{"id":123802,"date":"2018-02-20T23:50:30","date_gmt":"2018-02-20T23:50:30","guid":{"rendered":"https:\/\/writemyessayfree.com\/investment-and-portfolio-management"},"modified":"2017-08-12T07:48:45","modified_gmt":"2017-08-12T07:48:45","slug":"investment-and-portfolio-management","status":"publish","type":"post","link":"https:\/\/www.benedictsol.com\/blogs\/investment-and-portfolio-management\/","title":{"rendered":"Investment and Portfolio Management"},"content":{"rendered":"
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\n March 20, 2017<\/time>\n <\/div>\n

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Investment and Portfolio Management<\/h2>\n

Investment and Portfolio ManagementEugene Fama from the University of Chicago and Kenneth R. French from the Yale School<\/p>\n

of Management examined the validity of the Capital Asset Pricing Model (CAPM) in a study<\/p>\n

that was published in 1992. The CAPM is the most recognized model to explain stock price<\/p>\n

returns and forms the foundation of Modern Portfolio Theory. Their extensive study showed<\/p>\n

that, at minimum, the CAPM was not a complete explanation of the factors explaining asset<\/p>\n

pricing. Their findings also have some implications for investment performance of growth<\/p>\n

versus value stocks. A summary of their key findings can be found in Rethinking Stock<\/p>\n

Returns. After reading this summary, answer the following questions:<\/p>\n

1) How did the researchers in the article \u201cRethinking Stock Returns\u201d define value versus<\/p>\n

growth stocks? What relevance did their findings have on investing?<\/p>\n

2) What factors did Fama and French examine that may explain stock returns?<\/p>\n

3) The CAPM is built on a single measure of risk that explains asset returns. What<\/p>\n

measures of risk did Fama and French conclude were necessary to explain stock<\/p>\n

returns?<\/p>\n

4) Describe the CAPM model and the Fama and French model and the implications of<\/p>\n

these models for investors.<\/p>\n

5) Finally download an academic paper of your choice from the last five years posted on<\/p>\n

the Financial Economics network of the SSRN website<\/p>\n

(http:\/\/www.ssrn.com\/en\/index.cfm\/fen\/). The academic paper must use the Fama-
French model in its analysis. Provide a 1000 word summary of the objective of this<\/p>\n

academic paper of your choice and the reasons why the Fama-French model was<\/p>\n

used in the paper.<\/p>\n

Rethinking Stock Returns<\/p>\n

New Evidence on Value Versus Growth<\/p>\n

Research by Eugene F. Fama<\/p>\n

Investors generally subscribe to the conventional wisdom that growth stocks outperform<\/p>\n

value stocks. But a study of international portfolios by professors at the University of Chicago<\/p>\n

Graduate School of Business and the Yale School of Management has shown that in reality<\/p>\n

the reverse is true: Value stocks reap higher returns than growth stocks in markets around<\/p>\n

the world.<\/p>\n

\u201cValue Versus Growth: The International Evidence,\u201d a 1997 working paper co-written by<\/p>\n

finance professor Eugene Fama of the University of Chicago Graduate School of Business<\/p>\n

and Kenneth R. French, a former Chicago faculty member now at the Yale School of<\/p>\n

Management, argues that the conventional wisdom is wrong. Speaking about growth stocks,<\/p>\n

Fama says \u201cpeople think because these are good companies, their stock returns will be<\/p>\n

high. But in fact, their prices are pegged so high by the market that their returns actually tend<\/p>\n

to be low.\u201d<\/p>\n

Fama and French define value stocks as those stocks that have high ratios of book value to<\/p>\n

market value and growth stocks as those that have low ratios of book value to market value.<\/p>\n

\u201cThe intuition is that value stocks have low prices relative to their book value, so the market<\/p>\n

feels they\u2019re relatively distressed,\u201d says Fama. \u201cThe intuition is the opposite for growth<\/p>\n

stocks.\u201d<\/p>\n

Fama and French reached their findings in the process of examining the validity of the<\/p>\n

Capital Asset Pricing Model (CAPM) and other asset pricing models. For 20 to 30 years,<\/p>\n

CAPM has been touted in business schools as a means of describing the relationship<\/p>\n

between expected return and risk in stocks.<\/p>\n

Seeking to test the validity of CAPM, Fama and French in 1992 examined the variables \u2014<\/p>\n

price-earnings ratios, firm size, book-to-market equity and leverage \u2014 that research had<\/p>\n

determined to be related to average returns.<\/p>\n

\u201cWhat we found was that size and book-to-market equity picked up all the variation in returns<\/p>\n

that could be explained by the other variables, including the beta (sensitivity to the market<\/p>\n

return) of the CAPM,\u201d recalls Fama. \u201cOne implication of that finding was that CAPM couldn\u2019t<\/p>\n

possibly explain all the variation in expected returns. It says that you only need one measure<\/p>\n

of risk, and that\u2019s the sensitivity to the market return.\u201d<\/p>\n

Having shown CAPM doesn\u2019t work, Fama and French went on to examine multi-factor<\/p>\n

models that allow many different sources of risk to impact expected returns.<\/p>\n

\u201cIf you want to explain average stock returns, we found you need three measures of risk,\u201d he<\/p>\n

says. \u201cThose measures are sensitivity to the market return and two other measures: a<\/p>\n

measure to distinguish the risks in small stocks versus big stocks, and a measure to<\/p>\n

distinguish the risks in value stocks versus growth stocks.\u201d<\/p>\n

In papers published since then, Fama and French have tested that theory to determine<\/p>\n

whether it holds up. \u201cWe tested it first on U.S. stocks and found that the theory holds up<\/p>\n

pretty well in domestic portfolios,\u201d he explained. \u201cIn this report, we looked at international<\/p>\n

stocks as well. We looked at 13 countries, the U.S. among them, and found that again the<\/p>\n

theory worked well. The data base allowed us to look only at big stocks, so we couldn\u2019t test<\/p>\n

the size measure. But the measure of value versus growth holds up.\u201d<\/p>\n

Fama and French discovered that what was needed to explain average returns in this set of<\/p>\n

large international stocks was a market risk factor and a value-growth risk factor. The market<\/p>\n

risk factor is the return on an international market portfolio of stocks, and the value-growth<\/p>\n

factor is the difference between the return on an international portfolio of high book-to-
market stocks and the return on an international portfolio of low book-to-market stocks.<\/p>\n

The implications for investors are that, first, the CAPM gives \u201ctoo simplistic a view of the<\/p>\n

world,\u201d says Fama. \u201cThere are at least two additional dimensions of risk that get rewarded in<\/p>\n

average returns. And that\u2019s true in both domestic and international portfolios of stocks.\u201d<\/p>\n

A second implication for investors is that value stocks have higher returns than growth<\/p>\n

stocks in markets around the world. Looking at book-to-market equity, Fama and French<\/p>\n

found that value stocks outperformed growth stocks in 12 of 13 developed countries from<\/p>\n

1975 to 1995, and that the difference between average returns on global portfolios of high<\/p>\n

and low book-to-market stocks was 7.6 percent per year. Furthermore, when earnings-to-
price, cash flow-to-price and dividend-to-price were examined, the value premium continued<\/p>\n

to be evident.<\/p>\n

Eugene F. Fama is the Robert R. McCormick Distinguished Service Professor of Finance at<\/p>\n

the University of Chicago Graduate School of Business.<\/p>\n

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