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FLAM Lets Make It Simple PDF
FLAM Lets Make It Simple PDF
percentage terms. This means that as a result in the literature the authors assume constant
the alpha is expressed in percentage (we have IC.
situation: percent - i corrected by a
IC depend on market conditions. If the
coefficient IC, corrected by coefficient Z). market is efficient enough, each information
According to (1.), high alpha is possible to is already included in the price of assets and
serves to determine the equilibrium price.
get assets with high active risk i . If i is high,
There is no other source of information that
then E ( ) is high also. It's a little strange lead to changes in prices and therefore cannot
conclusion. Always in investment area the become a predictor. In this situation, even
high risk is associated with high uncertainty, intelligent, knowledgeable, experienced and
therefore bigger problems for the investors. trained investor, as claimed by Thomas (2000)
But here we have a manifestation of the was not able to have the ability to forecast. As
strangeness of active portfolio management, the market is imperfect, the IC of an investor
expressed in (1.). According to the logic of might be higher.
active management, assets whose active risk
is high should be regarded as a preferable According to (1.) high alpha can be created
candidate for investment. This is by an investor with high IC. Investor without
understandable: only assets that have a large the ability to predict the future (i.e. IC = 0) will
deviation from their equilibrium yield could not be able to create additional income. On
be used to provide an additional (active) the other hand, the higher IC is not sufficient
returns. Assets whose profitability is always to create high alpha. If return, which assets
close to equilibrium are interested only for provide is always equal to the equilibrium, the
passive investment. But active investors seek skill of the investor to forecast cannot create
to find those assets that only they "know" that additional income. Under these conditions,
will achieve returns other than equilibrium. that the investor has the ability to select those
assets that will perform well in the future
cannot be fruitful. If the investor will select
2.2. Information coefficient IC one or other asset is not essential because
both will ensure return, which everyone
Information coefficient is based on
expects - equilibrium. High IC makes sense
intuitive understanding of economic indicator.
only if there are assets whose returns deviate
It measures the ability of the investors to
predict the future state of the analyzed from equilibrium (i.e., assets with higher i ).
variables. Mathematically we can present IC Then the skill of the investor to predict is
as a correlation between expected alpha and essential for the selection only those assets
realized alpha, but this formula is more which will realize higher returns.
theoretical than providing practical economic
meaning. It is hard to collect such data base
for the ability of the investor to forecast future 2.3. Scoring Z
returns.
The scoring is that peculiar element in
IC depends on personal characteristics of formula (1.), which makes it strange in the
the investors. These characteristics include eyes of investors accustomed to heavy
intelligence, knowledge, experience, training econometric models, but along with that
and more. These are characteristics which makes the active management highly
cannot easily be changed. That is why often attractive for the investors.
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The scoring is standardized measure of that the investors "like" the asset and
subjective preference of the investors to the evaluate it at the forefront compared to other
object of forecasting. This kind of techniques assets. But if this asset cannot create an
are very popular in our everyday life. In our active income, i.e. additional return above the
life we often have to give a quantitative expected equilibrium value (which means low
estimate of one kind and another objects. ), then it is not possible to set high E ( ) .
It should be emphasized that the scoring Conversely, assets with high can create
is standardized measure. Standardizing is E ( ) only if they are positively assessed by
expressed in the fact that its average is 0 and the investor with high Z. And let’s not forget,
the standard deviation is 1, as noted in (2.) this can only be done by an investor which IC
is high.
From the signal f i investor have to extract be applied. The simplest way to apply the
information process is by fitting normal
the information and to convert it into a
regression – (3.)
forecast R i . This process can be done by
several very complicated econometric
methods but also very simple methods could
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(7a.) if E (ri ) 0
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(7a) stands for additional simplification. If we and annualize it. I this way we obtain ri . The
assume that the investors do not based their
results are presented in column 2 of Tabl1.
decisions on other information that
Calculation the score. Actually in our case the
We apply the simple variant of information
factor we use is the recommendation rating.
process to calculate expected alpha for the
The rating system is established by Yahoo
stocks of the 10 biggest Taiwanese companies.
Finance and it presents recommendations for
Our approach is based on several principles: buy/sell from financial analysts. Strong buy
is marked as 1 and strong sell – as 5. We
1. We try to make the process as simple assume that each stock has the same chance
as possible. We believe that academic to be marked from 1 to 5. This assumption
models should be developed in such allows us to fulfill the requirement (2.). Of
way to assist the ordinary individual course, the average score is 3, so, to convert
investors. Usually these investors are
it to Z 0 it is just necessary to extract each
nor armed with high-level statistical
sore from the average score=3. The resultative
tools for taking decisions
scores are presented in column 2 in Tabl.1.
2. We try to keep the process close to
investment intuition. Usually the Calculation the IC. In every attempt the
academic models apply such deep Fundamental law to be applied this has been
quantitative models that sometimes the most difficult part. Usually the authors
the result cannot be understood by the assume some level of IC around 0.1. Our
manager itself. This leads to gap approach is much simpler, but fully reflects
between the results and investor’s the investor intuition. We use the information
intuition. The models gives some provided by Yahoo Finance as Earning
results, investor does not believe in estimated. They publish the following
these results or cannot understand indicator for the 4 previous quarters: EPS
how they have been achieved. estimated, EPS actual, difference between
3. We try to use as input only highly them and surprise. We regard this
accessible public information. information as a representative of the ability
4. We try not to apply complicated of analysts to predict the value of the
calculation tools. company. Whatever model of valuation they
use, the main indicator for their forecasts is
Yahoo Finance web site is used as the only
estimated EPS. If they miscalculated the
source of information. There is nothing
estimated EPS the estimated value of the
special in this site neither we think it is the
company will be miscalculated and their
best source of information. It is just one
recommendation for buy/sell will be not
available source of information among others.
correct. That is exactly what we think it must
We use very few items from this site: historical
be IC. For each quarter we calculate the
stock prices for last year, recommendation
estimated value of the stock by applying the
rating and earnings history. We downloaded
simplest valuation:
the basic information on the 1st of Feb 2017.
EPS actual
Vactual
P/E
The positive or negative side of the diversion
is not important but the absolute value of (8.).
We calculate the average percent of diversion
The difference between estimated value and
for the last 4 quarters (or as many as there is
actual value gives us the information how
available information). This percent we
much the analyst’s evaluation diverse from
subtract from 100 and this gives us ability of
the actual value. This difference as a percent
the analysts to forecast correctly and to
of the Vactual we assume as an indication of IC: produce correct recommendation. We take
this variable as IC i and it is presented in
column 6 in exhibit 1.
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The final result for generated alpha is here is the aquarium expected return which
calculated by the model (7b.). The results are in our case is assumed to be 0.
presented in column 5 of exhibit 2.
Comments on alpha.
References
First, we have to emphasize that our model,
1. Clarke, R., H.de Silva and B. Wander. Risk
according (7b.) involves E (ri ) 0 . That means
Allocation versus Asset Allocation, Journal
that we do not model the stochastic process of Portfolio Management, fall 2002, pp.9-
of return. In other words, these expected 30
alphas are generated based only on one factor 2. Clarke, R., H.de Silva and St. Thorley.
– the recommendation ratings. Because of Portfolio Constrains and Fundamental
that the value of alphas are too high Law of Active Management, Financial
comparing to other studies. Analysts Journal, September/October
Second, the highest alpha we derive for Hon 2002, pp.25-32
Hai Precision. This is company which has 3. Flood, E. Jr. and N. Ramachandran.
been rated by financial analysts higher Integrating Active and Passive
comparing to other companies. It volatility is Management, Journal of Portfolio
not the highest, neither it’s IC. For that Management, fall 2000, pp.10-19
company we can say that the tree elements 4. Grinold, R. Alpha is Volatility Times IC
consisting the Fundamental law are optimal. Times Score, Journal of Portfolio
Management, summer 1994, pp.9-16
Third, the consistence of the alpha –
percentage is given by the stock’s volatility.
The other two elements are only correctors to
that indicator. We may observe that
increasing in volatility decreases the IC. That
is consistent with the normal investment logic
– the less volatile stocks are more precise
evaluated (and as a result – higher IC could
be achieved by analysts).
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