CAIA L2 - 6.2 - Directional Strategies and Methods Flashcards
Define
Efficiently inefficient markets
6.2 - Directional Strategies and Methods
When there’s enough competition among active managers to keep markets almost efficient, but some inefficiencies persist
If there were no real inefficiencies to exploit, then active managers would not exist
‘–
There are two paradoxes of informational market efficiency:
1. If markets are perfectly efficient, there is no incentive to incur costs in the pursuit of new information. This infers no mechanism with which to keep markets efficient.
2. If markets are perfectly efficient, then fees paid to active managers imply high inefficiency in the market for asset managers.
6.2 - Directional Strategies and Methods
Formula and interpret
signal-to-noise ratio
(SNR)
market divergence index
(MDI)
6.2 - Directional Strategies and Methods
SNR’t’(n) =|Pt–Pt–n|/ ∑|Pt–i–Pt–i–1|
Ex: Prices follow a path of 48, 49, 50, 49, 48, 47, and 45
SNR =[|45-48| ] / [|49-48|+|50-49|+|49-50|+|48-49|+|47-48|+|45-47|] = 3/7 = 0.429
SNR = 0 = noise
SNR = 1 = trending
MDI = média do SNR dos vários mercados
6.2 - Directional Strategies and Methods
Identify
Technical strategies
based on machine learning
Pro and con
6.2 - Directional Strategies and Methods
- Genetic algorithms - identify patterns in data using an evolutionary approach in which genes represent trading rules that either survive within a simulated trading environment or perish if profits do not accrue
- Neural network - software uses this approach (AI) to form nodes and layers within a dataset to create connections in which a model learns to form trading rules.
Pro - powerful digital tools
Con - potential for data dredging (i.e., sufficiently address past data but fail to accurately forecast future data)
6.2 - Directional Strategies and Methods
Define
Crisis alpha
strategy
6.2 - Directional Strategies and Methods
The potential for
superior returns
during market crisis
market participants
tend to be synchronized (trending herd behavior)
in their actions
It’s not timing strategy - it exploits the risks that develop as a crisis unfolds.
6.2 - Directional Strategies and Methods
Define
FCFF - Free Cash Flow to the Firm
6.2 - Directional Strategies and Methods
FCFF =
net income
‘+ noncash charges
‘+ [interest expense × (1 – tax rate)]
‘– investments in fixed assets
‘– investments in working capital
6.2 - Directional Strategies and Methods
List
four key procedures
in the
fundamental investment process
6.2 - Directional Strategies and Methods
1. Understanding the business. The purpose of understanding the business is to assess where the firm is able to generate stable and attractive cash flows and the firm’s competitive position. Market share, product quality, and red flags are also important considerations.
2. Understanding management. Considering the ethical nature and incentives of a firm’s management are important ways to think about firm culture.
3. Analysis of published financials. The published financials may need to be adjusted for one-time events (e.g., pension expenses, sale of a division). There is a long list of metrics that can be used to evaluate the financials of a firm. One option is the DuPont model, which breaks down return on equity (ROE) as the product of the firm’s profit margin (net income / sales), asset turnover (sales / total assets), and leverage (total assets / total equity).
4. Valuation. Financial data (e.g., dividends, free cash flows, enterprise value) can be used to estimate a value for an investment. This presents a measure for comparison with the price of the firm’s shares and its attractiveness relative to peer-, industry-, and market-level metrics.
6.2 - Directional Strategies and Methods
List
four mechanics of the
fundamental strategy
in allocation process:
6.2 - Directional Strategies and Methods
1. Idea generation. Financial ratios can be used to screen the universe of available investments down to a manageable consideration set. Newsletters, commentaries, and idea luncheons are also sources of ideas. Ideas become less likely to generate superior returns when the source of the idea is widely publicized.
2. Optimal trade. Once an idea is sourced and vetted, investors need to determine the optimal trade to exploit the hidden value uncovered through the idea-generation step.
3. Sizing. After the optimal trade is determined (long or short, shares or derivatives, etc.), the next step is sizing the trade. This step is informed by the goals and risk profile of the investor and the depth of their conviction in the trade.
4. Executing. Managers need to determine if they plan to trade passively (i.e., join a bid/ask offer), buy aggressively (lift offers), or sell aggressively (hit bids). Consideration should be given to liquidity, proximity to major announcements, and access to shares (if short selling is involved).
6.2 - Directional Strategies and Methods
List and describe
Schools of thought within
top-down fundamental analysis
6.2 - Directional Strategies and Methods
1. Feedback-based global macro managers assume markets are mostly rational, but pockets of irrationality sometimes exist. These pockets arise from complacency (money is too easy to make) or panic (quick losses lead to feelings of distress). These managers attempt to ride market psychology by selling into perceived bubbles and buying in advance of expected recoveries
2. Information-based global macro managers look for informational gaps between micro-level and macro-level data. Sometimes, there is a lag between a macro-level announcement and a micro-level impact. These delays can be exploited if uncovered.
3. Model-based global macro managers are relying on financial models and economic theories to uncover opportunities. They might look for monetary or fiscal policy mistakes. They also might extract implied factors from market data and compare these with rational expectations.
6.2 - Directional Strategies and Methods
Recognize
risks
of directional fundamental strategies
6.2 - Directional Strategies and Methods
1. Fundamental risk is the chance for an unexpected change in a variable that impacts the profitability of a fundamental trade. For example, a commodity trader uncovers an arbitrage opportunity where a commodity is trading at different currency-adjusted prices in two different countries. The trader might naturally take offsetting long and short positions to exploit this perceived arbitrage opportunity. If one country unexpectedly imposes tariffs, then this could dramatically alter the profitability of this trade.
2. Noise traders are investors who make trades for reasons that are not fundamental in nature. This could be a pension fund selling securities to meet cash needs. It could also be someone buying due to technical momentum indicators. Noise trading risk introduces the possible influences of irrational and emotional decision-making into otherwise-fundamental strategies.
6.2 - Directional Strategies and Methods
List
six sentiment indicators
in directional strategies
6.2 - Directional Strategies and Methods
- discount on closed-end funds
- turnover on the NYSE
- # of IPOs
- average first-day returns on IPOs
- equity share in new issues
- dividend premium (P/B ratio of dividend payers over nonpayers)
6.2 - Directional Strategies and Methods
List
four behavioral biases
that relate to an over-reliance on the past
in Directional Strategies
6.2 - Directional Strategies and Methods
1. Anchoring is a bias that leads someone to stick with a prior reference point and fail to properly integrate new information. For example, an investor might get stuck in their mind that a stock is worth $200 per share and not the current value of $25 simply because it was at $200 in the recent past. This bias is also very likely to influence a sell-side analyst’s forecasts.
2. Confirmation bias occurs when someone selectively accepts and retains information that supports a previously held belief. Duong, Pescetto, and Santamaria studied value investors and growth (a.k.a. glamour) investors in the U.K. from 1991 to 2007.5 They documented asymmetric reactions to good and bad news. They found that value investors underreact to good news and act overconfidently with bad news; growth investors underreact to bad news and act overconfidently with good news. In other words, both groups reacted favorably to information that supported their views.
3. The loss aversion/disposition effect suggests that people prefer to avoid losses more than they are attracted to the potential for gains. In other words, there is an observed reaction to losses that is more intense than the joy experienced from an equal dollar amount gain. Relatedly, prospect theory finds that people will underweight outcomes that are probable relative to those that are certain. For example, investors tend to lock in small gains but fail to stop losses from accruing quickly.
4. Representativeness bias mistakenly speculates that one past event will repeat again in an expanded form. For example, if Facebook has a history of amazing earnings releases, investors might extrapolate this growth trend out to the entire social media industry incorrectly. In other words, investors tend to impute a company-level successful (or failure) to the whole industry.
6.2 - Directional Strategies and Methods
