Efficiently Inefficient Market Flashcards
Learn Different Investment Styles and Strategies
What is Efficient Market Hypothesis and its implication?
The idea that all prices reflect all relevant information at all times.
Implication: Passive investing, if prices reflect all information, efforts to beat the market are in vain. investors paying fees for active management can expect to under perform by the amount of the fee
What is Inefficient Market and its implication
The idea that market prices are significantly influenced by investor irrationality and behavioural biases
Implication: Active investing
What is Efficiently Inefficient Markets?
The idea that markets are inefficient but to an efficient extent. Competition among professional investors makes markets almost efficient, but the market remains so inefficient that they are compensated for their costs and risks
Implication: Active investment by those with comparative advantage
What is Value investing and its Return Drivers?
Buying cheap securities with a low ratio of price to fundamental value. E.g stock with a low price to book or price earning ratio while shorting expensive ones.
Return Drivers: Risk premium and overreaction
A security that has a high risk premium or is out of favour becomes cheap, especially when investors overreact to several years of bad news.
What is Trend Following Investing and its Return Drivers?
Buying securities that have been rising while shorting securities that are falling, i.e momentum and time series momentum.
Driver: Initial under reaction and delayed overreaction
Behavioural biases, herding, and capital flows can lead to trends as prices initially underreact to news, catch up over time, and eventually overshoot.
What is Liquidity Provision and its Return Driver?
Buying securities with high liquidity risk or securities being sold by other investor who demand liquidity
Driver: Liquidity risk premium
Investor naturally prefer to own securities with lower transaction costs and liquidity risk, so illiquid securities must offer a return premium.
What is Carry trading and its Return Driver?
Buying securities with high carry. i.e securities that will have a high return if market conditions stay the same
example: global macro investors are known to pursue the currency carry trade where they invest in currencies with high interest rate, bond traders often prefer high yielding bonds, equity investors like stock with high dividend yields, and commodity traders like commodity futures with positive roll return
Driver: Risk premium and frictions
Carry is a timely and observable measure of expected return as risk premiums are likely to be reflected in the carry
What is Low risk investing and it return driver?
Buying safe securities with leverage while shorting riskt ones, also call betting against beta
driver: leverage constraints
low risk investing profit from a leverage risk premium as other investor demand high risk “lottery” assets to avoid using leverage.
Quality investing and its driver?
buying high quality securities- profitable, stable, growing, and well manage companies- while shorting low quality securities
driver: slow adjustment
securities with strong quality characteristic should have high prices, but if market adjust slowly, then these securities will have high return.
How efficiently inefficient market explain modigliani miller theorem
Modig suggest the value of the firm is irrelevance of capital structure
capital structure matter because of funding frictions
Explain discretionary long short equity
Discretionary long short equity manager typically golong or short based on a fundamental analysis of the value of each company, comparing its profitability to its valuation and studying its grow prospects. These fund managers also analyze the quality of the company’s management, travelling to meet managers and see businesses. Furthermore, they study the accounting numbers, trying to assess their reliability and to estimate future cash flow. they mostly bet on specific companies, but they can also take views on whole industries
“ it’s easy to be a contrarian, except when it’s profitable”
Betting against the beta
taking a short position with stock that has high beta and long position in stock that as low beta
What is Beta and its implication
Is the statistical measure of the risk of an individual stock or portfolio against the market as a whole. Beta measure the strategy’s tendency to follow the market. Beta risk or market exposure is easy to obtain at very low fee, for example, by buying index funds, exchange traded funds (ETFs), or futures contracts.
Another use for beta is that it tell us how to make the strategy market neutral, by hedging out the market exposure or for every dollars of exposure we have to short B dollars of the market
Hedge fund freedom and restrictions
In term of freedom, hedge fund can use leverage, short selling, derivatives, and incentive fees.
In term of restrictions, hedge fund investor must be accredited investors, meaning that they need a certain amount of financial wealth and/or financial knowledge to be allow to invest
Also hedge fund cannot advertise or actively approach people for investments.
Alpha
Alpha is the excess return after accounting for performance due to market movements.
since the idiosyncratic risk is zero on average, the expected excess return of the market neutral strategy is alpha.
