI
FactBook
2014
63
Open-End Closed-End
Capital structure Open, new shares
issued for subscriptions
Closed, like any
ordinary firm, the nr. of
shares is fixed
Buying / Selling into
fund
Subscription may
involve sales charge
(load)
From another investor,
like buying/selling a
stock: trading costs but
no loads.
Cost of a share Redemption of
investments is at net
asset value (NAV)
May deviate from NAV.
Two risks: NAV and
changing discount.
Performance is reduced
by fees and
transactions costs
yes yes

Types of Mutual Funds:
go thru a financial intermediary
sell directly to another investor
64
Passive vs. Active Management

Passive: - Aims to track (come as close as possible to) a
fixed portfolio of stocks, such as the S&P500.
- Minimizes costs and trades as little as possible.
Active: - Portfolio manager chooses strategy: bottom
up: security analysis; top down: asset allocation
Source: ICI
FactBook
2014
trade as MUCH as possible not LITTLE
65
Passive vs. Active: Performance

Percentage of active funds below Wilshire 500
Index
66
Co-Insurance in Mutual Fund Families,
by Goncalves-Pinto and Schmidt

Within a mutual fund company, for example fidelity, funds-manager can trade
within the firm to reduce transaction cost
However is this best for the shareholder?
67
Passive vs. Active:

68


buy on margin

hedge funds

new: ETFs that replicate
investment classes
Do-it-Yourself Portfolio Management:
Source: ICI
FactBook
2014
Trend: increasing over time
70
Exchange-Traded Funds (ETFs)
71
ETFs offer public investors an undivided interest in a pool
of securities and other assets

Shares can be traded throughout the day on a securities
exchange. ETFs do not sell or redeem at NAV. Financial
institutions purchase and redeem ETF shares directly in
large blocks called "creation units" (in kind, a basket of
securities in the same proportion held by the ETF)

Many types:
Indices (ex: SPDRs, Diamonds, Cubes, iShares),
leveraged, short, commodities, etc.

Other ETFs include value (growth) stocks of all sizes and
all small (large) cap stocks of all sizes.

inverse ETF
Many types:
Indices (ex: SPDRs, iShares), leveraged, short
Commodities

http://etf.peacefulgains.com/A-List-of-exchange-traded-funds/
73
Mispricing of ETFs
Intraday Pricing Inefficiencies in International-Based
Exchange-Traded Funds, by Goncalves-Pinto, Chua,
and Stefanescu (2012)

74
Investing directly into Value-Growth & Size
Ex: iShares are exchange traded funds (ETFs) that
replicate the 9 Morningstar styles

iShares trade sector and small stocks
75
Why the Lack of Interest for
ETFs in Singapore?
Field Study Supervised by Goncalves-Pinto and Zahalka
in 2014:

Client Company: Singapore Exchange (SGX)

Survey Evidence:

- Small range of ETF product offerings
- Lack of knowledge by retail investors
- Home bias investing
- Value opinion of financial advisors highly
76


buy on margin

hedge funds

new: ETFs that replicate
investment classes
Do-it-Yourself Portfolio Management:
77
Hedge Funds:

- Growing. Assets may exceed $2Trln (in Q3 2007,
Institutional Investors)
- No legal definition. Generally, a private investment
fund open to limited range of qualified/accredited
investors
- Invest in more complex and more risky investments
(short-selling, derivatives, leverage). Dominate some
specialty areas (derivatives, high-yield/distressed
bonds, macro strategies)
- Many of these so-called "hedge funds" do not actually
hedge their investments!
78
Hedge Funds:

- Only available to sophisticated investors.
Partnership organization with max # of investors
Large minimum investment
Significant minimum holding period
Performance-based compensation.

- No requirement to register with SEC, unlike open-to-
the-public "retail" funds (e.g., U.S. mutual funds)

- Difficult to benchmark. Have a tendency to blow up

- Effective Activists
try to get a big stake on the firm and push for changes
79
Hedge Fund Activism:

Daniel Loeb
Third Point Management

Carl Ichan
Ichan Enterprises

UrbanLIfe
Yahoo CEO: was not an engineer
80
Short-Squeeze Risk and Activist HFs
Honours Thesis by
Gavin Loh (2014),
supervised by Luis
Goncalves-Pinto
the type of firms that activitsts are likely to intervene -> more likely to push for companies with short squeeze risk
81
Some Well-Known Hedge Fund Companies:

Amaranth Advisors
Citadel Investment Group
D. E. Shaw & Co.
Fortress Investment Group
Goldman Sachs Asset Management
Long Term Capital Management
Renaissance Technologies
Soros Fund Management

Hedge Funds: Risk and Return, study by Prof. Burton Malkiel
http://www.cfapubs.org/doi/pdf/10.2469/faj.v61.n6.2775
For a critical look at hedge fund performance numbers:

82
Hedge Fund Styles:

Global macro seeking assets that deviated from some anticipated
relationship. Heavy in bonds, FX and derivatives.

Arbitrage seeking assets that are mispriced
Convertible arbitrage (convertible bond vs. equity)
Fixed income arbitrage (between related bonds)
Risk arbitrage (between securities whose prices appear
to imply different probabilities for one event)
Statistical arbitrage (between securities that have deviated
from some statistically estimated relationship)
Derivative arbitrage (between a derivative and its security)

Long / short equity hedged investment in equities
Short bias (emphasizing short positions)
Equity market neutral (balance long and short positions)

> Twice the risk and half the reward?
-> Ex: George Soros
83
Hedge Fund Styles:

Event driven
Distressed securities (companies close to bankruptcy)
Regulation D (distressed companies issuing securities)
Merger arbitrage (between acquiring and target companies)

Other
Emerging markets- (unhedged long in emerging markets)
Fund of hedge funds (long only positions in hedge funds)
Quantitative
130-30 funds
-> Bet is on the probability that the merger happens
-> Usually contrarian
high frequency trading funds
84
HF Prospectus
85
HF Prospectus
86
HF Prospectus
long/short strategy
87
HF Prospectus
Fees are
related to fund performance
large
option-like
mostly paid only after the high water mark is met
(2-20 structure) 2% for the asset, 20% for the gain on the "game"
the game referring to any increase
high water mark - always need to outperform
for example, if the value of the fund starts at 10
and increase to 20, so the diff (10 units = the game), 20% of the gain and 2% of the asset
"High water mark" always outperform themselves, for example in year one increases to 20 but in year 2 decreases to 15 then increases to
30. increase = 15 BUT the firm only gain the diff from 20-30 (which is the "mark" in which they reached the previous year)
88
To Do (For Next Class)
Finish reading BKMJ Chapters 3, 4

Read BKM Chapter 5.4, 5.5. and 5.6. and review
your statistics (Expected values, Standard deviations,
variances, Covariance, correlations) !

Next class we will assign the case studies to be
presented/discussed by each group submit your
group formation 4-6 people ASAP!

People without a group come talk to me and I will
assign them to one!

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Investment Analysis and

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