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The 3FM As already discussed, the 3FM has Javier Estrada - PDF document

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Application 3: The Three Factor Model Javier Estrada ADFIN Winter/2014 1. The Three Factor Model Your results The distribution of the required return on equity Impact on performance evaluation Fundamental indexation

  1. Application 3: The Three ‐ Factor Model Javier Estrada ADFIN – Winter/2014 1. The Three ‐ Factor Model • Your results • The distribution of the required return on equity • Impact on performance evaluation • Fundamental indexation (smart beta) and the 3FM • Buffett’s alpha and the 3FM 2. Risk ‐ Adjusted Returns & Fees and Returns • Risk‐adjusted returns: A few comments on your results • Fees and returns: A few comments on your results The 3FM  As already discussed, the 3FM has … Javier Estrada  corporate finance applications IESE Business • Estimation of the required return on equity School  Input in the cost of capital Barcelona Spain  Hence, project evaluation, company valuation, …  portfolio management applications • Estimation of the required return on funds  Input in alpha  Performance evaluation  Your work in App3 largely focused on corporate finance applications  So far , but before we move on, a few more thoughts on the CorpFin applications of the model GoXls ADFIN Winter/2014 1

  2. The Distribution of RRE Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 Performance Evaluation  Legg Mason Value Prim Javier Estrada  4‐year mean annualized return: 27.3% IESE Business • S&P 500 annualized return: 21.6% School  Is the outperformance due to skill? (Assume luck away) Barcelona Spain  CAPM  R t – R ft = α + β ⋅MRP t + u t • β = 0.93 • α = 0.46% (and significant)  3FM  R t – R ft = α + β ⋅MRP t + β S ⋅SMB t + β V ⋅HML t + u t • β = 0.99 / β S = 0.36 / β V = 0.22 • α = 0.22% (and non ‐significant) • Hence, a large part of the outperformance was due to ‘naive’ exposure to the size and value factors ADFIN Winter/2014 2

  3. Fundamental Indexation Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 Smart Beta Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 3

  4. Smart Beta Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 Smart Beta Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 4

  5. Fundamental Indexation Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 Equally ‐ Weighted ETFs Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 5

  6. Warren Buffett  What about Buffett? Javier Estrada  Can his spectacular outperformance be explained IESE Business away by size and value exposures? School Barcelona Spain +11.6% ADFIN Winter/2014 RARs & Fees  Risk‐adjusted returns Javier Estrada  A few rounding comments IESE Business • Alpha School • Sharpe v . RAP Barcelona • Rankings Spain GoXls  Fees and returns  A few rounding comments • The more you pay, the less you get! ADFIN Winter/2014 6

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