Investment Strategies

MA-Thesis / Master von Gerhard Wörtche

This thesis explains the methodology of the considered investment strategies and demonstrates gradually how they are implemented. Besides the ebook, the purchaser of this article receives also the underlying excel sheets. These excel sheets show without using macros how step-by-step the different strategies are implemented.

Introduction:

Nowadays the merits of international portfolio diversification are widely acknowledged in the academic literature. The risk reduction of an international portfolio can be achieved because the correlations between international asset markets are rather low compared to a portfolio which entirely consists of national securities. Hence, international investment strategies are superior compared to strategies which invest solely in a local market since they are able to generate a greater return for a certain risk, or less risk for a given return.

Beside the advantages of international diversification, the investment in other currencies bears an additional uncertainty that arises through foreign exchange rate fluctuations. However, the development of the exchange rate is not solely a one-sided downside risk; it is also a chance of a higher return since the movement can be in favor of a position. In other words, exchange rate changes have different effects on investors of different currencies. Even if the domestic return is much lower than in other countries, it might be the case that an investment in another state will result in a lower return because of the exchange rate development. Therefore, the residence and the therewith-associated currency of an investor is crucial for the result of an international diversified portfolio.

In order to analyze the two risk drivers of an international diversified portfolio separately, the results of the investment strategies are calculated in two ways - with and without the exchange rate development. This method allows evaluating whether exchange rate movements are dispensable or if currency fluctuations are significant for international equity portfolios and therefore the exchange rate risk should be hedged.

The choice of the investment strategy should be compatible with the needs, the expectations and the personality of an investor. In many papers utility theory is used to determine an investor’s optimal investment strategy. These approaches use utility functions to figure out which strategy fits best to an investor. The methodology of this paper is from another angle since no individual utility functions are incorporated, it is different in the way that an empirical study will be carried out to demonstrate the relevant performance parameters of different investment strategies and thereafter it can be chosen which strategy is most appropriate for an individual investor.

The investment strategies which will be applied are the Crossover Simple Moving Average, the Equally Weighted Portfolio, the Mean Variance Portfolio, the Certainty Equivalence Tangency Portfolio, as well as the James Stein Estimator and the Black Litterman Model. In order to gain from the merits of low correlated markets, an international portfolio is set up which comprises ten indices from all over the globe that range from countries with low GDP per head to those with relative high levels.

Motivation and Aim of the Thesis:

There is a large amount of evidence, which indicates that international investment strategies are superior to those strategies which entirely invest in the domestic market. Most of the studies regarding this topic are carried out from the viewpoint of a US investor. The author did not find any recent evidence in the context of an international diversified portfolio which consists entirely of equities from the perspective of a European investor. For this reason, this thesis investigates from a European point of view how different investment strategies performed. In other words, this thesis aims to demonstrate, in mean-variance terms, how each considered strategy performed over the last 8 years as different variables are allowed to vary. The main goals are to answer the following questions:

How did individual investment strategies perform over the last 8 years?

Could this performance also have been achieved when the exchange rate development was considered? (viewpoint from a Euro-based investor) Which out of the sample length was optimal for each strategy?

How robust are the results of each strategy?

Does a superior strategy exist or is one strictly dominated?

Structure of the Thesis:

The paper is divided into three major sections. Section 1 contains a literature review in the context of Modern Portfolio Theory (MPT) and the investment strategies that are considered in this thesis, describes how the optimal portfolio is constructed by using MPT and offers a discussion of the general validity of investment strategies. Section 2 provides reasons for the choice of data, explains the fundamentals of the calculation of the portfolio risk- and return parameters and shows how the resulting magnitudes for each investment strategy are calculated. Section 3 presents the empirical results of the analysis. In this section, the performance and the robustness without- and with the exchange rate development will be demonstrated. After the three major sections, the final part summarizes the main findings and provides ideas which further research seems promising and fruitful.

Inhaltsverzeichnis:

Content:

Chapter 2.3, Efficient Market Hypothesis:

The Efficient Market Hypothesis (EMH) serves the reason to question the general validity of the later presented investment strategies. If financial markets are perfectly efficient in the sense that all relevant information is immediately correctly incorporated in the market prices, then there remains no unexploited profit opportunity. Choosing specific assets or indices cannot result in continuous abnormal profits since the portfolio manager does not have more information than the market. Therefore, in the case that the market is in this manner efficient, the moving away from a passive portfolio to an active managed portfolio cannot systematically result in abnormal returns and hence the later presented investment strategies cannot be superior to a passive portfolio management.

Papers concerning market efficiency are often based on Eugene Fama’s influential article Efficient Capital Markets. According to Fama, the efficiency of a market can be characterized as weak, semi-strong or strong. The weak form efficiency implies that all past information concerning the prices and returns of assets are incorporated in the actual security price. Hence, if the market would be weakly efficient then the applied strategies in this thesis (except from the Black Litterman Model) would not be able to achieve abnormal returns since these strategies, if at all, take solely the first two moments. The semi-strong efficiency builds upon the weak form but it is an enhancement since it assumes that in the actual security prices all public information is incorporated as well. In the case that the market would be semi-strong efficient then neither of the considered investment strategies would be able to outperform the market. The last possibility, the strong form of market efficiency states that no information, whether public or private, can be exploited because security prices fully reflect all information that is in the system.

All three different forms are based on competition. In a market with low barriers and high profits, new competitors will enter until no abnormal profits can be systematically realized. Since security trading has low barriers and information is widely available to investors, the economic expression ‘perfect competition’ seem to fit well to security pricing. Therefore, the EMH rests on the idea of a ‘random walk’. If prices follow a random walk then the flow of information is instantaneously and information is immediately reflected in security prices. Hence tomorrow’s price movement will only depend on tomorrow’s news and are absolutely independent from the past. As news comprises by definition new events, news is unpredictable and thus, future price movements must be unpredictable.

However, in reality there is no such thing as perfect competition. Different financial markets have a different aggregate supply and demand. Further, information is not freely and instantaneously available to all investors. There are market participants like banks and other companies which have information advantages; and interestingly, it is not surprising, when these firms report their abnormal profits, that nobody argues that it is a violation of the Efficient Market Hypothesis.

Applied Methodology:

The theory is explained in a short mathematical way. Since numerous papers deal with the MVP- and the CET strategy, their methodology is only covered very briefly. The thesis focuses on JSE and the BLM as these methods are becoming more and more popular nowadays and further since these methods are not as much analyzed in the context as it is done in this thesis.

Data:

The main idea behind the choice of the time period and the data that was collected can be characterized with four points:

- Relative up-to-date sample with the characteristics of the 21st century to clarify conclusions for the near future.

- Internationally markets, geographically representing different locations.

- Solely equity indices. The intake of bonds or derivatives would probably have had improved the performance, but however, the results of the applied strategies would have to be divided into different factors.

- To analyze whether the portfolio weights are composed mainly of equity markets or of developed markets, the equity indices range from countries with a relative low GDP per head to those which have a relative high GDP per head.

Fulfilling these criteria, the chosen sample consists of 2261-daily observations from the 31st December 1999 until the 1st September 2008 covering a period of more than 8 years. The collected data concentrates on four different types of time series.