Tag Archives: ideas

Identifying Alpha With The Capital Asset Pricing Model: An Example In Dr Pepper Snapple

The Capital Asset Pricing Model (CAPM) is a tool that can be used to identify whether a stock can potentially generate alpha based on its risk-return characteristics relative to the market index. For instance, suppose that we have a stock that returns 5 percent annually where the market index returns 7 percent. Given a high risk in terms of beta (discussed further below), the CAPM would argue that this stock is a non-alpha stock; since the return generated does not compensate an investor for the given risk. On the other hand, suppose that the stock now returns 10 percent while the market index returns 7 percent. Additionally, the stock has very low risk meaning that the risk of a lower return is, well, very low. This type of stock is said to generate alpha returns – it compensates an investor above and beyond that which they should be entitled given the risk and return on the market index. Parameters Average Daily Return vs. Expected Return: The average daily return shows the actual percentage daily return of each company over the given time period; this is the benchmark that we use against the expected return (the return that the CAPM says we should receive for holding the stock) to determine if a stock is undervalued or overvalued. The expected return is defined as the risk-free rate plus the product of the company’s beta and the average daily market return, i.e. Risk-free rate + ß(Average Daily Market Return) = Expected Return. If the stock lies above the Security Market Line, it is undervalued. If it lies below, it is overvalued. Beta: This figure tells us how volatile a company’s price is relative to its market index. In this case, a company with a beta of less than 1 is less volatile than the S&P 500 Index; a company with a beta of greater than 1 is more volatile than the S&P 500 Index. R-Squared: The R-Squared figure indicates the degree of the company’s returns that can be explained by the market return, e.g. a company with an R-Squared of 100% means that 100% of the company’s returns are “explained” by the market. Conversely, a company with an R-Squared of 0% means that none of the company’s returns can be explained by the market return. Jensen’s Alpha: Jensen’s alpha indicates the excess return generated by a stock over its expected return according to the CAPM. If a company has an average daily return greater than the expected return, then the excess return is defined as Jensen’s alpha. An Example of Dr Pepper Snapple Group ( DPS ) Companies Coca-Cola PepsiCo Dr Pepper Market Daily Return -0.04% -0.04% -0.04% Company Daily Return -0.04% -0.02% 0.06% Beta 0.64 0.75 0.74 R-Squared 45.39% 56.29% 39.66% Intercept -0.00018 0.00006 0.00082 Expected Return 0.02% 0.01% 0.01% Jensen’s Alpha -0.06% -0.03% 0.04% Valuation Non-Alpha Non-Alpha Alpha With data run over a one-year period (November 2014 to November 2015), we see that of the three companies, only Dr. Pepper shows alpha returns of 0.04%. This means that the average daily return of the company is 0.04% higher than what is required to compensate the investor for the risk of holding the stock. Moreover, we see that the company has the lowest R-Squared of the three companies, which means that only 39.66% of the company’s returns are attributable to the returns on the market index; the rest are unrelated to the market. Additionally, with a beta below 1, Dr. Pepper could be considered an ideal low-risk alpha stock on the basis of its past returns. Conclusion An obvious limitation of the Capital Asset Pricing Model is that it is backward looking and cannot predict the future. Nevertheless, it is extremely useful in the sense that it allows us to analyse other fundamental factors taking past returns into account. While past returns cannot predict future returns, understanding a stock’s return characteristics allows for a very handy guide in making investment decisions. Original source .

Global Rout To Start 2016

Below is a look at our trading range screen for the 30 largest country ETFs traded here in the U.S. As shown, just 3 of 30 are NOT in oversold territory after today’s sell-off. And three of the biggest countries – Germany (NYSEARCA: EWG ), Japan (NYSEARCA: EWJ ) and the US (NYSEARCA: SPY ) are the most oversold of the bunch. Nine countries are starting the year down more than 3%, and twenty-one are more than 5% below their 50-day moving averages. The three countries that aren’t oversold are Australia (NYSEARCA: EWA ), Colombia (NYSEARCA: GXG ) and India (NYSEARCA: PIN ).

A Fund Selection Case Study

Recently, we received an inquiry as to why we did not use more Fidelity funds for the 401(k) plans that we manage. Specifically, we were asked why we did not include the Fidelity Select Biotech Portfolio (MUTF: FBIOX ), which has done well recently. We’ve written about how to select securities , but in this article, we are going to apply those principles to the process of selecting a specific fund for a specific sector of the economy . The decision is which fund we should select to represent healthcare. We use the Vanguard Health Care Fund (MUTF: VGHAX ), which is comprised of 82 different stocks. FBIOX is made up of 262 holdings. This measure would favor the Fidelity fund. Having more holdings is a sign of diversification for the fund. There is no such thing as over diversified , more holdings is better. For both of these funds, the top ten holdings of each fund represent 41% of the fund’s assets. This is not as diversified as it could be, but they are comparable in this way. Foreign stocks represent about 10% of FBIOX and about 20% of VGHAX. Neither of these percentages matter to our definition of the Healthcare sector, but if we were specifically targeting or avoiding foreign stocks with the sector, it would be relevant. Both funds have a 14-year track record. Fourteen years may seem long but is still an insufficient time period for long-term investing statistics. Even the S&P 500 is flat or down for a decade about 6% of the time. The fact that both healthcare funds more than doubled the return of the S&P 500 over this time period is not an indication that they will perform this way going forward. With those caveats in mind, here is how each fund performed. VGHAX had a better return over the fund’s histories. The return was both smoother and superior. A $10,000 investment in VGHAX grew to $45,335 vs. $43,435 for the Fidelity fund. Click to enlarge We specifically do not use how many Morningstar stars a fund has received. Morningstar themselves have done the analysis to show that selecting funds with low expense ratios is a better method of predicting superior future performance. The Vanguard fund has an expense ratio of 0.29% while the Fidelity fund has an expense ratio of 0.74%. This 0.45% difference in expense ratio is a hurdle that the Fidelity fund has to work to overcome. Yet when you compare the average annualized return of the two funds, it appears that the Fidelity fund has simply underperformed the Vanguard fund by the difference in expense ratios. Click to enlarge A final measurement is to see if the Vanguard fund had a superior return by taking additional risks. Risk is usually measured by measuring the standard deviation of annual returns. For the Vanguard fund, the standard deviation of its annual returns was 15.34% while the Fidelity fund’s standard deviation was 22.75%. Click to enlarge The Fidelity fund’s greater volatility is probably a result of having a larger percentage of its investments in mid and small-cap funds. The Fidelity fund has 47% of its holdings in large cap funds while the Vanguard fund has 89% in large cap. Mid and small-cap companies exhibit greater volatility even when you are diversified among hundreds of smaller holdings. Even though these two funds have very similar long-term returns, in the short term, they can be very different. Every month the delta between the return of each fund can be 10% or more in either direction. Here is a graph showing how much VGHAX outperformed or underperformed FBIOX each month. Click to enlarge We do look at a fund ranking system put out by the Center for Fiduciary Studies at fi360.com . Fi360 ranks funds from zero (best) to 100 (worst) within each sector. VGHAX has a three-year average ranking of 10, and FBIOX has 26. One of the fi360 criteria is that the fund’s Sharpe ratio must score in the top 50% of its peer group. Sharpe ratio is a measure of the historical return per amount of risk taken. The Fidelity fund scores poorly for having taken additional risk but not achieve a sufficient return to justify the risk taken. Other criterion used by fi360 include having 80% of its assets actually being invested in the target sector or style, a three-year track history, 75-million under management, and most importantly a relatively low expense ratio. These criteria provide a simple short example of how we go about fund selection and why we selected VGHAS over FBIOX for the 401(k) plans we manage.