In this episode, Wes talks with Doug and Greg about why Alpha Architect is abnormal, the method to their madness, how Wes challenged Eugene Fama (and nearly won), how Alpha Architect is responding to today’s volatile markets, and what the future looks like for value investors.
Reschenhofer’s findings demonstrate the important role that portfolio construction rules (such as creating efficient buy and hold ranges or imposing screens that exclude stocks with negative momentum) play in determining not only the risk and expected return of a portfolio but how efficiently the strategy can be implemented (considering the impact of turnover and trading costs)—wide (narrow) thresholds reduce (increase) portfolio turnover and transactions costs, thereby increasing after-cost returns and Sharpe ratios. His findings also provide support for multiple characteristics-based scorings to form long-only factor portfolios, encouraging the combination of slow-moving characteristics (such as value, investment and/or profitability) conditional on fast moving characteristics (such as momentum), to reduce portfolio turnover and transactions cost. Fund families such as AQR, Avantis, Bridgeway and Dimensional use such an approach, integrating multiple characteristics into their portfolios conditional on momentum signals.
We show, using machine learning, that fund characteristics can consistently differentiate high from low-performing mutual funds, as well as identify funds with net-of-fees abnormal returns. Fund momentum and fund flow are the most important predictors of future risk-adjusted fund performance, while characteristics of the stocks that funds hold are not predictive. Returns of predictive long-short portfolios are higher following a period of high sentiment or a good state of the macro-economy. Our estimation with neural networks enables us to uncover novel and substantial interaction effects between sentiment and both fund flow and fund momentum.
The authors investigate how the interaction between entries and exits of informed institutional investors and market anomaly signals affects strategy performance. The long legs of anomalies earn more positive alphas following entries, whereas the short legs earn more negative alphas following exits. The enhanced anomaly-based strategies of buying stocks in the long legs of anomalies with entries and shorting stocks in the short legs with exits outperform the original anomalies, with an increase of 19–54 bps per month in the Fama–French five-factor alpha. The entries and exits of institutional investors capture informed trading and earnings surprises, thereby enhancing the anomalies.
The analysis above suggests that portfolios that include or exclude emerging allocations are roughly the same. For some readers, this may be a surprise, but for many readers, this may not be "news." That said, even if the data don't strictly justify an Emerging allocation, the first principle of "stay diversified" might be enough to make an allocation.
Of course, the assumptions always matter.
The application of machine learning models to Sentix relative sentiment data appears to extract more predictive information than our original, simplistic approach was capable of.
We find that three factors—cryptocurrency market, size, and momentum—capture the cross-sectional expected cryptocurrency returns. We consider a comprehensive list of price- and market-related return predictors in the stock market and construct their cryptocurrency counterparts. Ten cryptocurrency characteristics form successful long-short strategies that generate sizable and statistically significant excess returns, and we show that all of these strategies are accounted for by the cryptocurrency three-factor model. Lastly, we examine potential underlying mechanisms of the cryptocurrency size and momentum effects.
Since the 1992 publication of “The Cross-Section of Expected Stock Returns” by Eugene Fama and Kenneth French factor-based strategies and products have become an integral part of the global asset management landscape. While “top-down” allocation to factor premiums (such as size, value, momentum, quality, and low volatility) has become mainstream, questions remain about how to efficiently gain exposure to these premiums. Today, many generic factor products, often labeled as “smart beta”, completely disregard the impact of other factors when constructing portfolios with high exposures to any single factor. However, recent research, such as 2019 study “The Characteristics of Factor Investing” by David Blitz and Milan Vidojevic, has shown that single-factor portfolios, which invest in stocks with high scores on one particular factor, can be suboptimal because they ignore the possibility that these stocks may be unattractive from the perspective of other factors that have demonstrated that they also have higher expected returns.
We document a striking pattern in U.S. and international stock returns: double sorting on the previous month’s return and share turnover reveals significant short-term reversal among low-turnover stocks, whereas high-turnover stocks exhibit short-term momentum. Short-term momentum is as profitable and as persistent as conventional price momentum. It survives transaction costs and is strongest among the largest, most liquid, and most extensively covered stocks. Our results are difficult to reconcile with models imposing strict rationality but are suggestive of an explanation based on some traders underappreciating the information conveyed by prices.
A few quick charts for our readers. As we all know, technology-related sectors and names have been crushed. But is blood in the streets? Not really.
Investors care about more than just returns. They also care about risk. Thus, prudent investors include consideration of strategies that can provide at least some protection against adverse events that lead to left tail risk (portfolios crashing). The cost of that protection (the impact on expected returns) must play an important role in deciding whether to include them. For example, buying at-the-money puts, a strategy that eliminates downside risk, should have returns no better than the risk-free rate of return, making that a highly expensive strategy.
Investing is no different. A question we regularly get in the current environment is "How does inflation affect value stocks?" Well...it depends. I could show you some data on how value stocks did in the 70's (period of high inflation) versus how they did in the 90's (low inflation). But if WW3 broke out tomorrow, wouldn't that variable quickly top all other variables? Probably. So let's table that variable.
A large body of evidence demonstrates that momentum, including time-series momentum (trend following), has improved portfolio efficiency. Research has found that there are a few ways to improve on simple trend-following strategies. Techniques that have been found to improve Sharpe ratios and reduce tail risk include volatility scaling and combining fast and slow signals as well as combining long-term reversals. These have been incorporated by many fund managers into investment strategies. Cheng, Kostyuchyk, Lee, Liu and Ma provided evidence that machine learning could be used to further improve results. With that said, a word of caution on the use of machine learning is warranted. The powerful tools and the easy access to data now available to researchers create the risk that machine learning studies will find correlations that have no causation and thus the findings could be nothing more than a result of torturing the data. To minimize that risk, it is important that findings not only have rational risk- or behavioral-based explanations for believing the patterns identified will persist in the future, but they also should be robust to many tests. In this case, investors could feel more confident in the results if their findings were robust to international equities and other asset classes (such as bonds, commodities and currencies).
Some individuals, e.g., those holding multiple directorships, are insiders at multiple firms. When they execute an insider trade at one firm, they may reveal information about the value of all—both the traded insider position and not-traded insider position(s)—the securities held in their “insider portfolio.” We find that insider “not-sold” stocks outperform “not-bought” stocks. Implementable trading strategies that buy not-sold stocks following the disclosure of a sale earn alphas up to 4.8% per year after trading costs. The results suggest that even insider sales that are motivated by liquidity and diversification needs can provide value-relevant information about insider holdings.
This was a simple question posed to me by one of our blog readers--what impact does excluding stocks trading at 10x P/S have on a Momentum portfolio? A good question--especially for those who are "value" investors that are interested in momentum. For most systematic value investors, the prospect of adding stocks trading at over 10x P/S sounds ludicrous. Since I didn't know the exact impact, I went and ran the tests described below.
An interesting question is do the trades of the more sophisticated institutional investors against anomalies provide information on returns? To answer that question, Yangru Wu and Weike Xu, authors of the study “Changes in Ownership Breadth and Capital Market Anomalies,” published in the February 2022 issue of The Journal of Portfolio Management, examined whether the entries and exits of informed institutional investors (or ownership breadth changes) interact with the aforementioned 11 anomaly signals studied by Stambaugh and Yuan can be used to improve the performance of anomaly-based strategies. They explained that they emphasized institutions’ new entries and exits because they could be triggered by private information and correlated with future earnings news, thereby capturing useful information regarding future stock returns. To determine if the trades of the institutional investors were informed, they sorted all stocks into 10 decile portfolios based on quarterly changes in ownership breadth. Their data sample covered all NYSE/AMEX/Nasdaq common stocks from May 1981 to May 2018.
Value and momentum are two of the most powerful explanatory factors in finance. Research on both has been published for about 30 years. However, it was not until recently that the two had been studied in combination and across markets. Bijon Pani and Frank Fabozzi contribute to the literature with their study “Finding Value Using Momentum,” published in The Journal of Portfolio Management Quantitative Special Issue 2022, in which they examined whether using six value metrics that have an established academic background combined with the trend in relative valuations provide better risk-adjusted returns than Fama-French’s traditional HML (high minus low book-to-market ratio) factor. The value metrics chosen were book value-to-market value; cash flow-to-price; earnings before interest, taxes, depreciation, and amortization (EBITDA)-to-market value; earnings-to-price; profit margin-to-price; and sales-to-price. Using six different measures provides tests of robustness, minimizing the risk of data mining. However with so many dials to turn there is a risk of achieving positive returns that aren't material or achieving postive results with the potential for overfitting.
In this article, the author discusses current structural research and investment trends that are shaping the future of factor investing. Specifically, the author focuses on three emerging trends: the ongoing evolution of traditional factor models and strategies, recent innovation in data sources and modeling techniques, and the potential disruption from integrating factor strategies into the asset allocation process.
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