Finance 663 – International Finance Passive / Active Strategy on the Euro Stoxx 50 Index

2 Agenda Rise of passive investing Hypotheses Methodology Results Conclusion

3 Rise of passive investing

Market Share Development 4 Sources: 1. Moore

5 Passive Investment Industry First ETF began trading in 1993 As of 2013, the US market for ETFs totaled US$1,578 billion at year-end 2013, compared with US$1,213 billion at year-end 2012 ETF returns only as good as their underlying index –Minimize tracking error by full portfolio replication –Customer Value Proposition: Diversification with low management fees – according to research 3 on average actively managed funds underperform various benchmarks Sources: Deutsche Bank Bogle, p 17

6 Hypotheses

7 1.Passive investors who follow the same methodology act on the same triggers -> increasing volume 2.Increased volume drive the price away from fundamentals creating an opportunity for active investors 3. In particular, increased buy orders from passive investors should increase the price when a stock is included in an index (trading strategy)

8 Methodology

9 Index compositions change over time according to their calculation method Passive investment strategies replicating indices must rebalance when index composition changes in order to avoid tracking error Euro Stoxx 50 was chosen as the index for closer examination 18 plain vanilla ETFs tracking the Euro Stoxx 50 Sources: 4. Stoxx Ltd. August

Methodology 10 To validate our hypothesis, changes in stock trading volume during the window* were examined Performance of all stocks during the window were calculated Stock performance compared to sector and market indices to isolate sector/market events –Euro Stoxx supersectors and Euro Stoxx 600 indices were used Sources: 5. Stoxx Ltd. August

11 Results

Volume 12 Announcement Month After The Inclusion Month Before The Announcement Window Period Inclusion + 160% in avg daily volume + 152% in avg daily volume + 189% in avg daily volume

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Window Returns – Stocks Added 14 During the window period –32 out of 40 stocks outperformed their respective sector and market indices –Looking at the time series, there is some evidence that the returns are higher today than it was at the end of the 1990s

Trading Strategies (1/2) 15 1.Passive / Active Strategy –Buying at the announcement and selling at the effective date Equal weight when multiple windows present –Hold market portfolio (ETFs Euro Stoxx 50) in-between windows 1.Trading / Hold Cash –Buying at the announcement and selling at the effective date Equal weight when multiple windows present –Money in cash outside window, assume no taxes –Allows us to free up cash that we can invest in other asset classes

Trading Strategies (2/2) 16 Strategies beat the market by more than 4% annually

17 Conclusion

1. Increase in volume? –Yes, seems that passive investors increase volume in certain periods –However, might be due to other unknowns 1. Volume drives the price up? –Yes, in window period –Momentum behind stock performance? 2. Trading Strategy? –Passive / Active Strategy: 3.14% annual return since 1999 –Trading / Hold Cash: 3.75% annual return since 1999 –Strategies outperform the market by 4% and 4.6% annually, respectively! 3.Drawbacks –Does not guarantee greater returns over every episode –Few trades limit returns above market –Strategy limited to one benchmark index 18 To make this viable, we would need to apply the same methodology and trading strategy to other markets and indices

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