2.

Capital Market Expectations and Equity Return Behavior

Fin411. Investments (Anzhela Knyazeva)

Capital market expectations Return and risk concepts Statistical St ti ti l properties of returns and departures from the ti f t dd t f th normality assumption Downside risk Challenges in forming capital market expectations International equity returns

Forming capital market expectations: overview

Capital market expectations are the investors expectations concerning risk and return of various asset classes Essential input to formulating a strategic asset allocation

Forming capital market expectations: process

Specify the final set of expectations needed, including the time horizon to which they apply Research the historical record S Specify the method/model th t will b used and required if th th d/ d l that ill be d d i d information inputs Research the sources for information inputs Interpret the current investment environment using the selected data and methods, applying experience and judgment Formulate the set of capital market expectations Then monitor actual market outcomes and compare them to expectations to inform and provide feedback to the expectations-setting process

Real v. nominal returns

Real returns: adjusted for inflation Nominal returns: not adjusted for inflation (1+r) = (1+rreal) * (1+ )
Why does it matter? Even if real returns matter, cant we simply adjust by a constant (1+ ) t t t (1+) term? ?

Real v. nominal returns

Why does it matter? Real returns may be relevant for an investor aiming to form a portfolio that meets estimated spending needs in real terms Individual retirement investors who seek to maintain a standard of living in retirement Defined benefit pension plans that pay out retirement benefits indexed to inflation Foundations who seek to maintain support for charitable pp causes in real terms Well see an illustration in the Harvard Management Co case

 Even if real returns matter, cant we simply adjust by a constant (1+) term? BLS annual CPI growth data: long-term mean 3.15%, but it is not necessarily constant (stdev. 4%, serial correlation 0.7)
Annual inflation rate, %
14 12 10 8 6 4 2 0 -21925 -4 -6 -8 -10 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

After-tax vs. before-tax returns

After-tax returns: returns after accounting for taxation of dividends, capital gains, interest Before tax returns: returns realized by the investment Before-tax before taxes are withheld Why does it matter? Examples?

After-tax vs. before-tax returns

Does not matter for tax-exempt institutions (nonprofits) Current tax rates would not (but future tax rates would) matter for tax-deferred retirement portfolios tax deferred Does matter for everyone else: comparing returns on different types of investments, Examples:

Money market, bonds, stocks: bank and bond interest taxed at (higher) marginal income rates, long-term capital gains and qualified dividends taxed at lower rates (through 2010 - marginal 15%) Muni v. corporate bonds: muni interest is exempt from federal income tax and usually from state taxes in issuing state Equivalent taxable tield = rmuni/(1-t), where t is the marginal income tax rate

Marginal individual fed. income tax rates

100% 95% 90% 85% 80% 75% 70% 65% 60% 55% 50% 45% 40% 35% 30% 25% 20% 1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Source: http://www.taxfoundation.org/publications/show/151.html

Return and risk measures

Mean returns: well use arithmetic mean returns (which provide unbiased estimate of expected returns, E(r))
In Excel AVERAGE Excel,

Total risk: Standard deviation measures total risk,

In Excel, STDEV

Historical S&P500 returns

Over 1928-2009:

S&P500 returns: mean 11.3%, stdev 20.3% Compare: 3-mo T-bill rates mean 3.8%, stdev 3.1% 10-year T-bond 10 year T bond returns mean 5 2% stdev 7 8% 5.2%, 7.8%

60% 50% 40% 30% 20% 10% 0% -10%1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 -20% -30% -40% -50%

Source: data from http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histret.html

Sharpe ratio

Sharpe ratio is a basic performance measure that trades off expected returns and risk:

SR

E ( r ) rf

Generally prefer a higher/lower Sharpe ratio?

Correlations

Correlation:measurestheextenttowhichreturnsonanytwo assetsmovetogether,12 (between1and1) Covariance = 12 * 1 *2 Covariance= InExcel,CORREL;covariance=CORREL*STDEV1*STDEV2

Howdoreturncorrelationsrelatetodiversification

benefits?
Cantotalportfolioriskbelessthantheriskofanindividual

asset?Explain.

Correlations

Total risk of a portfolio (w denotes weights):

w w
i j ij j i i j

For two assets: P

2 2 2 w12 2 w2 2 2 w1w2 12 1 2

Generally, as the number of (imperfectly correlated) assets in a portfolio goes up, total portfolio risk decreases, all else equal. Eventually converges to what?

Correlations
Howdoreturncorrelationsrelatetodiversification

benefits? Low positive correlations (or even negative) correlations Lowpositivecorrelations(orevennegative)correlations generatemorediversificationbenefits Cantotalportfolioriskbelessthantheriskofanindividual asset?Explain. Yes,ifcorrelationsarelow. Eventuallyconvergestowhat? Marketrisk(allidiosyncraticriskhasbeendiversified away)

Correlations

Source: Coaker, 2007, "Emphasizing Low-Correlated Assets: The Volatility of Correlation," Journal of Financial Planning

Stock return distribution

A useful starting point is the normal distribution assumption, which simplifies portfolio problems
- positive and negative deviations from the mean are equally likely - can compute probabilities of future scenarios using only two parameters, mean and - returns on a portfolio of normally distributed stocks are also normally distributed

To find probability that returns are below x%: With a calculator + standard normal distribution table: 1) compute z=(x mean)/ t ( )/ 2) look up p-value that corresponds to this z in the table For example, mean=11%, =20%, x=0% z=-0.55, which corresponds to p=0.2912 assuming normality, annual returns are expected to be negative 29% of the time

In Excel, p=NORMDIST(x,mean,,TRUE)

Departures from normality

Skewness (positive/negativedeviationsfromthemeanarenotequallylikely)

skew E [r E (r )]3 3 Forsymmetricdistributions(e.g.normal):equals0 Negativelyskewed alonglefttail.Moredownsideriskgiventhesame meanandtotalrisk Positivelyskewed alongrighttail. InExcel,SKEWcommand

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Departures from normality

Kurtosis (characterizestheincidenceofextremeobservations)

excess _ kurtosis E[r E (r )]4 4 3

Normal distribution: 0 Excess kurtosis >0 (leptokurtic): fat tails (extreme good/bad obs. are more likely than under normality) Excess kurtosis <0 (platykurtic): thin tails

InExcel,KURTcommand

Deviations from normality: simulations

When normality assumptions are not applicable, we can simulate an empirical distribution from past historical data
Assume that all historical returns are equally likely Decide how far back to go (e.g. 80 years) and how many obs. to simulate (e.g. 50,000) Benefit: can estimate downside risk, probability of losses etc. without assumptions of normality Flexible tool. Can also be used for long-horizon tool long horizon simulations, for simulations of portfolio values with fund flows, taxes etc. Caveat: Historical record need not be representative of future return distribution

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Historical stock return distribution

On aggregate, some degree of negative skewness and positive excess kurtosis However, excess kurtosis driven by 1931-1955 period Black swan investing article

[Reading] Black swan investing

Source: Looking for the next black swan, WSJ, 26-AUG-2010

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[Reading] Black swan investing

Downside risk

Total risk measure, , does not specifically account for downside risk Why should we care?

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Downside risk

Downside risk

Why should we care?

Individual utility may be affected by risk of loss An individual or institutional investors objective to meet liabilities or minimum liquidity needs may be compromised in the event of a shortfall

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Downside risk measures

Downsidedeviation (semistandarddeviation):standard deviationofreturnobservationsthatarebelowtargetreturn,rT (e.g.mean,rf,oranothermin.acceptablereturn) ValueatRisk% (VaR):aworstcasescenarioproxy;atleasthow muchdowestandtolosein%ofthecases;typically,=1%,5%

Expressedin%terms,itistheth percentileofadistribution Alternatively,canbeexpressedin$(multiplybyportfoliovalue)

ConditionalTailExpectation(akaExpectedShortfall)isthe averageofrealizationsinthelefttail(whatwestandtoloseon averagein5%ofthecases) Probabilityofashortfall(likelihoodthatreturnsarelessthan thetargetreturn)

VaR
Under normality, VaR5% = mean 1.65* (in Excel or using a calculator) using S&P500 returns for 1928-2009: i t f 1928 2009 11.3% - 1.65*20.3%= -22.2% For actual returns in Excel, PERCENTILE(,0.05) using S&P500 returns for 1928 2009: 1928-2009: VaR5%= -25% alternatively, simulate an empirical distribution from past data

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VaR in Practice

Any issues with applying VaR in practice?

VaR in Practice

Caveat: historical record need not be representative of the future return distribution

[Readings: FT, WSJ articles] European FT Investment Practices Survey 2008 (229 institutional investors and asset managers), quoted in FT Feb. 25
More than half of the asset managers use VaR in risk measurement. In 42% of the cases, normality is assumed VaR VaR is more commonly used than volatility these days, but if you assume normality, you might as well just use volatility. Less than a third of asset managers surveyed use VaRbased measures to evaluate risk-adjusted performance

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VaR in Practice

Whenvolatilityislowinthemarkets asithasbeenduring mostofthisdecade,whenVARmodelshaveflourished these toolstypicallyofferaveryflatteringpictureofrisk taking.That tools typically offer a very flattering picture of risktaking. That promptsbankstotakemorerisk,whichreducesmarket volatilityfurtherasmorecashchasesassets.However,if marketseverturnedvolatile,thisdynamiccouldquickly unravel,theBankwarnedbackinApril. TheformergeneralcounselofLTCM,JamesRickards,reflected onhowanincompleteVaR modelunderminedhisfirm:"Since p wehavescaledthesystemtounprecedentedsize,weshould expectcatastrophesofunprecedentedsizeaswell."

Capital market expectations: challenges

Need to ensure consistency in return and risk definitions (see above) Be aware of potential data concerns
esp. with aggregate economic data: definition differences (such as indexing to different bases) and changes in methodology accuracy and subsequent revisions, errors in measurement and in recording data t di di d t timeliness and leads/lags

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Capital market expectations: challenges

When using historical data, consider that:

Means can be influenced by extreme observations Regime changes could affect distributional properties

check for major events, outliers, influential obs. j , ,

Technological, political, legal and regulatory environments, disruptions (war, natural disaster) Result in nonstationarity differing underlying properties during different parts of a time series Tradeoff between using a longer time series for statistical analysis and increased likelihood of regime changes can test for structural breaks in the regression; verify if results are sensitive to the time period used

Capital market expectations: challenges

Time period bias research findings often sensitive to start and end dates for measurement period check sensitivity of results to time period Conditioning information - historical averages incorporate many economic environment parameters condition on current environment (e.g. through multivariate regression) Expected vs. ex post returns: history of prices could reflect potential risk factors that did not materialize ex post (when risks fail to materialize risk is underestimated but return is overestimated) does the sample period span both booms and busts? do other methods of forecasting returns produce similar results?

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Capital market expectations: challenges

Survivorship bias including only those entities that have survived for the entire measurement period (tends to overestimate returns) a concern with returns for the hedge f d i h d fund universe Use of appraisal (smoothed) data infrequent measurement tends to understate volatility and correlation with other assets a concern with alternative investments (e.g. PE) Data mining with enough data there will be random correlations that are not economically meaningful
Correlation

may not mean causation caution about using y g correlation relationships in a prediction model; multivariate regression addresses some but not all issues Caution in interpreting anomalies is the model correctly specified (model risk), are variables measured correctly?

Capital market expectations: approaches

Main approaches in this course:

Sample estimators estimate future mean and variance on samples past mean and variance (historical data on means/covariance matrix) Multi-factor models explains returns to an asset in terms of exposure to a set of risk factors (predict returns based on exposure to common sources of systematic risk, such as market risk, under equilibrium/no-arbitrage assumptions) Time series estimators forecasting variable based on lagged variable itself or lagged values of other variables (statistical methods) Valuation (e g Gordon (constant) growth model) (e.g. Survey/panel - qualitative

Other approaches:

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The concept of returns and different types of returns Define d D fi and compute average returns, total risk, t t t t l i k and return correlations Discuss departures from normality in the distribution of returns and their implications Define key downside risk measures and compute downside risk from a return series Discuss challenges in setting capital market expectations

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