Chapter 4: Fund Management and Investment

• Introduction
Learning outcomes
• describe fundamental trends in historical mutual fund performance
• confidently explain the efficient market hypothesis and fully distinguish between its many
forms
• cogently discuss the existence of common cognitive biases in human information
processes, and concisely explain how these biases can lead to effects (momentum and
reversals) that violate the efficient market hypothesis
• describe how the effects of momentum and reversals can be translated into profitable
investment strategies in detail
• clearly identify distinctive characteristics of ‘hedge funds’ in the context of the investment
management industry
• briefly discuss the problems related to evaluating hedge fund performance
• adequately define ‘algorithmic trading’ or ‘statistical arbitrage’

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Introduction

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Historical mutual fund performance

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Market efficiency and behavioural finance
• 1. The efficient market hypothesis
• 1.1. The weak-form efficient market hypothesis
• 1.2. The semi strong-form efficient market hypothesis
• 1.3. The strong-form efficient market hypothesis

• 2. Implications
• 3. Criticism

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1. The efficient market hypothesis

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1.1. The weak-form efficient market hypothesis
• The weak-form efficient market hypothesis states that stock prices reflect all information in
past and current prices and transaction volumes. Future price movements are, therefore,
unpredictable on the basis of information about these. This rules out, among other things,
making consistent trading profits on the basis of so called ‘technical analysis’. We know
that technical trading is very popular among practitioners, but of course the efficient market
hypothesis does not predict that profits cannot be made at all, only that you make roughly
the same number of profitable trades as you make losing trades.

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1.2. The semi strong-form efficient market hypothesis
• The semi strong-form efficient market hypothesis states that stock prices reflect all publicly
available information, which includes, in addition to past and current prices and volumes,
company and industry data such as accounting and market data as well as broad
economic indicators such as interest rates, currency rates, inflation, and unemployment.
Semi strong efficiency rules out making consistent trading profits on the basis of so called
‘fundamental analysis’.

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1.3. The strong-form efficient market hypothesis
• The strong-form efficient market hypothesis states that all information, public and private, is
reflected in the current prices. There are both practical and theoretical reasons why we
should not expect markets to be strong-form efficient. On the practical side, there are many
restrictions on insider trading making it difficult for those who have private information to
benefit from speculation. Thus, there are barriers in place preventing private information to
reach the market. On the theoretical side, if we assume prices are strong-form efficient,
there is no incentive to spend resources acquiring private information. There is reason to
believe, therefore, that prices can never reach strong-form efficiency (this is the so called
Grossman-Stiglitz paradox).

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2. Implications
• What are the implications of the efficient market hypothesis on fund management
performance? Only if professional fund managers have better information (or a finer
information set) than is currently embedded in the prices, should they reasonably expect to
make trading profits. A trader in possession of superior information who trades against an
uninformed market expects to make superior trading profits. Of course, there will be some
information leakage due to the fact that trading activity is detectable by the uninformed
market participants but this process is not perfect so some private information remains
hidden, and this is the basis for the superior trading profits. An assessment of the
performance of mutual funds within this framework is, therefore, essentially an assessment
of whether the fund manager is in possession of a sufficient amount of hidden private
information to make substantial trading profits. The private information needs to come from
somewhere, however, and fund managers spend enormous resources on acquiring such
information (through research, fundamental and technical analysis) each year. It is,
therefore, perhaps unreasonable to expect that fund managers should easily be able to
make trading profits over and above the holding profits of a broad index.

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3. Criticism
• The efficient market hypothesis is itself subject to criticism, however. Empirical evidence
demonstrates certain patterns of predictability in asset prices, the most prominent being
momentum (prices that have gone up tend to increase further and prices that have gone down tend
to decrease further) and overreaction to news and events. For instance, a study found that
portfolios of the best-performing stocks in the recent past (three- or 12-month holding period) tend
to outperform other stocks. The performance of individual stocks remains highly unpredictable. The
fads hypothesis asserts that the stock market overreacts to news, leading to positive
autocorrelation over shorter time horizons while the stock market and a reversal or negative
autocorrelation over longer time horizons. Although there is empirical evidence to support short run
momentum effects, the long run reversal effect has less conclusive empirical support. Studies have
found, nonetheless, that when ranking stocks into groups based on their five-year past
performance, the loser portfolio (the bottom 35 stocks) outperformed the winner portfolio (the top
35 stocks) by an average of 25% over the subsequent three-year period. Where do these patterns
come from? The growing field of behavioral finance has built a systematic foundation for the
momentum and reversal effects based on imperfections in the human ability to process new
information rationally. There is substantial evidence to suggest that we tend to add too much weight
to recent evidence, that we tend to be overconfident (a famous study of drivers in Sweden found
that 90% of those asked ranked themselves better-than-average), that we are also sometimes too
slow to react to news, and finally that our choices are affected by a phenomenon called framing. An
individual might reject a bet when it is posed in terms of the risk surrounding the potential gains,
but may accept the same bet when it is similarly posed in terms of the potential losses. In this case,
his decision is affected by framing – i.e. the framework within which the prospect is outlined.
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4. Further reading
• You can learn more about efficient markets and behavioural finance by reading Chapter 11
"The Efficient Market Hypothesis" and Chapter 12 "Behavioural Finance and Technical
Analysis" of Bodie, Kane and Marcus.
• Video

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Return based trading strategies

1. Jagadeesh and Titman

1. Jagadeesh and Titman
• There is now a rapidly growing literature to assess the profitability of contrarian and
momentum trading strategies. Jagadeesh and Titman find in a study that stock prices react
with a delay to common factors, but overreact to firm-specific information. In Chapter 8 we
discuss factor models of stock returns, and the decomposition of the variance of stock
returns into systematic factor-driven risk and idiosyncratic firmspecific risk. This study
incorporates, therefore, both the overreaction element in the stock market’s response to
firm-specific news, as well as the conservatism in incorporating new information about
factor risk. This study finds that most of the short-term profits that can be made by
following contrarian trading strategies are due to the tendency of stock prices to overreact
to firm-specific news. The contrarian strategy tested was based on buying and selling
stocks over one month, based on the previous month’s return. Losers were bought and
winners were sold.

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2. Conrad and Kaul

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3. Chan, Jegadeesh and Lakonishok
• In a study of momentum strategies, Chan, Jegadeesh and Lakonishok find that that
underreaction to information might lead to momentum trading profits. In particular, they find
that past returns and past earnings surprises can each predict large drifts in future returns
after controlling for the other. The drifts cannot be explained by market risk, size effects or
bookto-market effects. Interestingly, they also find little evidence of a future reversal of the
returns process. They conclude, therefore, that the market reacts slowly to new information
about the earnings flow.

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Hedge Funds

1. Introduction
2. Strategies
2. Strategies
• One of the first hedge funds was set up in 1949: A.W. Jones & Co. developed an investment strategy based on
long/short positions in equities. The idea is to buy stocks you think will do well and sell (or short) stocks you think
would do badly. If the market moves in the meantime, the long and short positions will move together to maintain
your net portfolio value, and you make money if your stock picking is correct (in bull as well as bear markets). As
the sophistication of hedge funds grew, so did they turn to other markets. One of the investment strategies in
fixed income (bond) markets is the ‘on-the-run/off-the-run’ strategy employed by LTCM. The ‘on-therun/off-the-
run’ strategy employed by LTCM is based on the institutional feature of the US government bond market which
issues new bonds every six months. Every new auction brings, say, a new 30-year government bond to the
market which investors compete to buy (the bond goes ‘on-the-run’). When the bond is six months old, it
becomes a 29.5-year bond and a new 30-year bond is issued. The old bond goes ‘off-the-run’. LTCM observed
that the difference between a 30-year bond and a 29.5-year bond is almost imperceptible, so they should have
the same yield. In practice, however, there was a spread that was caused by the fact that when the new bond
went ‘on-the-run’ its price was bid up. Therefore, LTCM sold short the new 30-year bond and bought the old
29.5-year bond to unwind its position six months later when the spread was expected to tighten (the short
position would now be in a 29.5-year bond that is offthe-run’ and the long position in a 29-year bond, also ‘off-
the-run’). We have also seen hedge funds going from status as active traders but passive owners in stocks to
also become active as owners. An active owner is a shareholder who takes an interest in the running of the
company and seeks to influence the management and important decisions. Traditionally fund managers have
stayed away from this type of activity. An example is the recent Deutsche Brse’s attempt at a takeover of the
London Stock Exchange. A bid, tabled in early 2005, was later withdrawn under pressure from one of Deutsche’s
shareholders, a large London-based hedge fund. The fund had allegedly taken long positions in Deutsche and
short positions in the London Stock Exchange, since they figured that the announcement of a withdrawal of
Deutsche’s bid would cause the London Stock Exchange’s stock price to fall and the Deutsche’s stock price to
increase. Their longshort position in Deutsche and London Stock Exchange would, therefore, generate
considerable short term trading gains.
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2.1. Do all hedge funds 'hedge'?
• The investment strategy involving market neutral long-short positions (similar to LTCM’s
‘on-the-run/off-the-run’ strategy above) is relatively safe and profitable. As long as the
spread between the cheap asset held long and the expensive asset held short tends to
narrow over time, the position makes money regardless of other market movements. This
is a position, moreover, with little net investment of wealth (there are normally margin
requirements so it is impossible to have a zero net investment) and little exposure to
outside risk factors. Research into hedge fund returns shows, however, that the idea that
hedge funds on the whole engage in longshort market neutral arbitrage trading is
misleading. Hedge funds are a surprisingly heterogeneous group of funds adopting a
number of different styles. They are, in fact, diffcult to define in terms of their trading
strategies. What seems often to be the idea behind hedge fund strategies is, however, that
they carefully manage and target their speculative activity, choosing to hedge some risk
and take a targeted bets on other risk.

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2.2. Squeezing the market
• Hedge funds may take similar positions, where they cause large market movements and
may put the market under a squeeze. These types of trades are called ‘consensus trades’
or ‘crowded trades’. An example of large price movements caused by such a squeeze is
the recent stock price movements in the German car maker Volkswagen. In early 2008
Volkswagen’s preference shares were worth half the value of ordinary stock. Whereas
ordinary stock has voting power, preference shares have priority to dividend payments, so
it seemed preference stock was cheap relative to ordinary stock. A large number of hedge
funds bought preferred stock and sold ordinary stock. At the same time the car maker
Porsche, which already owned 42.5% of Volkswagen, had been buying call options on
Volkswagen stock which, if exercised, would take their ownership to 74.1%. A further
20.2% of Volkswagen ordinary stock is owned by the government of Lower Saxony, which
effectively made the ‘free float’ in the stock market for Volkswagen ordinary stock only
5.7% of the total. The hedge funds had collectively sold short (presumably not knowing the
extent of their collective action and Porsche’s call option position) 12.9%. When the hedge
funds were going to unwind their short position they would need to buy shares that were
not available on the free float, i.e. they had to buy from Porsche, which already had a large
long position in the stock and could, in effect, put a ‘squeeze’ on the hedge funds. The
resulting panic among hedge funds resulted in a massive increase in Volkswagen ordinary
stock share price (which at some point was trading at a price/earnings multiple of over 90
and became, briefly, the biggest company in the world measured by market capitalisation).
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Performance of hedge funds
• The following table summarises Lo’s example.

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Algorithmic or program trading
(statistical arbitrage)

1. Pairs trading
1. Pairs trading
• Statistical arbitrage aims at exploiting patterns in price movements to make trading profits,
normally using computers to identify buy and sell signals (hence the synonymous
algorithmic or program trading label). It is easiest to explain statistical arbitrage by way of
the so-called ‘pairs trading’ rule that was developed in the 1980s. The idea is simple: try
looking for two stocks (or portfolios of stocks) that behave similarly in terms of prices.
When the two diverge, place a bet on convergence by buying the cheaper stock and
shorting the expensive stock.

• For example, suppose two stocks, A and B, normally have similar prices, but currently A is
trading at 80 and B is trading at 110.

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1. Pairs trading

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2. Deviations of spreads

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• This chapter took an investor perspective on the history of finance, and looked at the
historical evidence of the performance of the managed fund industry.
• The main finding was that managed funds do not, on average, outperform broad stock
market indices, which is indicative that markets tend to be informationally efficient.
• The chapter went on to discuss critics of the efficient market hypothesis who use
arguments based on behavioral finance. Some trading strategies based on behavioural
finance (momentum and reversal effects) were outlined.
• The chapter concluded by looking at evidence of hedge fund performance, and finally
looked at some trading strategies based on so-called algorithmic (program) trading.

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Chapter 4 Forum Activity
• Discuss the differences between mutual funds and hedge funds. Is there a difference in
performance between these two categories of funds? If so, which are the likely drivers of
this discrepancy (or absence of it). What about holdings and strategies of the two types of
funds?

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• Activities

• 1. Efficient market hypothesis

• Describe the efficient market hypothesis.
• If the efficient market hypothesis is really true, but traders nonetheless keep searching for
trading strategies that can ‘beat the market’, do you think they would find useful trading
strategies?
• Suppose we can construct trading strategies that yield ‘symmetrical’ risk profiles where
abnormal gains and losses are similar in magnitude and frequency, and strategies that
yield ‘asymmetrical’ risk profiles where abnormal gains are small but frequent and losses
are large but infrequent. Which strategy do you think we would be more likely to find in an
efficient market if we were out to ‘beat the market’?

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Sample examination question
• Explain what we understand by a ‘hedge fund’.
• Momentum and contrarian trading strategies are so-called returns based trading
strategies’. Describe what this means in words, and also design a weighting scheme to
determine how much to invest in assets based on such strategies.
• Demonstrate that, if the spreads between two rates or asset prices are identically and
independently distributed random variables in successive trading sessions, you make a
profit 75% of the time by betting on a reduction in spreads if the current spread is above
the average, and on an increase in spreads if the current spread is below the average.

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