Modern Capital Market Theory and Its Imp

慎思

Modern Capital Market Theory and Its Implications for Investors

By Michael Wu

Modern capital market theory was developed initially by Harry Markowitz in 1940s.  The central concept of the capital market theory is to minimize investment risk of a portfolio by diversification. According to the capital market theory, a portfolio has two types of risks.  One is the systematic risk and the other is the unsystematic risk.  The systematic risk is related to the market factors such as business cycle, interest rate, inflation rate, yield spread of long and short term government bond, etc.  The systematic risk cannot be diversified away.  The unsystematic risk is related to specific securities and their capital structure, size, operation, and industry.  The unsystematic risk can be diversified away by establishing a portfolio with adequate number of securities with low correlation.

According to modern capital market theory, investment managers should identify investor’s investment objectives and risk tolerance, liquidity requirements, legal constraints, etc., and then set up a diversified portfolio to meet the needs of the investor.  An adequate investment portfolio should consist of three types of asset classes: (1) cash and cash equivalents; (2) bond and other fixed income products; and (3) equity.  (Note: A broadly defined investment portfolio also includes real asset class.) The allocation of different asset classes should be identical to the investor’s objectives and risk tolerance.  If the client’s risk tolerance is very low, the majority of the portfolio should be allocated to cash, bond and other fixed income class.  If the client’s risk tolerance is at medium level, investment portfolio could have slightly higher proportion of holding in equity.  If investor’s risk tolerance is at high range, then the proportion of equity can be further increased.  After the allocation of asset classes, investment managers will select specific securities products in order to achieve adequate return and diversification. While selecting bonds, investment manager will pick government bonds or high quality corporate bonds with credit rating above A from different sectors for investors with low risk tolerance.  While selecting stocks, investment manager will pick stocks from different industries and sectors in order to achieve adequate return and diversification.  While selecting different securities products, investment managers will pay special attention to the correlation of the return of different securities products.  By adding more stocks with low correlation, investment managers could obtain diversification.  If the correlation of stocks is high, it will be difficult to achieve diversification.  For example, if all the stocks in a portfolio are high tech stocks whose correlation is high, no matter how many stocks are included, there will be no adequate diversification and the portfolio will be vulnerable to the fluctuation of high tech industry.  Some studies indicate that a portfolio with 12 to 18 stocks with low correlation can fully diversify the unsystematic risk of a portfolio.  Other studies indicate that the number of securities in a portfolio should be 30 in order to fully diversify the unsystematic risk.  Asset allocation is the dominant factor in portfolio performance.  Some studies indicate that 90% of the portfolio performance is attributable to asset allocation and the remaining 10% of the portfolio performance is attributable to market timing and some other factors.  

After establishing an optimal portfolio for clients, investment managers will have to monitor and evaluate changing market expectations as they affect the risk return expectation of the assets in the clients’ portfolio.  Investment managers will also have to monitor the client’s needs and circumstances.   Then, investment managers will have to rebalance client’s portfolio when changes are necessary.  

According to modern capital market theory, investment managers should follow the prudent investor rules to take care of their clients.  Under the prudent investor rules, with the permission of investors, investment managers can use derivative products such as options to manage risk of a portfolio.  The use of the derivative products was deemed as speculation by the old investment theory.   The evaluation of the performance of an investment manager is also very different under the modern capital market theory than the old capital market theory.  It is the performance of a portfolio not the return of an individual securities that is evaluated.  

Aside from diversification and portfolio management, the modern capital market theory also includes efficient market hypothesis (EMH).  There are 3 types of EMH.  The first one is the weak-form efficient market hypothesis.  It assumes that current securities prices fully reflect all currently available security market information.  The weak form assumes that the current price of a security already reflects all the currently available (historical) market information.  Thus, past price and volume information will have no relationship with the future direction of security prices.  If the weak form of the EMH holds, then investors cannot achieve excess returns using technical analysis (e.g. charting).  Tests of statistical and trading rules support the weak form EMH, indicating that investors cannot get extra profit by using technical analysis. It must be noted that in practice, there are many technical experts who compile and track different technical indicators.  Many investors also use those technical indicators to guide their investment decision.  Whether or not they are effective, it is much debatable.  Perhaps, technical analysis can help in the short term.  However, the test result disputes the weak form EMH, that is, technical analysis does not work.

The second EMH is Semi-strong Form EMH.  It assumes that security prices adjusts rapidly to the release of all new public information.  Thus, current securities prices fully reflect all public information.  The semi-strong form says security prices include all market and non-market public information available, such as earning and dividend announcement, economic and political news, etc.  If the semi-strong form of the EMH holds, then investors cannot achieve excess return using fundamental analysis.   Empirical evidence most supports the semi-strong EMH though there are some anomalies:
·        Studies show that dividend yield, default spread, and term structure can be used to predict stock and bond returns in the long run.  
·        Studies of quarterly earnings indicate that the markets have not adjusted stock price to fully reflect the release of quarterly earnings surprises as fast as would be expected based on semi-strong EMH. As a result, it appears that earnings surprises can be used to predict returns for individual stocks.
·        The January anomaly shows that due to tax induced trading at year end, an investor can profit by buying stock in December and selling them through the first week in January.  
·        P/E tests indicate that low price-earnings ratio stocks experienced superior results relative to the market, while high P/E ratio stock have significantly inferior results.  
·        The size effect indicates that small firms consistently experienced significantly larger risk-adjusted returns than larger firms.  This is called small firm effect.
·        Tests of the small firm effect also found that firms that have only a small number of analysis following them have abnormally high returns.  These excess returns appear to be caused by the lack of institutional interest.
·        Studies show that the greater the ratio of book value/market value, the greater the risk adjusted rate of return.  

As a result, there are limited opportunities for investors to earn extra profit by using fundamental analysis.  Investors could make extra return if they can estimate the relevant variables that cause long-run trends in the variables that relate to value.  It is also possible to achieve above average performance by selecting stocks that are neglected by analysts, have high book value/market value ratios, and are small market capitalization firms.  
In addition, investors can use earning surprises to earn extra return.

The third EMH is the Strong Form EMH.  It assumes that stock prices fully reflect all information from public and private sources.  The strong form includes all types of information: market, non-market public, and private (inside) information.  This means that no group of investors has monopolistic access to information relevant to the formation of prices.  If the strong form of the EMH holds, then no group of investors should be able to consistently achieve excess returns.  The strong form assumes there exist perfect markets.  However, some evidences do not support the strong form EMH.  First, some researches indicate that corporate inside purchaser have made above average profits.  Other tests show that public traders tracking the purchases of insiders via SEC filings were able to make excess returns.  Second, studies indicate that stock exchange specialists have monopolistic access to information in the limited order book.  Tests show that specialists derive above average returns from this information.  Third, changes in the Value Line rankings appear to be significant.  Also studies of the “Heard on the Street” column in The Wall Street Journal show that stocks have a significant price change on the day they appear in the column.

I personally believe that capital market is efficient in the long run, as indicated by the results of the empirical tests of the efficient market hypothesis.   However, there are some cases where information is not rapidly transferred into prices.   Investors could benefit by taking advantage of these cases via market timing. In practices, investors could also use technical analysis tools to help them make investment decisions.  However, investors should note that based on empirical study of EMH, no technical trading system that depends only on past trading data can have any value.  The implication of the fundamental analysis is not much better.  However, investors could benefit from certain anomalies, such as anomalies related to earning surprise, low P/E, low BV/MV, small size effect, and etc.  Investors could also earn extra profit if they can estimate the relevant variables that cause long-run trends in the variables that relate to value.  Overall, based on modern capital market theory, investors should pay special attention to asset allocation and diversification that are the dominant factors in portfolio performance.

Reference:  This article is written based on Schweser Study CFA Note and Canadian Securities Institute’s textbook “Portfolio Management Technique”.

(Author: Michael Wu is an investment advisor of HSBC Securities (Canada) Inc.  He holds a Canadian Investment Manager designation and an MBA from the University of Western Ontario and a PhD in Economics from Nankai University.  Tel: 416-756-2298; Cell: 416-274-8978.)

General Disclaimer
This article is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment.  HSBC makes no guarantee, representation or warranty and accepts no responsibility or liability as to its accuracy or completeness.  HSBC Securities (Canada) Inc. is a wholly owned subsidiary of, but separate entity from, HSBC Bank Canada, Member CIPF.