I believe that there are some market-wide systematic patterns which cause groups of stocks with common characteristics to be mispriced for prolonged periods of time. These market inefficiencies are the result of investor action in aggregate, and drawing from the world of psychology they are often referred to as behavioural biases. For the rest of my talk, I’d like to share a few examples of these with you and explore how they might work in real life as investment ideas.
In general, investors appear to be too confident about their own views of stock prices. Despite compelling evidence to the contrary, they hold on to their views, even when the market moves further against them, and stock prices become distorted. We also have a tendency to focus on specific items of financial data, bottom line profitability, or leverage ratios and so on, ignoring other important items or the depth of information at our peril. Nor are our attitudes to risk symmetric. For example, faced with the option of a 50% chance of winning £2k and a 50% chance of £0 versus an alternative of a certain gain of £1k, most people would opt for the guarantee even though the payoffs are equal. Now, reverse the deal, where the choices become a 50% chance of losing £2k and a 50% chance of £0 against a certain loss of £1k, and we all turn in to gamblers. The chance of avoiding a loss seems to skew our judgement. Our views on risk are simply not the same on the upside and the downside.
We can use these notions from psychology to develop investment strategies. To exploit overconfidence, we can attempt to gauge the level of agreement or disagreement about a particular stock’s price. We can think of the market as a clearing mechanism or exchange in which buyers and sellers interact to establish an equilibrium fair value for a stock. We can then track stock prices around which there is more disagreement. We can also look at the quality of a firm’s earnings rather than just the quantity. To the extent that earnings are driven by accruals, they may be less repeatable in the future than those that are driven by genuine cash flow. Accruals themselves tend to reverse and they may well offer evidence of management manipulation of earnings. And lastly, we can attempt to exploit the asymmetry of our attitude to risk – in aggregate, investors are more inclined to hold on to their past losers believing that they will come good in the end, but they harvest the gains of winners in a far more disciplined way. We can search for this behaviour, and its relationship to selling pressure, in simple price patterns.
Applications of behavioural finance in quantitative modeling Eoin Murray: Head of Quantitative Strategies November 2005
OMAM <ul><li>A rapidly growing specialist investment manager; focused on high performance and absolute return products </li></ul><ul><li>Independent investment teams; centralised risk management </li></ul><ul><li>US$7.7 billion assets under management* </li></ul><ul><li>Backed with seed capital by Old Mutual plc, a FTSE 100 company </li></ul>* Source: OMAM, as at 31/10/05.
Business platform Equities Investment teams Business infrastructure Legal Risk Management Marketing Investment Operations Systems Manager Recruitment Product Development Seed Capital Finance Business Management Clients Investor Relations Distribution Fixed Interest Quantitative Strategies Multi Strategy Products
Quantitative strategies <ul><li>Global and regional equity long-only </li></ul><ul><li>Multi-asset class </li></ul><ul><li>Global equity market neutral </li></ul><ul><li>Global equity long/short </li></ul><ul><li>Products in development </li></ul><ul><li>Global macro </li></ul><ul><li>Technology long/short fund </li></ul><ul><li>Volatility arbitrage </li></ul>
Quantitative strategies <ul><li>Experienced portfolio management team </li></ul><ul><li>In depth and focused research team </li></ul><ul><li>Currently manage nearly US$2bn in quantitative hedge fund strategies </li></ul><ul><li>Proven process </li></ul><ul><li>Existing framework </li></ul><ul><li>Track record: </li></ul>Source: OMAM, as at 31/10/05. Old Mutual Global Equity Market Neutral Fund Limited > Launch: December 2001 > Annualised performance: 7.3% > Annualised volatility: 4.2% > Sharpe ratio: 1.3 Old Mutual GEM Plus Fund Limited > Launch: May 2003 > Annualised performance: 12.5% > Annualised volatility: 6.8% > Sharpe ratio: 1.5
Investment philosophy <ul><li>Market inefficiencies result from behavioural biases and structural anomalies </li></ul><ul><li>Investment insights, not statistics, drive research </li></ul><ul><li>Rigorous backtesting of data to validate investment criteria </li></ul><ul><li>Continuous research to maintain and enhance Sharpe ratio </li></ul><ul><li>Multi-factor models designed to perform throughout the business cycle </li></ul>
Are there systematic patterns we can exploit? <ul><li>Systematic patterns </li></ul><ul><ul><li>affect all stocks in aggregate </li></ul></ul><ul><ul><li>appear as behavioural biases </li></ul></ul><ul><ul><ul><li>based on psychology </li></ul></ul></ul><ul><ul><ul><li>investors are sometimes irrational </li></ul></ul></ul><ul><ul><ul><li>persist due to limits to arbitrage </li></ul></ul></ul>
Behavioural biases … <ul><li>Overconfidence </li></ul><ul><ul><li>people are generally overconfident of their own judgement </li></ul></ul><ul><li>Limited attention </li></ul><ul><ul><li>there are limits to the amount of information we can process </li></ul></ul><ul><li>Prospect theory </li></ul><ul><ul><li>attitudes to risk are not symmetric </li></ul></ul>
… lead to investment insights <ul><li>Differences of opinion (overconfidence) </li></ul><ul><ul><li>stocks where investors disagree more will be further overpriced and earn lower future returns </li></ul></ul><ul><li>Earnings quality (limited attention) </li></ul><ul><ul><li>investors tend to focus on the quantity rather than the quality of reported earnings </li></ul></ul><ul><li>The disposition effect (prospect theory) </li></ul><ul><ul><li>investors predisposed to sell past winners in preference to past losers </li></ul></ul>
Ongoing research V-Lab Academic Advisory Board Broker research Quantitative Strategies team Investment intuition drives the process Idea generation
Global Equity Market Neutral Investment process Trade list Trade cost model Relative return model Risk model Optimisation and portfolio construction Continuous research on all three proprietary models and process
Academic consultants <ul><li>Dr Nicholas Barberis Professor of Finance Yale School of Management </li></ul><ul><li>Previously, Nick was an Associate Professor of Finance at the University of Chicago Graduate School of Business; he has also held visiting professorships at Harvard University and at London Business School. B.A. (mathematics), Cambridge University, 1991; Ph.D. (business economics), Harvard University, 1996; Publications include Style Investing (with A Shleifer), Journal of Financial Economics (2002), and A Model of Investor Sentiment (with A Shleifer and R Vishny), Journal of Financial Economics (1998). </li></ul><ul><li>Dr Peter Pope Professor of Accounting and Finance Lancaster University Management School </li></ul><ul><li>Previously he was the Touche Ross Professor at Strathclyde Business School and visiting professor at the Stern School, New York University and the University of California at Berkeley. He is the Academic Co-ordinator of the Institute of Quantitative Investment Research and a member of the UK Accounting standards Board Academic Panel. </li></ul><ul><li>Dr Stephen Satchell Reader in Financial Econometrics, and Fellow of Trinity College University of Cambridge </li></ul><ul><li>Academic Advisor, Alpha Strategies; Advisory Panel, IFC (Subsidiary of the IMF); U.K. Representative, Pension Research Institute (State University of California); Fellow, Pensions Institute (Birkbeck College); Visiting Professor, City University; Visiting Professor University of Technology, Sydney; Visiting Professor Birkbeck College; Visiting Lecturer, University of Oxford, applied mathematical finance diploma. </li></ul>
Academic consultants (cont’d) <ul><li>Dr Lionel Martellini Professor of Finance and Director Research EDHEC Risk and Asset Management Research Centre </li></ul><ul><li>Lionel Martellini is a Professor of Finance at EDHEC Business School and the Scientific Director of the EDHEC Risk and Asset Management Research Centre. A former member of the faculty at the Marshall School of Business, University of Southern California, Dr. Martellini conducts active research in quantitative asset management and derivatives valuation. He is on the editorial board of the Journal of Alternative Investments and the Journal of Bond Trading and Management, and on the editorial advisory board of the Journal of Portfolio Management. </li></ul>
Regulatory information This document is being issued inside and outside the United Kingdom by Old Mutual Asset Managers (UK) Limited (‘OMAM’) (which is regulated by the Financial Services Authority (the ‘FSA’)) only to and/or is directed only at persons who are both a) intermediate customers or market counterparties for the purposes of the FSA Conduct of Business Sourcebook (‘COBS’) and b) of a kind to whom the Fund may lawfully be promoted by a person authorised under the Act (an ‘authorised person’) by virtue of Section 238(5) of the Financial Services and Markets Act 2000 (the ‘Act’) and Annex 5 to Chapter 3 of COBS. The shares in the Old Mutual Global Equity Market Neutral Fund Limited and the Old Mutual Gem Plus Fund Limited (the ‘Funds’) are only available to such persons and this document must not be relied on by any other persons. This document is exempt from the scheme promotion restriction (in Section 238 of the Act) on the communication of invitations or inducements to participate in unregulated collective investment schemes on the grounds that it is being issued to and/or directed at only the types of person referred to above. Any recipient of this document who is not an authorised person may not distribute it or otherwise promote the Funds to any other person. The Funds are unregulated collective investment schemes for the purposes of the Act and the rules of the FSA. The Funds are registered as regulated mutual funds with the Cayman Islands Monetary Authority under Section 4(3) of the Mutual Funds Law (2001 Revision) of the Cayman Islands. The investment activities of the Funds will not be regulated or otherwise overseen by the Cayman Islands Government. The information in this document should not be construed as a solicitation to invest in the Funds or be relied upon for the purpose of making an investment in the Funds. Before investing in the Funds prospective investors should read the Fund prospectus and consult with their own professional advisors on the suitability of such an investment. Investors may rely only on the information contained in the Fund prospectus for which OMAM takes no responsibility. Please remember that the value of an investment and the income from it can go down as well as up and that you may not get back the full amount invested. Past performance is not a guide to future performance. Exchange rate fluctuations can also affect both capital and income values. Old Mutual Asset Managers (UK) Limited is the investment manager of the Funds and is authorised and regulated by the Financial Services Authority. Old Mutual Asset Managers (UK) Limited, 2 Lambeth Hill, London EC4P 4WR, England. Registered in England No. 2949554 H825/11/05
A particular slide catching your eye?
Clipping is a handy way to collect important slides you want to go back to later.