Hibbert, Kang, Kumar and Mishra provided us with yet another explanation: social media is providing analysts with information that reduces their forecasting errors. The result has been an increase in market efficiency, leading to a reduction in the PEAD anomaly. The bottom line is that the ability to generate alpha continues to be under assault—trying to outperform the market by stock selection is becoming even more of a loser’s game.
New research reveals that the performance of the hedge fund industry has not been as bad as the results from studies that relied on hedge fund data providers.
While the empirical research on cross-sectional (long-short) momentum has shown that returns have been high, investors have also experienced huge drawdowns—momentum exhibits both high kurtosis and negative skewness. Since 1926 there have been several momentum crashes that featured short, but persistent, periods of highly negative returns. For example, from June to August 1932, the momentum portfolio lost about 91%, followed by a second drawdown from April to July 1933.
Strong empirical evidence demonstrates that momentum (both cross-sectional and time-series) provides information on the cross-section of returns of many risk assets and has generated alpha relative to existing asset pricing models.
The benefits of diversification are well known. In fact, it’s been called the only free lunch in investing. Investors who seek to benefit from diversification of the sources of risk and return of their portfolios must accept that adding unique sources of risk means that their portfolio will inevitably experience what is called tracking error—a financial term used as a measure of the performance of a portfolio relative to the performance of a benchmark, such as the S&P 500.
In their two papers, Goulding, Harvey, and Mazzoleni showed that observed market corrections and rebounds carry predictive information about subsequent returns and showed how that information could be utilized to enhance the performance of trend-following strategies by dynamically blending slow and fast momentum strategies based on four-state cycle-conditional information.
Short squeezes are often associated with a large positive jump in the price of a stock. Filippou, Garcia-Ares, and Zapatero demonstrated that skewness-seeking investors try to identify securities that could experience a short squeeze in the near future and are willing to pay a premium for them. That results in an overvaluation of the options and, on average, negative returns. Investors are best served to avoid investments with lottery-like distributions. One way to do that is to turn a blind eye to social media sites like Robinhood and Reddit so you don’t get caught up in the hype and excitement. That’s another example of why retail investors are called “dumb money.” Forewarned is forearmed.
Be careful before acting on what is considered to be conventional wisdom. Make sure it’s supported by empirical evidence. In this case, the evidence makes clear that “cut your losses and let your profits run” should not be conventional wisdom.
Making a bet on biotech/pharma firms that have not yet achieved significant revenue is the equivalent of buying a lottery ticket—with the same poor risk/return relationship.
While analysts underwrite high growth for companies that have grown quickly and slow growth for companies that have grown slowly in the past, a large body of evidence demonstrates that reversion to the mean of both positive and negative abnormal earnings growth is the norm.
Advisors and investors should be aware that fund families that invest systematically have found ways to incorporate the research findings on the limits to arbitrage and the evolving changes we have discussed to improve returns over those of a pure index replication strategy. It seems likely this will become increasingly important, as the markets have become less liquid, increasing the limits to arbitrage and allowing for more overpricing.
While the evidence makes clear that active management is a loser’s game (one that it is possible to win but so unlikely you should not try), we don’t want active managers to disappear. Hope should continue to triumph over evidence, wisdom, and experience because active managers help eliminate market anomalies and inefficiencies created by the misbehavior of investors (such as noise traders). That helps to ensure that capital is allocated efficiently.
For investors that use trend-following strategies, Avramov, Kaplanski, and Subrhmanyam provided new evidence supporting momentum strategies and showed that the distance between short- and longer-term momentum signals provides additional explanatory power in the cross-section of equity returns.
Antonello Cirulli and Patrick Walker, authors of the December 2023 study “Outperforming Equal Weighting,” examined whether equally weighted portfolios could be enhanced by avoiding negative exposure to some of the most prominent factor anomalies documented in asset pricing literature.
The risk-based explanation provided by a peer-based review is a necessary ingredient for considering investment, but it is not a sufficient ingredient.
Crowded equity positions in anomalies remain and have significant impacts in terms of risk and return dynamics.
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 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.
Ignoring the impact of taxes on the returns of taxable accounts is one of the biggest mistakes that can be made.
Covered calls implemented to deliver higher derivative income should be expected to have (1) lower total returns, (2) higher tax realizations along the path, and (3) a more negatively skewed return profile. Investors who allocate to these strategies for their income alone, without accounting for these other considerations, might have made a devil’s bargain
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