Developing an Investment philosophy

Developing an Investment philosophy

Executive Summary This report attempts to investigate and present the advantages of a passive investment strategy in an effort to collect a sufficient amount of funds and invest it in two of the largest indices in the NYSE. At the introduction ,we point out the irrational behavior of active investors throughout their effort to achieve returns and beat the index .In contrast to the active management’s pressure and exhaustion , we propose a more reasonable strategy ,the passive, which does not try to beat the index but replicate its performance. Of course this plan works out only under the fundamentals of the EMH ,whose structure and regulations are being mentioned in the introductory paragraph. Then we analyze our investment philosophy .We underline the fact that passive strategy is a strategy accessible to all kinds of investors who are risk averse ,have a long term investment horizon and don’t get entitled to capital gains frequently .The next step is to revise the mostly updated bibliography debating the passive investment and its benefits against active and finally, we propose some evaluation techniques suitable for our strategy. Table of contents :      

Introduction and problem statement Description of the Investment philosophy Description of the investment strategy Implementation of the strategy Literature review of empirical results Recommendations regarding the valuation process of the

strategy  References Introduction and problem statement According to our perception of the human psychology and the constant search of man for the easy profits, which is in line with many researchers’ belief, when it comes in terms of

decision making ,active investors are mostly driven by emotional factors and irrational expectations for future wealth .Contrary to the traditional market theory which assumes that active investors are guided by rationality and past experience, when they give an order to buy or sell securities, most of them have developed their own misconception of how the security markets work and try to take advantage of minor market inefficiencies to exploit and achieve excess returns. Although stock markets are getting more and more efficient with the latest technologies applied, various calendar effects have been addressed in the past due to market anomalies .In 2011 an academic research paper has been conducted, attempting to shed light on the stock exchange anomalies that occur and the reasons that cause them, while we accept the efficient market hypothesis. These anomalies could occur once and then disappear or happen repeatedly. The point is that active investors try to spot these abnormalities and exploit them to earn excess returns. Three kinds of market anomalies have been detected: calendar anomalies, fundamental anomalies and technical anomalies .These deviations from the smooth function of the efficient markets, are mainly caused by irrational behaviors of some investors ,the weakness of emerging stock markets to fully reflect in time the intrinsic value of investments into stock prices and the herding behavior of following past investments that proved to be successful in their times(1) .These findings are in line with a second academic research paper which was conducted on capital investment and finance issues and deals as well with the concept of market anomalies. Authors’ perception is that market inefficiencies are random events which fluctuate from time to time and from market to market. Thus, active investors will not succeed in exploiting these anomalies short term strategies involve a high level of risk,

while on the long term, a very limited number of investors can take advantage of them ,the rest of investors will follow and the instant opportunity for above-average returns will be eliminated in no time.(2) Given some very good reasons above ,we believe that this is a very dangerous strategy for the average investor which might even result In a great devaluation of his/her portfolio assets in no time ,causing panic and thoughts of redeeming his securities. Thus, to avoid getting in dire straits, having to compete with large risks and price swings, we propose the passive investment strategy which guarantees future returns as a long term strategy that it is, according to the market index we attempt to follow. This is a safe strategy for investors who are willing to volunteer according to their financial position, in the construction and maintenance of the mutual index fund, seizing the opportunity to have access in market’s steady profits or losses according to their portion in the mutual fund’s net asset value. Although passive management ,has lots of benefits which will be examined later ,it can only be applied under the EMH. According to Malkiel’s view, who conducted a remarkable research paper demonstrating the benefits and weaknesses of the efficient market hypothesis, stock markets are strong form efficient ,reflecting immediately all new information ,public and private ,offering in this way ,an objective estimation of stock prices. In this way, technical analysis referring to the revision and interpretation of past prices and fundamental analysis referring to the interpretation of financial ratios, measuring company’s performance ,will be unnecessary. This happens due to the fact that strong form efficient markets , such as the NYSE in which we will choose to invest, are based on the random walk model where every future movements of stock price, will be determined solely by future events. He

accepts that both minor imperfections of EMH along with investors’ irrational behaviors can lead to a potential mispricing of stocks, but with the development of computers and sophisticated databases, we are heading towards a perfectly efficient market worldwide.(3) Description of the investment philosophy Passive investment strategy is a strategy which attempts to replicate the performance of an index, simply by investing a mutual fund into every stock that trades in the index ,in the exact weight that each company’s shares occupy in the total market capitalization .This strategy is called indexing and it is applied mainly in stocks and bonds markets. It helps investors to create a fully diversified portfolio ,in order to avoid asset selection which would probably expose them to a higher systematic risk. The first index fund created to fully replicate the index was the Vanguard500 in 1976. Another way to construct an indexed portfolio ,is to buy ETFs(exchange traded funds). Etfs trade as stocks in the stock market and they are investment vehicles designed to work in the same way as an index mutual fund, only that they are traded as stocks and so can be bought intraday. An alternative path to indexing which is more efficient in case the investors choose to follow large indices, such as Rushell2000,they can apply the method of sampling. Sampling means that the investor chooses which stocks of the market index, to buy and hold in the exact portions that they occupy in total market capitalization. The rest can be invested in bonds. This is a very efficient way to allocate your funds, since it is not necessary to review the index constantly ,to sell the stocks of redeemed companies and buy those of the recently entered companies. This is fortunately ,a problem that we won’t face as long as there are strict conditions and high standards for companies to enter SndP500 and DJIA.

The benefits of a passive investment are numerous .In a spring conference that held in 2002,professor Sharpe analyzed the benefits of investing in the index. He stated that index investments are a cheap and efficient way to construct a very competitive, low cost and widely diversified portfolio which in many cases can perform better than the average actively managed fund. He concluded by stating that although index funds are a boring and easy way to generate positive returns on the future, active investors do a lot more research to find undervalued stocks and they result in underperformance. Passive investors appear to be more wise and sensible on their gains.(4) Another article uploaded on the blog, Financial Times Adviser refers to the growing preference of money managers, asset managers, private bankers, institutional and retail investors for investing in physically replicating ETFs .In more detail, it supports that in 2012,preference rose from 75% to 90% for passive ETFs, while investors and bankers increased their preference for BlackRock’s iShares about 65%.Although concerns of counterparty risk ,ETFs seem to gain more and more popularity.(5) One more article referring to the benefits of passive investing was uploaded on Portfolio Management’s website ,gives a thorough explanation of the passive investment strategy .Passive strategy is a financial investment strategy which attempts solely to replicate the index without trying to predict any future prices of financial instruments to beat it. Investors buy some index funds which track major indices. This is a low cost ,tax efficient and low turnover strategy which is mostly preferred by investors who don’t need large amounts of mine in short term periods, who are comfortable with the volatility of the index ,especially if they invest in a bull market which follows normally an uptrend and investors

who want to acquire a fairly diversified portfolio with constant future returns.(6) In the same way ,there is an article presented by the Vanguard company which quotes mainly the perfections of an index fund in 2014. Description of the investment strategy : According to our investment strategy ,we plan to collect funds and create a mutual fund which will later be invested in both the two major indices of NYSE, the SandP500 and DJIA .Dow Jones Industrial Average is an index composed of a price weighted average of 30 stocks. It includes the 30 largest companies in the US from several industries apart from transportation and utilities .There are specific rules and regulations that large capitalization companies have to meet and they don’t get easily removed from the index ,unless an extraordinary change occurs.SandP500 is a market value added index of 500 stocks. It contains 500 of the largest companies in US from various sectors which value approximately over than 5 billion dollars each. Both of them reflect the general trend in US stock market, although SandP500 reflects instantly the changes in stock prices. NYSE is mainly a bull market meaning that it follows a steady uptrend apart from times of global financial crises where all the large stock markets experience a sharp downfall and recover again after a period of time .(13)So after we will invest the mutual fund in the two major indices ,we will have created the net asset value of the mutual fund ,out of which ,shares will be issued or share units as they are conventionally called for every investor that is interested. every investor who buys share units ,will have a quota on the index fund’s profits(losses).The funds will be handled by professional fund managers whose main duty, apart from raising investments is to get in touch with investors who want to buy or sell shares.

Implementation of the strategy : As we have already mention above ,the passive strategy is a strategy accessible to all kinds of investors who are risk averse, have a long term investment horizon and don’t get entitled to capital gains frequently .This is a buy and hold strategy where your duties as an investor is to track the index. Literature review of empirical results : There is a vast bibliography debating the issue of passive versus active management strategy. Empirical studies show that researchers haven’t reached a consensus on which of the two strategies is more efficient and profitable for the average investor. Results vary widely according to the performance ratios that have been measured, the pricing models that have been employed and the political situation as well as the economic development of the country under consideration. At this point ,we attempt to make a revision of the bibliography dedicated on this issue, in order to display what researchers believe on this topic. On 2009 an academic paper was conducted by Rombotis measuring the performance of both passive and active exchange traded funds listed in the US stock exchange .The results show a strong form efficient market(EMH applies almost 100%) and lack of market timing skills from active managers’ point of view .Actively managed ETFs underperformed both the index and the passive ETFs ,a result observed on the low performance rates (both Sharpe and Treynor ratios were very low while scoring a high tracking error, which already comes in line with the nature of active funds(they were not designed to track the index like passive funds do, but to beat it).The overall bad results of investment funds comply with the bulk of the literature carried out on the performance of passive and active investments, regarding highly performing stock markets like the NYSE.(7)

On 2012,a practitioners’ research paper was carried out, focusing on the positive and negative aspects of passive versus active investment ,mostly attempting to give a clear view on both strategies ,rather than expressing any special preference for the one rather the other .They state that times are getting harder for active investors as more and more rules and restrictions are imposed by governments on the financial markets .In the near future ,active investors won’t be skillful enough to beat the markets because markets tend to become more and more efficient than they used to be in the past ,leaving no margins for active managers to beat them. There gives of course many cases of value and growth investors who succeeded in beating the market but that happened mostly in cases of emerging stock markets. They point out that is wise to alter your investment position from active to passive, when your portfolio performs poorly. So it depends on the characteristics and inner needs of every investor to pick the strategy that is mostly suitable for him/her.(8) In line with the previous topics ,another research paper was conducted in 2012 observing once more the characteristics of passive and active management .They stress out that investors should be really careful when they select an investment strategy and take a position as passive or active investors according to their tax sensitivity, expected time horizon of their investments and risk tolerance or aversion. Overall, both active and passive strategy can be proved fruitful only that active strategy should be applied under specific conditions ,in example when there is a strong financial background and the proper portfolio to back up a long term active position. On the other hand, passive management is a safe and profitable steady investment, especially regarding large capitalization industries.(9) The following paper was conducted in 2015.It is an adviser guide to ETFs carried out by BlackRock. This paper attempts

first to quote the benefits of using ETFs and indexing methods in general and second, to blend passive and active strategy to perform an outstanding mixture which will combine the benefits of both while eliminating their weaknesses. Overall , it assumes that a combined strategy will carry the advantages of better risk management ,enhanced diversification and better cost efficiency with index beating performance and actively managed funds.(10) The following ,is an academic paper of 2012 which focuses on the virtues and the development of emerging markets and the performance of US stocks ,actively managed and traded in these markets .This research compares the returns between passive ETFs and active mutual funds .He discovered that due to the imperfections of emerging stock markets which lack efficiency ,actively managed funds perform better than the passive even by 2,87% which is a striking result. Particularly, mutual funds recorded higher returns than ETFs both in pre tax and post tax level. Of course ,in the case of a more efficient market like NYSE it would be too hard for active funds to outperform the passive ones ,mainly due to the fact that active investors have to bare a lot heavier fees and tax burdens.(11) In the sixth chapter of this book, written in 2011,the author try to explain why active investors tend to perform worse than the passive ones. This occurs mainly because active securities contain a high level of risk and excess returns will be eliminated fast after payments to brokers and government will be done. That is why a passive strategy is a successful strategy ,no matter what happens.(12) Recommendations regarding the valuation process of the strategy : Passive management is very popular for its satisfactory constant returns and its high beta estimation. Beta is a measure of the correlation between the returns of the market

index and the stock returns. The higher the beta ,the closer the stock returns to the average portfolio risk. Passively managed funds have a high beta, near to 1just like index beta ,only a bit lower due to management fees. Passive portfolios have low tracking errors, contrary to the active ones which seem to deviate a lot from the average index returns. Generally, when an investor decides to construct a passive portfolio, he should be aware in terms of diversification, so that he can eliminate unsystematic(firm-specific) risk. He should follow a passive investment strategy and never look on past stock prices to draw his future investing plans. Conclusion : According to the majority of the bibliography and researcher’s views on passive and active management, we draw the conclusion that passive investing is a safe ,tax efficient ,low cost, widely diversified and easy strategy that can be applied by anyone who wants to invest without requiring any professional experience on stock market issues or a superficial budget to maintain your position .It gives the opportunity to small investors to participate in market’s returns by gaining a great market exposure along with steady profits. References: 1)Latif, M. (2011). Market Efficiency, Market Anomalies, Causes, Evidences, and Some Behavioral Aspects of Market Anomalies. Research Journal of Finance and Accounting, 2(9/10). 3)Malkiel, B. (2003). TheEfŽcientMarketHypothesisandIts Critics. JournalofEconomicPerspectives, 17(1). 2)Saxena, A. (2015). Analysis of Stock Market Anomalies worldwide. [online] Slideshare.net. Available at: http://www.slideshare.net/AanchalSaxena2/analysis-of-stock-marketanomalies-worldwide [Accessed 21 Dec. 2015].

4)Sharpe, W. (2015). Indexed Investing: A Prosaic Way to Beat the Average Investor. 5)Ftadviser.com, (2015). Morningstar: 90% prefer physically replicating ETFs - FTAdviser.com. [online] Available at: http://www.ftadviser.com/2011/11/21/investments/etfs-andtrackers/morningstar-prefer-physically-replicating-etfsoiLqeNPJyzZyS3kNQ4VTWK/article.html [Accessed 21 Dec. 2015]. 6)Portfoliomanagement.in, (2015). Passive Portfolio Management Strategy. [online] Available at: http://www.portfoliomanagement.in/passive-portfolio-managementstrategy.html [Accessed 21 Dec. 2015]. 13)Staff, I. (2005). What's the difference between the Dow Jones Industrial Average and the S&P 500?. [online] Investopedia. Available at: http://www.investopedia.com/ask/answers/130.asp [Accessed 21 Dec. 2015]. 7)Rompotis, G. (2009). Active vs. Passive Management: New Evidence from Exchange Traded Funds. [online] Available at: http://file:///C:/Users/Eleftheria/Desktop/Investment%20and %20Security%20Analysis%20articles/t02.pdf [Accessed 21 Dec. 2015]. 8)BAIRD, (2015). Active vs. Passive Money Management. [online] Available at: http://file:///C:/Users/Eleftheria/Desktop/Investment %20and%20Security%20Analysis%20articles/active-vs-passivemoney-mgrs.pdf [Accessed 21 Dec. 2015]. 10)iShares, (2015). Adviser guide to ETFs