Undergraduate Student Investment Management Fund
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1 Undergraduate Student Investment Management Fund Fall 2016 Presentation 1
2 Fund Managers Gregory Nowicki Stephen McAleer Fund Analysts Charles Goode Gregory Goulder Ryan Hebel Sanketh Macha Caleb Boehnlein Michael Muscheid Alex Glenn Hamza Amjad Ernest Dela Cruz Daniel Martin Madeline Osadjan Paige Weisman Junci Zhao 2
3 IVOL Background Idiosyncratic Risk Is not priced CAPM Is priced and has a positive returns Levy Merton Found a negative premium Mispricing & Arbitrage Constraints Ang et al Stambaugh et al 3
4 Mispricing Anomalies Arbitrage Asymmetry and the Idiosyncratic Volatility Puzzle Stambaugh, Yu, and Yuan (2015) Financial Distress O-Score Probability Composite Equity Issues Net Operating Assets Return on Assets Investment-to- Assets Profitability Accruals Net Stock Issues Momentum Asset Growth 4
5 Mispricing Arbitrage Asymmetry and the Idiosyncratic Volatility Puzzle Stambaugh, Yu, and Yuan (2015) Overpriced Security Underpriced Security High Accruals High Asset Growth Negative Momentum Unprofitable High Net Stock Issuance Low Accruals Low Asset Growth Positive Momentum Profitable Low Net Stock Issuance 5
6 Arbitrage Constraints Securities with higher IVOL have higher constraints to arbitrage Mispricing not completely eliminated by arbitrage Margin Calls Closing Short Positions Size correlated with IVOL Redemption Risk 6
7 Arbitrage Constraints 6% 4% AEIS vs IWV Returns 6% 4% OMI vs IWV Returns 2% 2% 0% 0% -2% -2% -4% -4% -6% 8/29 9/09 9/20 10/01 10/12 10/23 11/03 11/14 AEIS IWV -6% 8/29 9/09 9/20 10/01 10/12 10/23 11/03 11/14 OMI IWV 7
8 Arbitrage Constraints Price Shares Short Sale Value Initial Margin Requirement (50%) Total Margin Posted AEIS $ $10,008 $5,004 $15,012 OMI $ $10,009 $5,004 $15,014 8
9 OMI AEIS \ Arbitrage Constraints Price Short Sale Value Maintenance Total Margin Margin to Margin Posted Margin (40%) Required Spare 8/29 $44.09 $10, $4, $14, $15, $1, /8 $45.53 $10, $4, $14, $15, $ /19 $45.47 $10, $4, $14, $15, $ /28 $46.77 $10, $4, $14, $15, $ /7 $47.80 $10, $4, $15, $15, ($178.19) 8/29 $33.93 $10, $4, $14, $15, $1, /8 $34.18 $10, $4, $14, $15, $ /19 $33.72 $9, $3, $13, $15, $1, /28 $34.89 $10, $4, $14, $15, $ /7 $33.83 $9, $3, $13, $15, $1,
10 $15,500 AEIS Margin Requirements $15,000 OMI Margin Requirements $14,500 $14,000 $13,500 $13,000 $12,500 $12,000 $11,500 $11,000 $10,500 $10,000 $9,500 8/29 9/5 9/12 9/19 9/26 10/3 10/10 10/17 10/24 Short Sale Value Total Margin Required Margin Posted $9,000 8/29 9/5 9/12 9/19 9/26 10/3 10/10 10/17 10/24 Short Sale Value Total Margin Required Margin Posted 10
11 Arbitrage Risk Limits of arbitrage restrict ability of investors to enter and/or hold profitable short position Higher IVOL suggests difficulty in maintaining short position Arbitrage Asymmetry and the Idiosyncratic Volatility Puzzle Probability of a Margin Call 20% 15% 10% 5% 0% Long Leg IVOL Short Leg IVOL 11
12 Monthly Abnormal Returns (%) \ Arbitrage Asymmetry Arbitrage Asymmetry and the Idiosyncratic Volatility Puzzle Stambaugh, Yu, and Yuan (2015) Arbitrage eliminates more underpricing than overpricing Greater amount of arbitrage capital in long positions versus short positions The negative IVOL effect among overpriced stocks is greater than the positive IVOL effect among underpriced stocks Monthly Abnormal Returns Most Overpriced Least Overpriced Highest IVOL Next 20% Next 20% Next 20% Lowest IVOL 12
13 Strategy 13
14 Charter Constraints Firms domiciled in the U.S. Market cap > $1B Long-only portfolio Maximum of 10% in one company and 25% in one sector 14
15 Accruals Companies with low accruals have a higher expected future return Invest in companies with the lowest accrual portion of earnings Number of securities: 1,714 Do Stock Prices Fully Reflect Information in Accruals and Cash Flows about Future Earnings? Sloan (1996) Accruals = (ΔCA ΔCash) (ΔCL ΔSTD ΔTP) ΔDep) Average Total Assets 15
16 Asset Growth Asset Growth and the Cross-Section of Stock Returns Cooper, Gulen, and Schill (2008) Firms that have high asset growth are less likely to perform well in future Invest in firms with low asset growth Number of securities: 2,212 Asset Growth = (Total Assets t Total Assets t 1 ) Total Assets t 1 16
17 Momentum Winners continue to win and losers continue to lose. Ranked on compounded monthly returns during September 2015 to September 2016 Number of securities: 2,757 Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency Jegadeesh and Titman (1993) Momentum = (R t-1 )(R t-2 )...(R t-13 )
18 Gross Profitability Firms with high gross profit are expected to generate abnormally high future returns Invest in companies with high profitability Number of securities: 1,642 The Other Side of Value: The Gross Profitability Premium Novy-Marx (2013) Gross Profitability = (Revenue Cost of Goods Sold) Total Assets 18
19 Net Issuance Management tends to repurchase shares when stock is undervalued Invest in companies with lower net issuance Number of securities: 2,592 Share Issuance and Cross-Sectional Returns Pontiff and Woodgate (2008) Net Issuance = ln(adj. Shares Outstanding) t - ln(adj. Shares Outstanding) t-11 19
20 Aggregate Ranking Construction Found the individual percentile ranking of each anomaly for every security Took the average of percentiles to find the total average mispricing percentile for every security Sorted securities based on the average percentile ranking Selected the top decile of securities based on mispricing anomaly ranking Ticker Accruals Asset Growth Momentum Net Issuance Profitability Aggregate Company A 10% 20% 30% 30% 10% 20% Company B 20% 30% 20% 20% 30% 24% Company C 30% 10% 10% 10% 20% 16% 20
21 Idiosyncratic Volatility (IVOL) High IVOL indicates high expected returns Calculated for 60 trading days from August 26, 2016 to November 17, 2016 Number of securities: 2,843 Arbitrage Asymmetry and the Idiosyncratic Volatility Puzzle Stambaugh, Yu, and Yuan (2015) R=α i +β i (R mkt - R i )+ε i IVOL= (ε i ) 2 21
22 IVOL Ranking \ Portfolio Construction 70% 60% 50% 40% 30% 20% 10% 0% 0% 5% 10% 15% 20% 25% 30% 35% 40% Aggregate Ranking 22
23 Portfolio Construction Security Weighting: 50 bps floor / 5% ceiling Market-cap weighted Comprised of 44 securities Excluded firms with pending M&A activity and performed news checks on each individual security 23
24 Portfolio By Market Cap IVOL Portfolio 10% 20% 40% Russell % 7% 19% 70% 31% 1.2-2B 2-10B 10B-200B 50M-300M 300M-2B 2-10B 10B-200B +200B 24
25 Portfolio By Sector IVOL Portfolio Russell % 12% 20% 5% 16% 4% 4% 3% 12% 8% 7% Consumer Discretionary Consumer Staples Energy Health Care 24% 3% 11% 3% 18% 12% 13% Industrials Information Technology 25
26 Returns Portfolio Return: 0.75% IWV Return: 0.23% Notable Securities: CLF Return: 19.92% IGT Return: % 26
27 Thank you. We will now welcome questions. 27
28 Anomaly Correlations 28
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