Making Investment Decisions Based on Data, Part 1: The Sharpe Ratio

PERSONAL FINANCE 101

We have learned from several past posts (like this) that returns and risk are two of the most important factors (some say the only factors) that investors should consider in evaluating available investment instruments. Returns are funds in excess of the invested amount (e.g., dividends, capital gains, interest) received by investors at some future date; the percentage return of an investment is the return divided by the invested amount. Risk is defined in many ways, most often as the chance for an investment loss or the volatility of investment returns and is commonly measured using statistics like variance or standard deviation. In this post and the next, I will show you how to apply these concepts on actual data and choose between investment alternatives objectively.

Computing for expected return and risk

The first step, of course, is to actually get data. I've looked long and hard for "free" sources of historical UITF NAVPUs, to no avail. Then I asked one of our readers, Max (who asked a question via email about asset allocation) if she could ask for historical NAVPUs from BDO, with whom she has a UITF account. BDO did give her historical daily NAVPUs of their equity and fixed income funds, but these came in the form of screen caps so I spent a good part of the day typing the data into Excel. I am now verifying with my contacts from BDO and BPI if they can provide current and potential clients with historical NAVPUs to perform data analysis with. And while we're waiting for their response, I guess this typed-in data set will have to do (download this Google spreadsheet as an Excel file).

Then, prepare the data by computing for the percent change in daily NAVPU. Divide the NAVPU on a particular day by the NAVPU of the previous day; do this to both funds on all days (except on the earliest date, January 2, 2012).

We get the expected return of each fund by computing for the geometric mean (we have learned from this post that it's more appropriate to use the geometric mean than the arithmetic mean for investment returns), for which we can use the GEOMEAN() function of Excel. For risk, we compute for the standard deviation of the daily % changes using the STDEVP() function. The results you get should be as follows (subtract one from the GEOMEAN results and apply the percentage format to all numbers):

	Equity fund	Fixed income fund
Expected return	0.1234%	0.0211%
Risk (standard deviation)	0.9444%	0.1414%

If you can choose to invest in only one of these two funds, which would you choose? While the equity fund has a higher expected return than the fixed income fund, its higher standard deviation indicates a greater possibility for a loss. This relationship illustrates the trade off between return and risk.

The Sharpe Ratio

To be able to evaluate the funds objectively taking in both return and risk, we can use a simple form of the Sharpe Ratio (named after William Sharpe, a Nobel Prize-winning economist and one of the proponents of the Capital Asset Pricing Model), which essentially just measures return for every unit of risk. In our example, we get the Sharpe Ratio by dividing the expected return of each fund by the standard deviation; intuitively, the investment with the higher Sharpe Ratio--the one with the "bigger bang for the buck"--is better. So which fund is it?

So far, we have seen how we can use data in choosing between two investment alternatives, taking both expected return and risk into consideration. Some of you may have noticed that this situation is simplified since it's always possible to invest in both funds simultaneously. In the next post, we will explore how we can use the data that we have and some of the concepts we have learned in this and prior posts to construct an "optimal portfolio"--the best combination of the two funds that may even be better than each individual fund, all thanks to the magic of diversification.

UPDATE 10:12 PM

My friend from BPI Trust kindly pointed out that historical prices of BPI funds as far back as 2005 are available on their website. You can try applying the procedure discussed in this post to some of BPI's funds. Since as rule bigger data sets lead to more reliable results, in Part 2 I will instead use BPI's data to illustrate optimal portfolio allocation.

UPDATE 02 AUG 2012

UITF.com.ph is a more complete source of historical NAVPUs. Thanks to reader Ace for sharing this with us.

Four Types of Industry Structure

If you're an aspiring business person, the level of competition is one of the most important things that you should look at in choosing a business or market since more intense competition among players in an industry typically results in lower profit margins; the reason why astute business persons like MVP aggressively seek dominant market positions and less competition is to be able to have greater control over pricing and profits. 

Industry or market structure is primarily defined by the number of competing firms or sellers, and to a lesser degree, the types of products offered by the firms. In this post, I will discuss four main types of market structure; hopefully, this post will be able to help you better evaluate businesses that you are thinking of pursuing in the future.

Number of firms	Type of product
	Identical products	Differentiated products
One firm	Monopoly	-
Few firms	Oligopoly
Many firms	Perfect competition	Monopolistic competition

1. Perfect competition

A perfectly competitive market has the following characteristics:

• There are many buyers and sellers (i.e., firms) in the market
• The goods offered by the various sellers are largely the same
• Firms can freely enter or exit the market

Because of these characteristics, the actions of any one buyer or seller in the market would have very little impact on the market price and firms just take price as given. Also, in perfectly competitive markets prices and margins tend to be low since, in theory, the only way for a seller to attract more buyers and generate more sales is to reduce prices (particularly if there's no effective way of using marketing strategies to differentiate the product).

2. Monopoly

A firm is considered a monopoly if

• It is the sole seller of its product
• Its product does not have close substitutes

The fundamental cause of a monopoly is barriers to entry. Barriers to entry have three primary sources:

• Ownership of a key resource. Although exclusive ownership of a key resource is a potential source of monopoly, in practice monopolies rarely arise for this reason.
• The government gives a single firm the exclusive right to produce some good (or render a service). Governments may restrict entry by giving a single firm the exclusive right to sell a particular good in certain markets. Patent and copyright laws are two important examples of how government creates a monopoly to serve the public interest.
• Costs of production make a single producer more efficient than a large number of producers. An industry is a natural monopoly when a single firm can supply a good or service to an entire market at a smaller cost than could two or more firms. A natural monopoly arises when there are economies of scale over the relevant range of output.

The most important advantage of being a monopolist is that it can set prices without regard to how other firms respond. Thus, while a perfectly competitive firm is a price taker, a monopoly firm is a price maker. 

3. Monopolistic competition 

Monopolistic competition is a market structure where many firms are selling products that are similar but not identical. A monopolistically competitive firm’s products may be differentiated due to factors like geography (when consumers prefer stores that are convenient to reach) or the idiosyncratic preferences of buyers (that is, if tastes differ markedly from one person to the next). These slight differences enable firms to charge higher prices and still attract buyers. This opportunity to profit in the short run encourages new firms to enter monopolistically competitive markets, which may eventually lower profits and move the industry closer to perfect competition.
4. Oligopoly 
An oligopoly market is characterized by few sellers offering similar or identical products. While it's possible for competition to be intense even when there are only a few or a couple of players, which places the industry closer to perfect competition (think the local telco industry prior to PLDT's acquisition of Digitel), sometimes firms realize that it's in their best interest to cooperate, and even collude when the law explicitly requires them to compete. When sellers in an oligopoly act in concert, the market becomes a quasi-monopoly since firms are able to set higher prices for greater profitability.

So, given these types of industry structure, as a prospective (or already practicing) entrepreneur these are some things that you have to keep in mind:

• Choose monopolistic or oligopolistic businesses for greater profitability. You do not have to have MVP's resources to achieve this--just remember Porter's Five Forces and choose industries with high barriers to entry (for other entrants) and a low threat of substitute. 
• While it's easier said than done, the best way to achieve monopoly profits is to innovate and create a business that can't easily be emulated. While intellectual property laws in the Philippines may still be limited (or maybe just the enforcement of these laws?), still always try to use them to protect your business.
• Or if you're already in a particularly competitive industry, try to differentiate your product and not just compete based on price. Enter unexplored geographic markets or be a niche player and change the product enough to suit particular tastes.
• If you think it's easy to copy your business but no one is doing it yet, you can enjoy "first mover" advantages and command higher margins for a while. But be ready for an exit strategy and execute this as soon as the market becomes saturated (innovating/improving your product may be considered one such strategy)
• Avoid perfectly competitive markets at all costs! Ask yourself this question: Why would a customer buy this product from me? If the only answer you can think of is "because my price is lower," then in all probability you'll just be wasting your capital, effort, and time if you start this business.

When There's Smoke, There's Fire: MVP Purchase of GMA 7 "Just a Matter of Time"

IN THE NEWS from Philstar Online

It now turns out that there's more than a little bit of truth to the rumored sale of GMA 7 to MVP, which we first heard about seven months ago. The actual offer price may not be as exorbitant as what was first reported (25 times GMA's market cap), but the premium of almost 100% (from an offer of up to 60 billion pesos against a market cap of 34 billion) must be making GMA majority shareholders salivate. Retail investors of the network giant should also have reason to be excited since they stand to gain still-handsome, if not as astronomical, returns.

At least now we have a more concrete answer to one of the questions we posted when the rumor first broke out in late December. In the next few months, we'll just have to wait and see how the remaining two issues will unfold:

• If ABS-CBN would go the same way as Globe with the PLDT-Digitel merger and try to block the deal
• How the stock prices of affected players (e.g., PLDT, GMA, ABS-CBN) would be affected

As of this writing, here's how the stock prices of the three firms mentioned above have behaved since the rumor broke out. 

PLDT (TEL): Up by 10% since December 26, 2011

GMA (GMA7): Up by a whopping 73% since December 26, 2011

ABS-CBN (ABS): Up by 23% since December 26, 2011

Finally, with this imminent deal we see how aggressively MVP has been pursuing monopoly profits in the industries that he enters, especially since the lack of an anti-trust law in the Philippines allows him to do so. In the next post, I'll discuss the different kinds of industry structure in more detail and why business persons like MVP find monopolies irresistible.

Stock Dividends and Stock Splits

DEAR INVESTOR JUAN
PERSONAL FINANCE 101

Dear Investor Juan

Sir, what can you say about ACE. I'm worried about my investment. I bought some shares of ACE and the trend is going down. Any insights. Thanks.

Maxin


Dear Maxin,

I checked the stock's performance on the PSE website, and you're right, ACE experienced a price drop of around 66% on June 20, from 15 pesos to 5 pesos per share. If this significant drop was due to some catastrophic event, it should be all over the news right? Especially since ACE or Acesite Hotel Corporation runs several well known hotel chains in the country, including The Holiday Inn and the Waterfront Hotels in Cebu. But after a quick "desktop" research, it turns out that the drastic drop in the per share price was just brought about by the issuance of stock dividends, so there's no real reason to worry. While it's still possible that you have lost money, depending on the price at which you bought your shares, it's definitely not as much as the "decrease" in stock price indicates.

Slicing the pie

On June 11, ACE announced the issuance of stock dividends to outstanding stockholders registered on or before June 20 (ex-date), to be paid on or before July 19, 2012. Stock dividends do nothing more than divide the company into more "slices" by issuing more shares to current shareholders: since the total market value of the firm's equity should theoretically remain the same, the move should result in a lower stock price. Stock splits pretty much work the same way; stocks could be split two-for-one, three-for-one, or in any other way.

Stock dividends and stock splits have the same fundamental purpose: to attain a particular level of stock price that is targeted by management, for whatever reason. Conceptually, a firm would want to avoid a very high per share price to make the stock more affordable to retail investors. In practice, however, the "cosmetically high" prices of stocks like Berkshire Hathaway in the US (at a whopping 126,995.00 USD per share) and even PLDT in the Philippines (2,716 pesos per share) puts this line of reasoning into question. And clearly, at 15 pesos per share before the stock dividend issue, this rationale does not apply to ACE at all.

Mailbag Cleanup: Bond Funds, UITF Types, and Portfolio Tracker Registration Using Twitter

DEAR INVESTOR JUAN

Dear Investor Juan,

I've been investing in bond fund UITFs for a year now and I still don't get what makes their NAVPU go up. Which environment does it earn more? In an environment where interest rates go up and bond prices go down or in an environment that interest rates go down and bond prices go up?

In holding individual bonds, you know exactly what you'll earn but in bond funds I don't know how it will react to changes in interest rates. 

Thanks,
Eugene


Dear Eugene,

As I discussed in this post, bond prices go up when interest rates go down, and vice versa. Since bond UITFs are basically just portfolios of government and corporate bonds, they should exhibit the same behavior. Effects of interest rates on NAVPUs, however, may not perfectly clear since: 1) the extent of the changes in the prices of a fund's bond components may be significantly different; and 2) interest earned on the bonds are kept in the fund and not distributed to unit holders.

***

Dear Investor Juan,

I have some money in the bank that I would like to invest in UITF's. I know BDO is a sure bet but which one product?  I won't be needing the cash for about 6 years.  Any suggestions.

Ms. Confused


Dear Ms. Confused,

First, in all of investing, there's no such thing as a "sure bet"; the only thing we have established in a past analysis was that BDO UITFs are more attractive than other offerings in terms of cost and a couple of other criteria.

Regarding your choice of UITF type, an investment horizon of six years would make you less immune to short-term fluctuations of stocks and enable you to take advantage of the generally better long-term performance of equity UITFs.

***

Dear Investor Juan,
I have a bit of a problem accessing the Bloomberg Portfolio Tracker. I click on Personal Finance >> Portfolio Tracker then sign in using Twitter but it takes me to a page where I can only edit my profile. There's no way I could get to the tracker page. Is there anything I missed? I have confirmed my email as well. Thank you so much. 

foehns_419


Dear foehns_419,

I tried connecting to Bloomberg using my Twitter account. After editing your profile, go to Bloomberg.com manually, click the PORTFOLIOS link on the upper right corner of the main page. If you're doing this for the first time, you'll land on a page with a link to construct your portfolio for the first time. Subsequent tries will take you directly to the Portfolio Tracker page.

Concerns Over ETFs

DEAR INVESTOR JUAN

Dear Investor Juan,

I've been reading your blog for the past 2 weeks and boy it's addicting! You got very serious talent in simplifying perplexing financial matters :)

Further to my inquiry, assuming a decent savings amount have been set aside, is it good to start investing in ETFs rather than UITFs/MFs? My colleague argues that ETFs are better than UITF/MF as investors tend to loose a lot from fees on the latter; which I agree to some extent. However, since ETF is yet to break into PH market, I can't help but be wary. I really hope they'll soon open ETF for local investors so we can finally test the waters.

Haezel


Dear Haezel,

First, I would like to thank you for patronizing the blog; I'm glad to hear that you find the posts helpful. :)

I understand how there could be much concern over ETFs because they are new, but as I mentioned in this post, in essence they're pretty much the same as run-of-the-mill UITFs and mutual funds. And in choosing between ETFs, UITFs, and MFs (of the same type), arguably the most important criteria to consider is cost--that is, choose the one with the lowest total fees. In general, ETFs, particularly those which simply track indices like the PSEi, would have lower fees than comparable UITFs and MFs since there would be no need to pay a financial or investment manager (the fund would just be invested in securities that comprise the index it follows). Also, since you can sell your ETF any time, "early redemption" fees don't apply.

One thing that must be made clear, however, is that while the term "ETF" is usually associated with index funds, in theory financial institutions may also offer ETFs that invest in commodities and currencies or even an actively-managed portfolio of securities; such ETFs could have relatively higher fees, so always read the fine print before you invest.

Finally, one distinguishing characteristic of an ETF over other similar instruments is that since its price is determined by supply and demand, it could trade at a significant premium over the index that it is tracking, such as if there is very high interest in the product. In the image above, we see how the Tracker Fund of Hong Kong (orange) has deviated from the Hang Seng Index (green) which it is tracking since sometime in 2009. If an ETF is priced priced significantly higher than the index, then it may be best to avoid buying the product (and sell if you have it).

If and when ETFs are finally sold in the Philippines, two things may happen: either investors will shun offerings because of lack of understanding, or be curious enough to embrace them. While each scenario may have its disadvantages, I'm rooting for the latter to happen. We are way behind the rest of the world when it comes to financial innovation, either due to conservatism or simple incompetence (or maybe a combination of both), and ETFs are a step moving forward. Done right, ETFs should be able to provide Filipinos investors, both in the Philippines and those living abroad, with a cost-effective and manageable way to participate in the growth of the country.

Why Do We Spend So Much Money on Stuff?

STUFF I LEARNED FROM Robert and Edward Skidelsky's How Much Is Enough? Money and the Good Life

In investigating why people seem to have lost sight of the quest for the "good life" (as articulated by Keynes in his 1930 essay "Economic Possibilities for our Grandchildren"), the authors look for explanations for insatiability and conspicuous consumption. This search leads to the pioneering work of Harvey Leibenstein more than half a century before credit cards and online shopping: "Bandwagon, Snob, and Veblen Effects in the Theory of Consumers' Demand." Here, Leibenstein posits that apart from the "utility" that a good or commodity directly provides--a concept which is at the heart of classical consumer theory--buying decisions are also affected by external effects on utility which the author refers to as the "bandwagon" effect, the "snob" effect, and the "Veblen" effect.

The bandwagon effect pertains to how demand for a good is increased because other people already have it. It is borne partly of conformity--"keeping up with the Joneses"--and partly of envy. Both mechanisms are strong in children, which may cause parents to work harder to satisfy this want, and in individuals and households with limited means or of lower socio-economic standing. Examples include everything your neighbor has which you don't have and makes you salivate.

How do we begin to covet, Clarice?

The snob effect, of the other hand, is the exact opposite of the bandwagon effect: it refers to the extent to which the demand for a commodity is decreased because other people (or too many of them) already own it. It follows, of course, that "snob goods" are desired because others do not have them; they are not necessarily the most expensive, but mark their possessors as having superior taste. This effect represents the desire of people to be exclusive and to stand apart from "the crowd." Examples include everything marketed by Apple.

Despite being polar opposites, snob goods can easily transform into "bandwagon goods," leading to their abandonment by the snobbiest of the snobs.

The Veblen effect (named after American economist and sociologist Thorstein Veblen) overlaps the two effects above: it pertains to the extent to which the demand for a good is increased because it is expensive and known to be expensive. Like bling on your favorite hip hop artist, Veblen goods are simply advertisements of wealth. Examples include everything you don't need and cannot afford.

"I Am Rich." Remember this?

To clarify, there's an important distinction between the snob and the Veblen effect--the former is a function of the consumption of others, the latter is a function of price.

I know how hard it can be to avoid or even just lessen the above effects on our spending decisions: after all, the opinions of people we interact with do matter to some (or a great) degree. Just remember that continuously succumbing to bandwagon, snob, or Veblen effects will just compromise our financial capabilities and delay our journey towards the good life.

SEC Seeks Comments on ETF Rules

IN THE NEWS from Business World Online

As draft rules that allow the listing of exchange-traded funds or ETFs on the Philippine Stock Exchange have been completed, the Securities and Exchange Commission (SEC) now solicits comments from market participants before finalizing the measure. The draft includes provisions that classify ETFs as a new investment product, thus allowing issuers to hurdle old rules that only recognized more traditional financial instruments, the SEC said.

This latest development moves us closer to having a more inexpensive and more liquid alternative to traditional UITFs and mutual funds. Learn more about the advantages of ETFs over comparable investment vehicles in this post.

Thanks to reader Neil for the heads up.

Monty Hall

The situation that I presented in the Quickie Problem post last week is popularly known as The Monty Hall Problem, where "Monty Hall" is the name given to the host of the fictional game show in most versions. I'll repost the problem here for those who missed it:

Suppose you're on a game show and you're given the choice of three doors (and will win what is behind the chosen door). Behind one door is a car; behind the others, goats. The car and the goats were placed randomly behind the doors before the show. The rules of the game show are as follows: After you have chosen a door, the door remains closed for the time being. The game show host, who knows what is behind the doors, now has to open one of the two remaining doors, and the door he opens must have a goat behind it. If both remaining doors have goats behind them, he chooses one at random. After the host opens a door with a goat, he will ask you to decide whether you want to stay with your first choice or to switch to the last remaining door. Imagine that you chose Door 1 and the host opens Door 3, which has a goat. He then asks you "Do you want to switch to Door Number 2?" Is it to your advantage to change your choice?

The correct answer is that it's to your advantage to switch doors (that is if you prefer a car over a goat), as was stated by a couple of readers in the post, although it's very hard to understand and accept why (even with the "solution" given by the movie "21"). There are more than a few ways to arrive at the correct answer, but from my research this short video clip presents the simplest and most understandable explanation.

Remember that the key to the solution--the detail that makes switching the best move--is that the host knows where the car is and always chooses a door with a goat to open.

The best thing about the videos, though, are the comments, which are indisputable proof that trolls and idiots abound online.