Chapter 7 INVESTMENT MATHEMATICS ‘Tastes techy mee ware einen tures presented earlier will be examined in greater detail and some new ones will be introduced. However, thi describe and demonstrate some mathematically ased approaches, to whet your appetite for analysis of funds closer to home isnot a mathematical treatise! This chapter aims t0 ‘The arithmetic of indices We have already covered the general nature and use of indices and introduced the necessary terminology of base dates and price relatives. At times during the life ‘of an index, it becomes necessary or desirable to re-base it, possibly hecause the stat: date is so Tong, ago that the present levels are too high to provide meaningful com- parisons. Re-basing requires election of a new start date and a fresh calculation by ceference to a selected base that date ‘numbe ‘The three most common ways of constructing an index are arithmetic, geomettic and weighted arithmetic. Remember that an index measures oF reflects average price changes over time. The differences between these three types of index lies in the way they treat or ignore the size or volatility of individual constituents. ‘Simple arithmetic index ‘This is constructed as: Sum of prices at the current date ‘Sum of prices at the base date * Bese number6f, in more mathematical terms: Prices. Index.g Pic Base number x 1 the simple aggregate of prices of each share contained in the index at I January is £1,234 and at 31 December the aggregate is £1,345, we ean choose I January as our base date, select 1,000 as our base number and express the 31 December index to be: 1345 1 1,600 = 1,090 Examples of simple arithmetic indices are the Dow Jones Industrial Index and the Nikkei Stock Average. Geometric index This is constructed by multiplying together the current price divided by the base dite price of each constituent share, taking the nth root of the answer [where zn=number of shares in the index) and multiplying the base number by this root. ‘The mathematieal expression is TRS) 2 sae ‘Geometric indices are less sensitive to price changes of a single constituent share, but suffer from the flaw that if one share becomes valueless, the index becomes zero. Generally, they underestimate the performance of 136 _AN INTRODUCTION TO FUND MANAGEMENT ‘constituents and are not secommended for performance ‘measurement, An example is the FT Ordinary Index of 30 industrial shares, ‘Using base number 1,000 and the following data: Share Price at Cureent Ratio base date price A 36 » 1.08: B n7 158 124 e 95; 90 095 D 260 300 115 ‘Totals sis 587 1a7 the arithmetic index calculations produce an index at the current date of 587 31,000 138.2 ‘The geometric index calculation is: TAT » 1,000 = 1,101 Weighted arithmetic index ‘This is calculated like the arithmeti index, but uses the ‘market capitalisation of constituent shares instead of share prices. Consequently, it places extra weight on those constituents that are larger companies. It is to be preferred over a simple arithmetie index, both asa guide to market behaviour and as a performance benchmark, because it removes the misleading consequence that @change in the price of a small company’s share has an ‘equal effect on the simple index as the same change in the price of a large company’s share. Examples are the FTA All Share, the FT-SE 100, the ‘SAP 500, each of which is an example of a Laspeyre Index - i, an index which ignores any capital changes and retains the base date weightings. An index which is re-based for capital changes ~ ic, to current weights at the time ofthe change ~is a Paasche Index. Each index is named after its creator. Indices provide useful benckmarks for actual or absolute retums, but what about volatility? Standard deviation To remind you, standard deviation is a measure of dis persion of values around their own average and can be applied to returns, prices, ages and almost anything, else that is meaningful to measure! The steps in calculating the standard deviation of a given set of data are: 1, Determine the arithmetic average, or mean, 2. Determine the individual differences from the mean lignoring plus or minus), 3. Square each of the differsnces. 4. Sum the squares. 5. Divide the sum by the number of constituents (less 1 ifthe set is not complete —ie., itis a sample, 6. Take the square root to -eturm to the required unit. 138 __AN INTRODUCTION TO FUND MANAGEMENT Because the calculation is usually backwand-looking, ‘when applied to investment situations, st is known as the ex post standard devistion and measures risk in terms of the volatility avaching to the item being ‘measured. Large swings around the average for any single item whose values are measured at successive ‘time intervals will produce a high standard deviation and indicate high volatility and, hence, risk, Ie isa fact that a minimum of ewo-thirds of values will fall within 41 SD and 95% within £2 SDs. 99% of values will fall ‘within £3 SDs, and this is usually depicted by a bell curve, so-called because of its shape (Figure 7.1). The vertical axis is more properly called the ‘probability density function’. igure 7.1, Distlluion of vances. ‘A more sophisticated risk-adjusted rate of return is given by the Sharpe measure, which compares the portfolio returns measured at successive intervals with the retums from a selected risk-free asset for the same intervals, The latter is subsracted from the former and the answer divided by the standard deviation of theportilio retums. The higher the resulting figure, the Detter, because either the fund is performing better than the risk-free asset or the standard deviation is low, indicating low volatility, or, possibly both. For example: Fund A Fund B Return 1% 10% Standard deviation 3% 4% Interest rate on gilt 4% 4% Sharpe measure (10-4)/3=2 (10 4)/4=15 In chs simplified example, Fund A has the higher Sharpe ‘measure and, therefore, is ty be preferred over Fund B. Capital Asset Pricing Model ‘The Capital Asset Pricing Model (CAPM) combines ‘much of what has been discussed to this point, but uses a refined approach to risk assessment, in an effort to predict the behaviour of portfolios under given con- ditions at particular times and to assist in fund or stock selection to maximise returns, It was developed by academies out of the so-called ‘Modern Portfolio Theory, which emerged circa 1960. Although much-maligned in the UK, it remains very popular in the USA, largely because of the simplicity ofits predictions. Detractors claim that this simplicity thas been achieved at the expense of a realistic view of the actual workings of markets. 1M0_AN INTRODUCTION TO FUND MANAGEMENT Assumptions and conclusions ‘The assumptions of CAPM are what cause the sceptics ‘most dificuley. They are that: ‘The market is perlectly competitive, ‘There are no tax considerations ‘There are no dealing costs. All investors agree on: ©. the investment perio 9 the return expectations (ER) ©. the standard deviation of al assets ‘© Investors can all borrow/lend at the same risk-free rate (Ry) ‘The conclu Wn is given the title The Security Market Line (SML) and introduces @ measure known as the CAPM Beta Coefficient, which can be developed for a portfolio and also for individual shares as a measure of the systematic component of risk, ‘The expression for the SME is: Ryne = Ry + {ER mares ~ Rj) This last bracketed expression is the Market Risk Premium (MRP) ~ ie, the difference between the ‘expected return on the market and the return from a risk-free asset. The difference between the expected retum on the portfolio and the risk‘ree retum is termed the Portfolio Risk Premium (PR?)INVESTMENT MATHEMATICS ua [Re-arranging the terms of this expression, we find ths _ pee ~ Re ‘igure 72. Market and porulio sik premiums. and to illustrate [Figure 7.2! PRP i MRPs 1375 ‘The Beta coefficient is calculated as the covariance of ‘the retum on the portfolio and the return on the market, divided by the variance of the retum on the market. Covariance is a mathematical term for the extent to which two variables move in sympathy. Variance is the square of the standard deviation. Caleulations are beyond our scope! If the portfolio returns move in an identical fashion to ‘those ofthe market, the co-variance will produce a Beta of 1. A Beta greater than 1 denotes an asset that is more risky than the market as a whole, and a Beta less than 1 denotes an asset that i less risky —Le,, the return (or the 142__AN INTRODUCTION TO FUND MANAGEMENT shate price] vaties more or less proportionately to the retum on the market (or the market index of prices). Creating portfolios using CAPM Portfolio Betas are calculated as the market value ‘weighted average of the Beras of the individual stocks ‘comprising the portfolio. The CAPM, ot more precisely the CAPM Beta coefficients, can be used to create portfolios to suit specific risk profiles. For example, ‘trustees of a pension fund with members nearing retire. ‘ment would want a portfolio with a low Beta, whereas a ‘younger, more adventurous investor could specify a high Beta, A further example might be that of an ethical investor deciding on the percentages he should hold of twa particular shares with Betas, respectively, of 1.5 and (06 in order to give a combined Beta of 1, To calculate ‘the answer requires facility with simultancous equations: Let x% be invested in Share A and y% in Share Bs 100% xty and the desired result is for: ‘Multiplying the first equation by 1.5 and subtracting the second equation we establish that 0.9y = 50 and, there- fore, y= 55.6 and x—A4.A, Rounding gives the split required of 56% in Share A and 44% in Share B.INVESTMENT MATHEMATICS Another application of the CAPM is in stock selection, using its prediction that over time or all other things being equal, all assets or portfolios should plot on the SSML (Figure 7.3) Sey et : gure 73 CAPM pedictions “The assets position on the chart is a function of both its retum and its Beta. Given that return is calculated as known or expected eamings divided by current price, ‘CAPM predictions mean that A’s price must rise for its retum to plot on the line, whereas B's price must fall so that its return is increased to plot on the line. ‘Treynor and Jensen measures ‘These are two further measures of risk-adjusted returns, which utilise CAPM Bets and, unlike the Sharpe ‘measure, assume that unsystematic risk in a portfolio is eliminated by the large number or spread of holdings. ‘This diversification permits the premise that only systematic risk remains ie, the general risk of the ‘market [Figure 7.4. AN INTRODUCTION TO FUND MANAGEMENT. Figure 74 eet of spread on risk ‘The Treynor measure is that of the portfolio's excess retum over its Beta and can be expressed as: (Byte — Ry) Spare Using the earlier data of Fund A and Fund 8, if their respective Betas were 1.5 and 09, their ‘Treynor ‘measures would be calculated as follows: Fund A Fund ao- 4/15, (0 4)/09) 4.00 667 According to Treynor, Fund 8 now gives the better value, as its risk-adjusted rate of rem is higher chan Fund A's. ‘Whether Sharpe or Treynor provides the better measure is a matter of taste - Sharpe ignores market performance and selects according to the volatility of the asset’s or portfolio's own risk premium ~ i.e, PRP/SD, whereas ‘Treynor selects according to the relationship of the PRP to the MRP. Both can be shown to be the gradientINVESTMENT MATHEMATICS of a line from the risk-free ate of return to the point of intersection of the actual rortflio return and its risk, ‘measured by Sharpe in standard deviations and by ‘Treynor as Beta. The steeper the gradient the better. ‘This is illustrated with Fund A in Figure 7.5. Pigae 75. Sharye and Treynor measures ‘The Fensen measure utilises a benchmark portfolio with an identical Beta to the fund's portiolio, The difference in returns of the two porticlios is then taken to be the ‘measure of the manager's skills [or otherwise] as an Sometimes known as the Jensen Alpha’ the generalised expression is simply Ryo ~ Rsentmuct- The higher the answer, the greater i the manager's skill, A straight: forward example of its application isa calculation of the ‘tacking error of an index fund, but ‘alpha’ is a measure ‘widely favoured by fund managers to show how well they have beaten their benchmark.