HELLO A

ND

WELC

OME,

LADIE

S AND

GENTLEMEN

EM

S P

RE

SE

NT A

TI O

NS

TOPIC:FUNDAMENTAL INDEXATION ON THE TAIWANESE EQUITY MARKET

Modern Portfolio Theory

Asset Pricing models and evidence

Fundamental Indexation and evidence

Data and Methodology

Results and analysis

Conclusion

BREAKDOWN

MODERN PORTFOLIO THEORYUnderpinned by the Efficient

Market Hypothesis (EMH) and Law of one price

Assumes Investor rationality and near certainty of outcomes

Foundation was laid by Harry Markowitz 1952

Efficient Frontier and Separation Theorem

Capital Asset Pricing Model - CAPM

Developed by William Sharpe 1964

One factor model and assumes Beta is the only risk factor

Has overly simplistic assumptions

E(ri) = rf + βi(E(rm)- rf)Critiques and upside

SECURITY MARKET LINE - SML

OTHER ASSET PRICING MODELS

- Arbitrage Pricing model – APT: Birthed by Ross 1976

Assumes Diversification and based on the law of one price

Introduces other factors but does not specify

them Chen, Roll and Ross (1986)

suggested possible factors

E(ri) = αi + β i1R1 + β i2R2 + β i3R3 + ... + β iRj

OTHER ASSET PRICING MODELS CONT…- Fama and French 3-factor model 1992;1993

Merton was first to introduce a multifactor model – 1973

E(ri) = αff + rf + βm(E(rm- rf) + βHMLrHML + βSMBrSMB

+ εi

- Carhart 4-factor model 1997

E(ri) = αff + rf + βm(E(rm- rf) + βHMLrHML + βSMBrSMB + βMOMrMOM + εi

EMPIRICAL EVIDENCE

Value Effect

Basu (1975:1977), Ball (1978)

Fama and French (1993; 1998)

Auret and Cline (2011), Hodnett, Hsieh and Rensburg (2012) Domestic market

Size Effect

Banz (1981), Reiganum (1981)

Fama and French (1992)

Momentum Effect

Jegadeesh and Titman (1993)

BEHAVIOURAL FINANCE

Based on Prospects Theory and Cognitive Psychology

Investors are risk averse with regards to gains but risk seeking with regards to losses

Takes into account emotions, thoughts and gut feeling in pricing assets

Kahneman and Tversky (1979 )

BEHAVIOURAL FINANCE

BEHAVIOURAL BIASES

Heuristics Simplification and Bounded Rationality

Conservatism Cognitive dissonance Herd Behaviour Overconfidence

FUNDAMENTAL INDEXATION - FIIntroduced by Arnott, Hsu and Moore(AHM) 2005 Rationale? Cap weighting results in a return

drag Noisy Market Hypothesis Uses Fundamental variables of the firm as

basis for investing Holds that fundamental variables are price

insensitive Critiques

EVIDENCE OF FI OUTPERFORMANCE AHM 2005 – US market (1.97pp over

market index & 2.15pp over Reference portfolio)

Hemminki and Puttonen (2008) European Market (1.76pp over market)

Tamura and Shimuzu (2005) and Hsieh, Hodnett and Rensburg (2012)

Estrada (2008) found not evidence of increased international diversification

Arnott and Shepherd (2009) Emerging markets

DATA AND METHODOLOGY

Period of research from January 2003 to June 2014

Data extracted from the Taiwanese Economic Journal database (TEJ) for 1436 stocks

Market index is the Taiwanese capitalisation weighted index (TAIEX)

Variables are adjusted for look-ahead bias, survivorship bias and other possible research biases

DATA AND METHODOLOGY CONT…

Fundamental variables: Book value of equity, Earnings, Dividends and Sales

Three year trailing averages for all variables

Portfolios of the top 50 stocks and Mid-100 stocks for each fundamental variable and also a composite index, as well as the reference portfolio

BASIC RESULTS FOR TOP 50 STOCKS  Market proxy Risk Free rate Reference

PortfolioBook Value

IndexEarnings Index Dividends Index Sales Index Fundamental

Composite Index

Basic Return statistics

 

Arithmetic Return 8.13% 1.30% 5.76% 8.69% 8.59% 7.35%  12.23% 10.70%

Geometric Return 2.77% 0.01%2.17% 4.07% 4.56% 3.60% 8.96% 5.20%

Cumulative Return 1.446 1.0011.335  1.713 1.825 1.613  3.184  1.982

Basic Risks Statistics    

           Standard Deviation  23.68% 0.03%

26.53% 29.92%  27.96%  26.89%  24.68%  27.15%Beta 1 N/A

1.085  1.152 1.112  1.076  1.005 1.060Max. Draw Down -56.26% -

-56,84% -56,49% -54,35% -57,06% -52,94% -56,26%Risk-adj. returns                

Sharpe Ratio  0.289 N/A0.168  0.247  0.261  0.225  0.443 0.346

Treynor Ratio  0.068 N/A0.041  0.064  0.066  0.056  0.109 0.089

Jensen’s alpha - N/A-2.95% -0.48% -0.31% -1.30% 4.06% 2.16%

Information ratio 0.345 N/AN/A  0.302  0.428 0.257  0.852 0.604

M-square 0.00 N/A -0.029 -0,010  -0.007  -0.015  0.037 0.014

BASIC RESULTS FOR TOP 50 STOCKSAll Fundamental indices outperform the

Reference portfolio in terms of arithmetic returns

On average FI outperforms the market and reference portfolios by 1.35% and 3.75% respectively

FIs produce higher standard deviations and betas relative to the market

Apart from the Sales and composite indices, all Fundamental indices produce lower Sharpe, Treynor and M-squared values relative to the market

All Fundamental indices however outperform the reference portfolio on a risk-adjusted basis.

SML FOR TOP 50 STOCKS

0 0.2 0.4 0.6 0.8 1 1.2 1.40

2

4

6

8

10

12

14

Composite

Reference

Sales L12M

Dividends

EarningsBook Value

Market Proxy

Rf: 1.30

Beta

Index Return (%)

BASIC RESULTS FOR MID-100 STOCKS

  Market Proxy

Risk Free rate Reference Portfolio Book Value

Index

Earnings Index Dividends Index

Sales Index Fundamental Compositeindex

Basic Returns statistics                

Arithmetic Return  8.13% 1.30% 9.50% 16.13%  12.53% 13.45% 19.48% 17.85%

Geometric Return  2.77% 0.01% 4.97% 10.84%  8.01% 8.77% 14.90% 12.91%

Cumulative Return  1.446 1.001 1.926 4.011  2.829 3.113 6.520 5.152

Basic Risks Statistics               

Standard Deviation  23.68% 0.03%  29.36%  31.10%   29.02%  29.41%  28.48%  29.86%

Beta 1 N/A1.157 1.171 1.114 1.119 1.084 1.096

Max. Draw Down -56.26% --63,96% -62,37% -59,59% -60,19% -57,26% -59,30%

Risk-adj. returns                

Sharpe Ratio 0.289 N/A0.279 0.477 0.387 0.413 0.638 0.554

Treynor Ratio0.068

N/A0.071 0.125 0.098 0.105 0.162 0.141

Jensen’s alpha-

N/A0.30% 6.73% 3.38% 4.23% 10.51% 8.52%

Information ratio -0.123 N/AN/A 0.664 0,506 0.728 1.537 1.029

M-square 0.000 N/A -0.002 0.045 0.023 0.030 0.083 0.063

BASIC RESULTS FOR MID-100 STOCKS

All FIs outperform the market and Reference portfolio on Arithmetic return basis and risk-adjusted returns.

On average, FIs generate an excess return of 7.76% and 6.38% over the market proxy and reference portfolio respectively

FIs reveal higher risk relative to the market but comparative risks levels with respect to the Reference Portfolio

SML FOR MID-100 STOCKS

0 0.2 0.4 0.6 0.8 1 1.2 1.40

5

10

15

20

25

Composite

Reference

Sales L12M

DividendsEarnings

Book Value

SML: Market Proxy

Rf: 1.30

Beta

Index Return

(%)

DEDUCTIONS

FIs produce higher standard deviations relative to the market possibly due to lower diversification

FIs produce higher active returns as indicated by the positive information ratios

All Fis for Mid-100 stocks are undervalued

Sales and the Composite are the best performing Fis while Book Value shows the poorest performance

PERFORMANCE ATTRIBUTION – CAPM REGRESSION

PANEL A: Top 50 Stocks

ReferencePortfolio

Book Value Index

Earnings Index Dividends Index

Sales Index FundamentalComposite Index

R-Squared[P-value]

 93.85% 0.000

 83.24% 0.000

 88.89% 0.000

 89.89% 0.000

93.07%0.000

 85.66% 0.000

Interceptt-statistics[P-value]

-0.002-1.546 0.124

-0.000-0.141 0.888

-0.000-0.120 0.905

-0.001-0.523 0.601

0.0032.0880.038

 0.002 0.701 0.485

b_Market risk premiumt-statistics[P-value]

 1.085 49.573 0.000

 1.151 28.282 0.000

 1.112 35.897 0.000

 1.075 37.838 0.000

1.00546.5130.000

 1.061 31.007 0.000

PANEL B: Mid-100 Stocks

ReferencePortfolio

Book Value Index

Earnings Index Dividends Index

Sales Index FundamentalComposite Index

R-Squared[P-value]

 81.68% 0.000

 87.97% 0.000

 87.39% 0.000

 87.24% 0.000

 87.22% 0.000

 86.98% 0.000

Interceptt-statistics[P-value]

 0.006 1.641 0.103

 0.003 1.104 0.271

 0.003 1.328 0.186

 0.008 3.330 0.001

 0.000 0.084 0.933

 0.006 2.557 0.012

b_Market risk premiumt-statistics[P-value]

 1.186 26.791 0.000

 1.149 34.305 0.000

 1.160 33.409 0.000

 1.123 33.173 0.000

 1.157 33.146 0.000

 1.175 32.800 0.000

PERFORMANCE ATTRIBUTION

For Top 50 stocks, Excess returns are well explained by the Market risk premium

Only sales produces a statistically significant alpha of 0.3% with t-statistics of 2.088 at a 5% significance level

For Mid-100 stocks, the market risk premium also explains Excess returns but the composite index and dividend index generate a statistically significant alphas of 0.6% and 0.8%, with a t-statistics of 2.557 and 3.330 respectively

PERFORMANCE ATTRIBUTION – FAMA $ FRENCH 3-FACTOR REGRESSION

PANEL A: Top 50 Stocks

  Reference Portfolio

Book Value Index

Earnings Index Dividends Index

Sales Index FundamentalComposite Index

R-Squared [P-value]

83.66%0.000

88.48%0.000

87.79%0.000

87.92%0.000

87.32%0.000

88.16%0.000

Interceptt-statistics[P-value]

0.0072.3710.019

0.0031.2730.205

0.0041.6290.105

0.0093.7650.000

0.0010.3650.715

0.0083.1420.002

b_Market risk premiumt-statistics[P-value

1.29324.7960.000

1.18829.0930.000

1.20528.2770.000

1.18428.8550.000

1.18427.3130.000

1.25329.4150.000

b_SMB (Size effect)t-statistics[P-value

0.3253.8720.000

0.1301.9820.049

0.1371.9920.048

0.1842.7800.006

0.0781.1130.268

0.2393.4830.001

b_HML (Value effect)t-statistics[P-value

0.0751.8900.061

0.0521.6750.096

0.0331.0010.318

0.0321.0310.304

0.0090.2610.794

0.0571.7560.081

PERFORMANCE ATTRIBUTION – FAMA $ FRENCH 3-FACTOR REGRESSIONFor Top 50 stocks, all Fis exhibit significant

loading on the size risk premium but only Sales, Earnings and composite indices display significant value bias

After controlling for style risk, only Sales and Composite index generate statistically significant alphas

For Mid-100 stocks, size risk premium doesn’t satisfactorily explain FI returns except BV and Composite indices

Value effect fails to fit the returns of Mid-100 FIs

PERFORMANCE ATTRIBUTION – FAMA $ FRENCH 3-FACTOR REGRESSION

PANEL B: Mid-100 Stocks

  Reference Portfolio

Book Value Index

Earnings Index Dividends Index

Sales Index FundamentalComposite Index

R-Squared [P-value]

83.58%0.000

 88.95% 0.000

90.09%0.000

93.13%0.000

 94.01% 0.000

 86.31% 0.000

Interceptt-statistics[P-value]

0.0030.8310.407

-0.000-0.120 0.905

0.0000.0220.983

0.0032.0130.046

-0.003-2.107 0.037

 0.004 1.570 0.119

b_Market risk premiumt-statistics[P-value

1.21024.0780.000

 1.120 0.474 0.636

1.11131.6500.000

1.01637.8630.000

 1.053 39.086 0.000

 1.128 27.070 0.000

b_SMB (Size effect)t-statistics[P-value

0.1672.0670.040

 0.029 0.474 0.636

0.1001.7630.080

0.0360.8310.407

-0.088-2.035 0.044

 0.185 2.751 0.007

b_HML (Value effect)t-statistics[P-value

0.0070.1850.853

 0.021 0.705 0.482

0.0050.2010.841

0.0150.7200.473

 0.004 0.186 0.853

-0.008-0.250 0.803

IMPLICATION OF FINDINGS & CONCLUSIONAll Fundamental indices outperform the

reference portfolio and Fis for mid-100 stocks outperform the market portfolio on a risk adjusted basis

The alphas of Fis have a significant loading on the market premium and size satisfactorily explains the alphas of Top 50 stocks

Lower portfolio concentration reduces the influence of size effect in explaining FI returns

Fis generate alphas because of possible size loading in stock selection

Neither value nor size explains the returns of the cap-weighted reference portfolio

THANKS

QUEST IO

NS?