1. HELLO AND WELCOME, LADIES AND GENTLEMEN EMS PRESENTATIONS

2. TOPIC: FUNDAMENTAL INDEXATION ON THE TAIWANESE EQUITY MARKET

3. Modern Portfolio Theory Asset Pricing models and evidence Fundamental Indexation and evidence Data and Methodology Results and analysis Conclusion BREAKDOWN

4. MODERN PORTFOLIO THEORY  Underpinned by the Efficient Market Hypothesis (EMH) and Law of one price  Assumes Investor rationality and near certainty of outcomes  Foundation was laid by Harry Markowitz 1952

5. Efficient Frontier and Separation Theorem

6. Capital Asset Pricing Model - CAPM  Developed by William Sharpe 1964  One factor model and assumes Beta is the only risk factor  Has overly simplistic assumptions E(r i ) = r f + β i (E(r m )- r f )  Critiques and upside

7. SECURITY MARKET LINE - SML

8. OTHER ASSET PRICING MODELS -Arbitrage Pricing model – APT: Birthed by Ross 1976  Assumes Diversification and based on the law of one price  Introduces other factors but does not specify them  Chen, Roll and Ross (1986) suggested possible factors E(r i ) = α i + β i1 R 1 + β i2 R 2 + β i3 R 3 +... + β i R j

9. OTHER ASSET PRICING MODELS CONT… - Fama and French 3-factor model 1992;1993 Merton was first to introduce a multifactor model – 1973 E(r i ) = α ff + r f + β m (E(r m - r f ) + β HML r HML + β SMB r SMB + ε i -Carhart 4-factor model 1997 E(r i ) = α ff + r f + β m (E(r m - r f ) + β HML r HML + β SMB r SMB + β MOM r MOM + ε i

10. EMPIRICAL EVIDENCE Value Effect Basu (1975:1977), Ball (1978) Fama and French (1993; 1998) Auret and Cline (2011), Hodnett, Hsieh and Rensburg (2012) Domestic market Size Effect Banz (1981), Reiganum (1981) Fama and French (1992) Momentum Effect Jegadeesh and Titman (1993)

11. BEHAVIOURAL FINANCE Based on Prospects Theory and Cognitive Psychology Investors are risk averse with regards to gains but risk seeking with regards to losses Takes into account emotions, thoughts and gut feeling in pricing assets Kahneman and Tversky (1979 )

12. BEHAVIOURAL FINANCE

13. BEHAVIOURAL BIASES  Heuristics Simplification and Bounded Rationality  Conservatism  Cognitive dissonance  Herd Behaviour  Overconfidence

14. FUNDAMENTAL INDEXATION - FI Introduced by Arnott, Hsu and Moore(AHM) 2005  Rationale? Cap weighting results in a return drag  Noisy Market Hypothesis  Uses Fundamental variables of the firm as basis for investing  Holds that fundamental variables are price insensitive  Critiques

15. EVIDENCE OF FI OUTPERFORMANCE  AHM 2005 – US market (1.97pp over market index & 2.15pp over Reference portfolio)  Hemminki and Puttonen (2008) European Market (1.76pp over market)  Tamura and Shimuzu (2005) and Hsieh, Hodnett and Rensburg (2012)  Estrada (2008) found not evidence of increased international diversification  Arnott and Shepherd (2009) Emerging markets

16. DATA AND METHODOLOGY  Period of research from January 2003 to June 2014  Data extracted from the Taiwanese Economic Journal database (TEJ) for 1436 stocks  Market index is the Taiwanese capitalisation weighted index (TAIEX)  Variables are adjusted for look-ahead bias, survivorship bias and other possible research biases

17. DATA AND METHODOLOGY CONT…  Fundamental variables: Book value of equity, Earnings, Dividends and Sales  Three year trailing averages for all variables  Portfolios of the top 50 stocks and Mid-100 stocks for each fundamental variable and also a composite index, as well as the reference portfolio

18. BASIC RESULTS FOR TOP 50 STOCKS Market proxyRisk Free rateReference Portfolio Book Value Index Earnings IndexDividends IndexSales Index Fundamental Composite Index Basic Return statistics Arithmetic Return8.13%1.30% 5.76% 8.69% 8.59%7.35% 12.23%10.70% Geometric Return 2.77%0.01% 2.17% 4.07% 4.56%3.60%8.96%5.20% Cumulative Return 1.4461.001 1.335 1.713 1.8251.613 3.184 1.982 Basic Risks Statistics Standard Deviation 23.68%0.03% 26.53% 29.92% 27.96% 26.89% 24.68% 27.15% Beta 1N/A 1.085 1.152 1.112 1.076 1.0051.060 Max. Draw Down -56.26%- -56,84% -56,49% -54,35%-57,06%-52,94%-56,26% Risk-adj. returns Sharpe Ratio 0.289N/A 0.168 0.247 0.261 0.225 0.4430.346 Treynor Ratio 0.068N/A 0.041 0.064 0.066 0.056 0.1090.089 Jensen’s alpha -N/A -2.95% -0.48% -0.31%-1.30%4.06%2.16% Information ratio 0.345N/A 0.302 0.4280.257 0.8520.604 M-square 0.00N/A-0.029 -0,010 -0.007 -0.015 0.0370.014

19. BASIC RESULTS FOR TOP 50 STOCKS All Fundamental indices outperform the Reference portfolio in terms of arithmetic returns On average FI outperforms the market and reference portfolios by 1.35% and 3.75% respectively FIs produce higher standard deviations and betas relative to the market Apart from the Sales and composite indices, all Fundamental indices produce lower Sharpe, Treynor and M-squared values relative to the market All Fundamental indices however outperform the reference portfolio on a risk-adjusted basis.

20. SML FOR TOP 50 STOCKS

21. BASIC RESULTS FOR MID-100 STOCKS Market Proxy Risk Free rateReference Portfolio Book Value Index Earnings IndexDividends Index Sales IndexFundamental Composite index Basic Returns statistics Arithmetic Return 8.13%1.30% 9.50% 16.13% 12.53%13.45%19.48%17.85% Geometric Return 2.77%0.01% 4.97% 10.84% 8.01%8.77%14.90%12.91% Cumulative Return 1.4461.001 1.926 4.011 2.8293.1136.5205.152 Basic Risks Statistics Standard Deviation 23.68%0.03% 29.36% 31.10% 29.02% 29.41% 28.48% 29.86% Beta1N/A 1.157 1.171 1.1141.1191.0841.096 Max. Draw Down-56.26%- -63,96% -62,37% -59,59%-60,19%-57,26%-59,30% Risk-adj. returns Sharpe Ratio0.289N/A 0.279 0.477 0.3870.4130.6380.554 Treynor Ratio 0.068 N/A 0.071 0.125 0.0980.1050.1620.141 Jensen’s alpha - N/A 0.30% 6.73% 3.38%4.23%10.51%8.52% Information ratio-0.123N/A 0.664 0,5060.7281.5371.029 M-square0.000N/A-0.002 0.045 0.0230.0300.0830.063

22. BASIC RESULTS FOR MID-100 STOCKS All FIs outperform the market and Reference portfolio on Arithmetic return basis and risk-adjusted returns. On average, FIs generate an excess return of 7.76% and 6.38% over the market proxy and reference portfolio respectively FIs reveal higher risk relative to the market but comparative risks levels with respect to the Reference Portfolio

23. SML FOR MID-100 STOCKS

24. DEDUCTIONS FIs produce higher standard deviations relative to the market possibly due to lower diversification FIs produce higher active returns as indicated by the positive information ratios All Fis for Mid-100 stocks are undervalued Sales and the Composite are the best performing Fis while Book Value shows the poorest performance

25. PERFORMANCE ATTRIBUTION – CAPM REGRESSION PANEL A: Top 50 Stocks Reference Portfolio Book Value Index Earnings Index Dividends Index Sales Index Fundamental Composite Index R-Squared [P-value] 93.85% 0.000 83.24% 0.000 88.89% 0.000 89.89% 0.000 93.07% 0.000 85.66% 0.000 Intercept t-statistics [P-value] -0.002 -1.546 0.124 -0.000 -0.141 0.888 -0.000 -0.120 0.905 -0.001 -0.523 0.601 0.003 2.088 0.038 0.002 0.701 0.485 b_Market risk premium t-statistics [P-value] 1.085 49.573 0.000 1.151 28.282 0.000 1.112 35.897 0.000 1.075 37.838 0.000 1.005 46.513 0.000 1.061 31.007 0.000 PANEL B: Mid-100 Stocks Reference Portfolio Book Value Index Earnings Index Dividends Index Sales Index Fundamental Composite Index R-Squared [P-value] 81.68% 0.000 87.97% 0.000 87.39% 0.000 87.24% 0.000 87.22% 0.000 86.98% 0.000 Intercept t-statistics [P-value] 0.006 1.641 0.103 0.003 1.104 0.271 0.003 1.328 0.186 0.008 3.330 0.001 0.000 0.084 0.933 0.006 2.557 0.012 b_Market risk premium t-statistics [P-value] 1.186 26.791 0.000 1.149 34.305 0.000 1.160 33.409 0.000 1.123 33.173 0.000 1.157 33.146 0.000 1.175 32.800 0.000

26. PERFORMANCE ATTRIBUTION For Top 50 stocks, Excess returns are well explained by the Market risk premium Only sales produces a statistically significant alpha of 0.3% with t-statistics of 2.088 at a 5% significance level For Mid-100 stocks, the market risk premium also explains Excess returns but the composite index and dividend index generate a statistically significant alphas of 0.6% and 0.8%, with a t-statistics of 2.557 and 3.330 respectively

27. PERFORMANCE ATTRIBUTION – FAMA $ FRENCH 3-FACTOR REGRESSION PANEL A: Top 50 Stocks Reference Portfolio Book Value Index Earnings Index Dividends Index Sales Index Fundamental Composite Index R-Squared [P-value] 83.66% 0.000 88.48% 0.000 87.79% 0.000 87.92% 0.000 87.32% 0.000 88.16% 0.000 Intercept t-statistics [P-value] 0.007 2.371 0.019 0.003 1.273 0.205 0.004 1.629 0.105 0.009 3.765 0.000 0.001 0.365 0.715 0.008 3.142 0.002 b_Market risk premium t-statistics [P-value 1.293 24.796 0.000 1.188 29.093 0.000 1.205 28.277 0.000 1.184 28.855 0.000 1.184 27.313 0.000 1.253 29.415 0.000 b_SMB (Size effect) t-statistics [P-value 0.325 3.872 0.000 0.130 1.982 0.049 0.137 1.992 0.048 0.184 2.780 0.006 0.078 1.113 0.268 0.239 3.483 0.001 b_HML (Value effect) t-statistics [P-value 0.075 1.890 0.061 0.052 1.675 0.096 0.033 1.001 0.318 0.032 1.031 0.304 0.009 0.261 0.794 0.057 1.756 0.081

28. PERFORMANCE ATTRIBUTION – FAMA $ FRENCH 3-FACTOR REGRESSION For Top 50 stocks, all Fis exhibit significant loading on the size risk premium but only Sales, Earnings and composite indices display significant value bias After controlling for style risk, only Sales and Composite index generate statistically significant alphas For Mid-100 stocks, size risk premium doesn’t satisfactorily explain FI returns except BV and Composite indices Value effect fails to fit the returns of Mid-100 FIs

29. PERFORMANCE ATTRIBUTION – FAMA $ FRENCH 3-FACTOR REGRESSION PANEL B: Mid-100 Stocks Reference Portfolio Book Value Index Earnings Index Dividends Index Sales Index Fundamental Composite Index R-Squared [P-value] 83.58% 0.000 88.95% 0.000 90.09% 0.000 93.13% 0.000 94.01% 0.000 86.31% 0.000 Intercept t-statistics [P-value] 0.003 0.831 0.407 -0.000 -0.120 0.905 0.000 0.022 0.983 0.003 2.013 0.046 -0.003 -2.107 0.037 0.004 1.570 0.119 b_Market risk premium t-statistics [P-value 1.210 24.078 0.000 1.120 0.474 0.636 1.111 31.650 0.000 1.016 37.863 0.000 1.053 39.086 0.000 1.128 27.070 0.000 b_SMB (Size effect) t-statistics [P-value 0.167 2.067 0.040 0.029 0.474 0.636 0.100 1.763 0.080 0.036 0.831 0.407 -0.088 -2.035 0.044 0.185 2.751 0.007 b_HML (Value effect) t-statistics [P-value 0.007 0.185 0.853 0.021 0.705 0.482 0.005 0.201 0.841 0.015 0.720 0.473 0.004 0.186 0.853 -0.008 -0.250 0.803

30. IMPLICATION OF FINDINGS & CONCLUSION All Fundamental indices outperform the reference portfolio and Fis for mid-100 stocks outperform the market portfolio on a risk adjusted basis The alphas of Fis have a significant loading on the market premium and size satisfactorily explains the alphas of Top 50 stocks Lower portfolio concentration reduces the influence of size effect in explaining FI returns Fis generate alphas because of possible size loading in stock selection Neither value nor size explains the returns of the cap- weighted reference portfolio

31. THANKS QUESTIONS?