Factor Investing

Financial Literacy in the US…Doesn’t look great!

This paper aims to analyze financial literacy in the United States, utilizing the most recent data from the National Financial Capability Study (NFCS) collected in 2021 by the Financial Industry Regulatory Authority (FINRA) Investor Education Foundation. The paper focuses on the importance of financial literacy, particularly in the context of the economic conditions in the US, such as the COVID-19 pandemic, inflation, and changes in the financial system.

The Financial Distress Puzzle

The empirical research findings demonstrate that the return premium generated by being long low-distress risk stocks and short high-distress risk stocks is persistent and that the capital asset pricing model (CAPM) and the Fama-French three-factor models cannot explain it. Hence, we have the distress puzzle, or anomaly.

The Temptation of Factor Timing

The timing of equity factor premiums has a strong allure for investors because academic research has found that factor premiums are both time-varying and dependent on the economic cycle.

Diseconomies of Scale in Investing

While the research shows that fund managers are skilled, skill doesn’t translate into outperformance due to the diseconomies of scale.

A new twist on momentum strategies: Utilize overlapping momentum portfolios

Momentum investors utilize different timeframes to identify high momentum equities: past 6, 9, 12 months as an example. Obviously, there is a significant degree of overlap in momentum stocks identified across various past time frames. However, there has been little research focused on understanding the characteristics of momentum stocks formed on six and 12 months that overlap one another. The authors refer to the subset as “overlapping” stocks and suggest they constitute the largest proportion of the profitability of the momentum strategy.

The Magnificent Seven

When a small subset of companies makes up a large portion of a portfolio, for better or worse their returns will have a greater impact on overall portfolio results.

Organization Capital and the Cross-Section of Expected Returns

This paper focuses on "organization capital," representing intangible assets in a firm's key employees that is not captured by classic value measures such as book-to-market. The authors propose a structural model to analyze the impact of organizational capital on asset prices and argue that shareholders perceive firms with high levels of organizational capital to be riskier than those with more physical capital.

Technology Spillover Impacts Stock Returns

The timelier adoption of new technology and the higher likelihood of large-scale technology adoption make the risk associated with technological innovation more systematic, which in turn increases returns required by investors for technology spillover recipients.

Dissecting the Idiosyncratic Volatility Puzzle

Idiosyncratic volatility (IVOL) is the volatility of a security that cannot be explained by overall market volatility—it is the risk unique to a particular security. IVOL contrasts with systematic risk, which is the risk that affects all securities in a market (such as changes in interest rates or inflation) and, therefore cannot be diversified away. On the other hand, the risks of high IVOL stocks can at least be reduced through diversification.

Factor Investors: Momentum is Everywhere

The Jegadeesh and Titman (1993) paper on momentum established that an equity trading strategy consisting of buying past winners and selling past losers, reliably produced risk-adjusted excess returns.  The Jegadeesh results have been replicated in international markets and across asset classes. As this evidence challenged and contradicted widely accepted notions of weak-form market efficiency, the academic community took notice and started churning out research.  As a result, a very large number of academic studies were published on momentum. The article summarized here has conveniently summarized 47 articles deemed as the highest quality and published in either the Journal of Finance, the Review of Financial Studies, or the Journal of Financial Economics, all three considered premier journals in the finance discipline. It is difficult to understate the importance of having a well-curated summary of momentum research. Keep it in your library.

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