International Capital Markets an der TU München

• It is impossible to outperform the market by deviating from the market portfolio
• A passive investment strategy is the rational decision while minimising costs (e.g. ETFs)
• Active investors underperform due to transaction costs and fees
• BUT: Professional investors make the market efficient by squeezing out every bit of information for analysis

1. Weak form efficiency:
   • security prices fully reflect all information in past prices
   • increase returns through fundamental analysis (not technical)
   • no prediction of future prices by using past ones
2. Semi-Strong form efficiency:
   • security prices fully reflect all publicly available information
   • increase returns through use of insider information
   • markets are at least semi-strong
3. Strong form efficiency
   • security prices fully reflect all publicly available information and insider information
   • impossible to achieve higher returns (--> Passive investments way to go)

• markets are inefficient to an efficient extent
• competition among professional investors makes markets efficient but they are still inefficient to a degree, compensating risks and costs 

--> Investors can beat the market by using economically motivated investment styles

• people are neither rational nor irrational but rather biological entities who's behaviour and features are shaped by the forces of evolution
• subject to behavioral biases and make suboptimal decisions but can learn from past and negative feedback to adapt heuristics
• people have capacity for abstract thinking (forward-looking what if analysis)
• financial markets are driven by our interactions
• survival is the ultimate force driving competition, innovation and adaptation

1. Asset premiums (currencies, FI, Equity)
2. Style premiums (momentum, value, size, high-yield spreads, TERM spread, credit spreads)
3. strategy premiums (momentum, value, carry trading, merger arbitrage, convertible arbitrage)

1. Value investing --> risk premiums + overreaction
   • buying cheap securities
2. Quality investing --> slow price adjustment
   • buying high quality stocks
3. Low-risk investments --> leverage risk premium
   • buying safe stocks and using leverage
4. Carry trading --> risk premiums + frictions
   • buying stocks with high carry
5. Liquidity Investing --> liquidity risk premiums
   • buying stocks with high liquidity risk
6. Trend-following investing --> initial under-reaction + delayed overreaction 
   • buying already increasing stocks

• 3,8% "world market" 1900-2010 (2000-2010 on most markets negative)
• returns between 2,5 - 7,4% (world market 5,5%)

• it is positive and from 1900-2010 it is 0.24
• over last 30 years it is negative

negative

• times of high risk aversion (e.g. crisis) --> bonds and stocks less correlated because investors sell stocks and flee to bonds

positive

• high inflation increases correlation between bonds and stocks (consumption today)

Empirical Evidence:

• Stock market volatility is higher when markets go down
• in periods of high volatility --> stock markets more correlated (vice versa)
• high correlations observed when equity markets go down simultaneously and when real economic activity is shrinking

Implications for investors:

• optimal portfolios are unstable because market parameters are time varying
• bad news lead to higher volatility than good news
• international diversification benefits seem to vanish in those market environments where they are most needed 
• widely used portfolio risk measurements such as VaR or shortfall are affected by asymmetric parameters

a market can be considered efficient if the stock prices always fully reflect the available information