OUTPERFORMING STOCK INDICES USING PROXIES FOR RISK AND RETURNS Vashishta Bhaskar Duquesne University Presented at QWAFAFEW September 9, 2014

Introduction Efficient markets Implications for investors Active equity portfolio management strategies Empirical results of sort by factor methodologies Expansion of existing quantitative techniques

Efficient Markets A market in which security prices rapidly reflect all available information Random walk (short term) Provide positive return (long term) Expected Returns are a function of Size, Relative Value (value-growth), Risk and Momentum

Implications for Investors and Money Managers Risk tolerance Diversification Passive investing Buy & hold portfolios Indexing

Active Equity Investing Fundamental Analysis Top-down Bottom-up Technical indicators Identify Attributes that provide superior returns

Empirical Results of Factor Based Strategies – Sort methodology Fama-French 1992 study concluded that small market equity portfolios performed better than large equity; And, higher book-to-market performed better than lower book-to-market.

Adapted from What Works on Wall Street. Size Effect Market CapitalizationReturn %Standard Deviation Sharpe Ratio <25 million million to <100 million million to <250 million million to < 500 million million to <1 billion >= 1 billion Market Leaders* Adapted from What Works on Wall Street pgs *Market leaders defined as: non-utility, market cap > avg., cf > avg., sales > 50% of avg. from COMPUSTAT.

Returns: Russell Indices Summary Statistics - Russell.fld 12/ /2013 Arithmetic Mean (%) Geometric Mean (%) Standard Deviatio n (%) Sharpe Ratio N Positive Periods Average Decline (%) Maximum Decline (%) Ending Index Value Russell 2000 TR ,914 Russell 2500 TR ,3430 Russell 1000 TR ,0728

Returns by Cap 250M – 1B 1B–5B and > 5B. ( ) Arithmetic Mean (%) Geometric Mean (%) Standard Deviation (%) Sharpe Ratio N Positive Periods Average Decline (%) Maximum Decline (%) Ending Index Value Small Cap ,589 Mid Cap ,634 Large Cap ,458

High 100 CAPX and Low 100 CAPX Portfolio Returns by Cap Arithmetic Mean (%) Geometric Mean (%) Standard Deviation (%) Sharpe Ratio N Positive Periods Average Decline (%) Maximum Decline (%) Ending Index Value Small Cap High CAPX ,374 Small Cap Low CAPX ,834 Mid Cap High CAPX ,013 Mid Cap Low CAPX ,250 Large Cap High CAPX ,449 Large Cap Low CAPX ,729

Small Cap High CAPX – Low CAPX ReturnSmall Cap High CAPX minus Period End High CAPXLow CAPX Dec941.15%-10.68%11.83% Dec %28.12%2.63% Dec %19.93%15.03% Dec %17.16%21.98% Dec %-15.00%7.45% Dec %35.98%-4.62% Dec %-16.65%51.23% Dec %-6.28%18.16% Dec020.93%-18.60%19.53% Dec %43.32%30.03% Dec %8.80%41.89% Dec %-4.81%33.63% Dec %11.36%27.05% Dec %-15.04%37.20% Dec %-45.61%4.55% Dec %29.06%89.86% Dec %13.89%34.98% Dec %-15.53%9.56% Dec127.33%18.62%-11.29% Dec %30.89%24.01%

Why Z – Score? Expected return from Corporate Bonds = Risk free rate + bond risk premium Expected Return from Equity = Company specific bond rate + equity risk premium Z score model and calculation provided at the end of this presenation

50 Stock portfolios based on high and low Z scores Arithmetic Mean (%) Geometric Mean (%) Standard Deviation (%) Sharpe Ratio N Positive Periods Average Decline (%) Maximum Decline (%) Ending Index Value Small Cap High CAPX High Z ,385,930 Small Cap High CAPX Low Z ,135 Mid Cap High CAPX High Z ,028,754 Mid Cap High CAPX Low Z ,201 Large Cap High CAPX High Z ,975 Large Cap High CAPX Low Z ,915.37

Z Score effects Small Cap High z - Low Z High CAPX High ZLow Z 50 Return thru Dec946.09%-2.43%8.52% Dec %35.64%-5.78% Dec %34.08%1.95% Dec %30.49%15.96% Dec %-15.39%10.33% Dec %23.78%25.37% Dec %44.47%-7.36% Dec %-2.36%27.16% Dec %5.39%-10.25% Dec %69.87%-2.63% Dec %50.29%2.19% Dec %21.57%9.81% Dec %32.26%18.34% Dec %27.10%-5.69% Dec %-45.14%9.26% Dec %91.94%55.27% Dec %38.82%14.96% Dec %-15.11%13.14% Dec %0.04%12.24% Dec %69.09%-22.80%

Arithmetic Mean (%) Geometric Mean (%) Standard Deviation (%) Sharpe Ratio N Positive Periods N Negative Periods Average Decline (%) Maximum Decline (%)Starting Index = 10.,000 Ending Index Value Large Cap , Large Cap High CAPX , Large Cap High CAPX High Z , Large Cap High CAPX Low Z , Large Cap Low CAPX , Mid Cap , Mid Cap High CAPX , Mid Cap High CAPX High Z ,028, Mid Cap High CAPX Low Z , Mid Cap Low CAPX , Small Cap , Small Cap High Capx , Small Cap High CAPX High Z ,385, Small Cap High CAPX Low Z , Small Cap Low CAPX , Summary Statistics - 12/ /2013

Limited conclusions and further research CAPX is indicative of future returns Z score can be used as a further discriminant as a proxy for risk There are additional factors such as value and momentum that can be incorporated in an overall strategy Scaled CAPX or items such as retention ratio may be useful