Quant Mashup - Alpha Architect Hedge Funds may Profit from Stock-Picking and Help Reduce Mispricing [Alpha Architect]What are the research questions? Do hedge funds exploit stock mispricing? Specifically, do hedge funds tend to hold undervalued stocks that exhibit positive alphas? Do hedge funds profit from these holdings in undervalued stocks? Does the trading in these stock reduce mispricing? What are the(...) Fund Capacity Analysis: How Much Capital Will a Strategy Handle? [Alpha Architect]The article addresses the estimation of capacity for an equity fund that forms portfolios based on a given investment strategy. It fits within three strands of literature: i) theoretical models of optimal trading or portfolio construction under alpha erosion and trade frictions; ii) empirical(...) Weekly Recap: Affiliated Funds and Diversification [Alpha Architect]This week Ryan and I discuss two topics. First, we discuss a paper examining the performance of bank affiliated mutual funds. Second, we examine a post by Larry Swedroe on diversification. Paper Links: Do Bank Affiliated Funds Underperform Affiliated Funds? Asset Diversification in a Flat World. Asset Diversification in a Flat World [Alpha Architect]Diversification is a fundamental principle of prudent investing due to its ability to mitigate/minimize risks. In fact, it has been called the only free lunch in investing because, done properly, it can reduce risk without reducing expected returns. This led to the conclusion that investors should(...) Alpha Architect Weekly Recap: Tracking Error and the “Mix Versus Integrate” Debate [Alpha Architect]You can watch the video via the link below: This week Ryan and Jack discuss several important topics. First, they discuss the tracking error associated with trend-following strategies. Second, they chat about a paper by researchers from Goldman Sachs, “Constructing Long-Only Multifactor(...) How large is the tracking error created by trend following? [Alpha Architect]A question I’ve received in the past is the following: If you could go back in time five years ago and tell yourself something about investing, what would it be? My response is the following: Tracking error. First, what is tracking error?(1) Tracking error is a measure of how much a strategy(...) Constructing Long-Only Multifactor Strategies: Portfolio Blending vs. Signal Blending [Alpha Architect]The heightened interest in factor investing has been accompanied by a corresponding focus on the nuts and bolts of constructing multifactor portfolios. There are essentially two ways to go: In a one-step process, single factor signals are blended into a composite signal and one multifactor portfolio(...) Weekly Recap: ETF Tax Efficiency, Profitability Factor, Trend Following [Alpha Architect]This week Ryan and I have a discussion on three topics. First, we discuss ETF tax efficiency based on the findings in a new paper by the RAFI team. Second, we discuss the profitability factor as Larry Swedroe highlights a new paper on international evidence. Third, we discuss my article on how one(...) The Profitability Factor: International Evidence [Alpha Architect]Robert Novy-Marx’s 2013 paper “The Other Side of Value: The Gross Profitability Premium” not only provided investors with new insights into the cross-section of stock returns, but also helped further explain some of Warren Buffett’s superior performance. (Wes Gray summarized that paper(...) What is the correct benchmark for trend following? [Alpha Architect]“What is the correct benchmark for trend following?” This is a difficult question, and there really is no perfect answer. As many of our readers know, we are fans of trend following and trend-followed portfolios. For those unfamiliar with trend following, the idea is rather simple–invest in an(...) How a Multi-factor Portfolio is Constructed Matters [Alpha Architect]The CAPM was the first formal asset-pricing model. Market beta was its sole factor. With the 1992 publication of their paper, “The Cross-Section of Expected Stock Returns,” Eugene Fama and Kenneth French introduced a new-and-improved three-factor model, adding size and value to market beta as(...) Fixed Income Factors: An Overlooked Corner of the Market [Alpha Architect]Factors, or “style” investing, seems to be all the rage these days, including the use of factors in fixed income (here, here and here are good places to start). However, many of these strategies focus on CUSIP level bond selection. This means executing a strategy with a fair amount of turnover(...) Investment Factor Timing: Challenging, but Not Impossible [Alpha Architect]Is it possible to time factors? (An old blog on the topic here and Jack discussing on a podcast here) Are there financial and economic indicators that can be used to predict factor returns? Are timing models just luck? What are the Academic Insights? YES. The authors use Fama-French 5 Factors(...) Summing up the Potential Benefits and Pitfalls of Diversification in 3 Slides [Alpha Architect]Not long ago I used to teach investment management courses to Master’s students (MBAs and MS Finance types). A core aspect of my course was so-called modern portfolio theory. We did a lot of math and problem-sets to make it feel like we were doing something useful. But I can summarize the core(...) How can the Investment CAPM Price Momentum? [Alpha Architect]“How can a q-theoretic model price momentum?” is a new paper by Robert Novy-Marx and goes right to the heart of an intense debate ongoing in empirical asset pricing — can neoclassic economic models explain the so-called momentum anomaly? A quote from the start of the paper, which answers the(...) When Diversification Fails [Alpha Architect]The paper investigates the following research question: Are left-tail vs. right-tail correlations symmetric for the majority of risky assets (including size and styles)? Is left-tail vs. right-tail correlations between stocks and hedge funds styles symmetric? Is left-tail vs. right-tail correlations(...) Value and Momentum and Risk [Alpha Architect]Early in the summer, I was on a podcast with Corey Hoffstein discussing momentum investing. During the discussion, Corey asked me a question regarding risk versus mispricing, specific to the momentum anomaly. We frequently cite the behavioral explanation for momentum–investors tend to underreact(...) Alpha Architect Weekly Research Recap (Jack & Ryan) [Alpha Architect]You can watch the video via the link below: Video Summary Ryan and I discuss three articles published on our blog this week. First, we examine a paper by Linda Zhang investigating the volatility of leveraged ETFs. Second, we discuss an article (and corresponding video and PPT slides from Wes)(...) Momentum Investing, Like Value Investing, is Simple, but NOT Easy [Alpha Architect]We’ve covered momentum investing extensively over the years, to include 94 posts, a book on the subject, and numerous discussions on various podcast outlets. There are a few things one notices after thinking about a topic for so long: You forgot half of the things you read and/or wrote (yes, we(...) Leveraged ETFs and Volatility Jumps [Alpha Architect]The paper investigates the following research question: What has the absolute risk behavior of leveraged products been historically? Did they behave as intended by design? Is the leverage multiple a reliable indicator of the volatility multiple? Is the leverage multiple a reliable indicator over(...) How Leverage Constraints Effect Mutual Fund Risk Taking [Alpha Architect]The 2014 study by Andrea Frazzini and Lasse Heje Pedersen, “Betting Against Beta,” found strong support for low-beta strategies. I’ve previously written on low-beta strategies here. This paper finds that, for U.S. stocks, the betting against beta (BAB) factor (a portfolio that holds low-beta(...) Video: Alpha Architect Weekly Research Recap [Alpha Architect]You can watch the video via the link below: Video Summary Ryan and I discuss three articles published on our blog this week. First, we examine a summary by Larry Swedroe that highlights the Betting Against Beta (BAB) factor and dives into two new papers examining when the BAB factor performs well.(...) The Conservative Formula: Quantitative Investing made Easy [Alpha Architect]Is it possible to build a simple systematic approach that beats investing in complex factor models? The research team here has proposed that a simple formula based on low return volatility, high net payout yield (dividends +/- stock buybacks), and strong price momentum gives investors exposure to(...) What's in Your Benchmark? [Alpha Architect]This article examines the magnitude of exposures to a set of systematic factors present in widely accepted Benchmarks (S&P500, the Russells, and MSCI global indices) and how they change over time. The authors use conventional style factors of value, size, quality, momentum, and minimum(...) Fintwit Might Matter for Momentum and Mean Reversion in Stock Prices [Alpha Architect]Do users of social media provide valuable information about liquidity that can be used to predict future liquidity? Does social media provide useful information, over and above that provided by traditional, fundamental news sources? Do positive and negative sentiment have the same effects on(...) Academic Factor Portfolios are Extremely Painful. Unless you are an Alien [Alpha Architect]Imagine you are an alien. You land on planet earth in 1927 and are given a mission. You are told that you need to solve a problem: compound $1,000,000. The goal: compound your extraterrestrial face off. The options: FF_VAL: Top decile B/M, annually rebalanced, market-cap weighted. FF_MOM: Top decile(...) Looking at Alternatives? Avoid Complexity and Magical Backtests [Alpha Architect]The paper investigates the following research question: Does persistence (out of sample performance) exist for alternative beta strategies sponsored by investment banks? Does adding complexity to a strategy increase the risk of backtesting overfitting? Do the strategies capture the factor exposure(...) Accruals Momentum as an Investment Strategy [Alpha Architect]Accruals are a part of any company’s financial reporting. For those unfamiliar with accrual accounting, a simple explanation is that accruals are adjustments made for (1) revenue that has been earned but not received and (2) costs that have been incurred but have not been paid. In short, one(...) The Best Research Paper Ever Written on Trading Costs [Alpha Architect]Trading costs are a hot topic these days. The topic has sparked investor attention because of the rise of systematic factor investing strategies available via the ETF structure. It seems as if everyone is a “quant” these days, slinging money around like drunken pirates, destroying the price(...) Macro Conditions May Enhance Short-term Predictability of the Shiller P/E [Alpha Architect]Is there a relationship between real yields and short-term market valuation? Is there a relationship between inflation rates and short-term market valuation? Does the predictive power of the Shiller P/E improve by using yields and inflation? What are the Academic Insights? YES. The authors describe(...) The Carry Factor and Global Risks [Alpha Architect]The carry factor is the tendency for higher-yielding assets to provide higher returns than lower-yielding assets — it is a cousin to the value factor, which is the tendency for relatively cheap assets to outperform relatively expensive ones. A simplified description of carry is the return an(...) Warning: Stock and Bond Correlation Assumptions are Regime Dependent! [Alpha Architect]It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so. — attributed to Mark Twain. Mark Twain had some great insights. The quote above can apply to just about every aspect of life, including investing. This axiom is particularly relevant(...) A Q&A Discussion with Vanguard Researchers on the "Fair Value CAPE Ratio" [Alpha Architect]As everyone who’s been invested for the last ten years knows, post-financial crisis stock returns have been incredible. The chart below highlights the total returns for the S&P 500 Index, the MSCI EAFE Index, the MSCI EEM Index, and the MSCI ACWI Index. The results are hypothetical results and(...) Finance Journals Rarely Publish Articles with low T-stats [Alpha Architect]Coined by Rosenthal in 1979, the term file drawer problem refers to the notion that journal editors are biased toward accepting articles that include statistically significant results over those with nonsignificant results. The competition for increasing the citation count and improving journal(...) Factor Investing Insights You Won't Hear from Fama and French [Alpha Architect]Factor investing research has a long storied past. Fama and French’s 1992 and 1993 papers arguably put factor investing “on the map,” but truth be told, factor investing is an old topic with roots grounded in the so-called arbitrage pricing theory. We have a longer piece on the history of(...) Which Investment Factors Drive Corporate Bond Returns [Alpha Architect]What are the research questions The presence of historical prices impacting future returns, i.e., momentum, has been well researched in the equity market, which we’ve covered here. We’ve also closely looked at momentum in bond markets here, here, and here. What the Bali, Subrahmanyam, & Wen(...) Portfolio Craftsmanship is Just as Important as Choosing an Investment Style [Alpha Architect]This is an important article for practitioners because it brings specific investing decisions that are often treated as afterthoughts, to the forefront in style-based investing. The authors propose that decisions made beyond the initial decision to invest in a style, such as value or momentum, are(...) Deconstructing the Low Volatility/Low Beta Anomaly [Alpha Architect]One of the big problems for the first formal asset pricing model developed by financial economists, the Capital Asset Pricing Model (CAPM), was that it predicts a positive relationship between risk and return. However, the historical evidence demonstrates that, while the slope of the security market(...) Do Fundamentals Still Drive Market Prices? Or Have ETFs Taken Over? [Alpha Architect]What causes a stock’s price to move? A great question, and one that puzzles most market observers every day. Since this is puzzling, it is an entertaining topic to discuss–enter CNBC and the financial media. In the short-run, stocks prices can move for a variety of reasons … noise trading,(...) Artificial Intelligence and Value Investing [Alpha Architect]The paper investigates the following research question: Can machines allocate capital in the classic style of a value investor like Benjamin Graham or Warren Buffett? What are the Academic Insights? By connecting two broad and disparate areas (the innovative AI domain and the more old-fashioned(...) For Consistency Across Market Conditions, Try a Quant Manager [Alpha Architect]What are the research questions? Using eVestment, a source of data for asset managers, the authors evaluate U.S. fundamental and quantitative managers, specifically core, growth and value styles. Eighteen strategy types (six in each style) were identified and results calculated using averages for(...) Podcast: Momentum in Theory, Momentum in Practice [Alpha Architect]Here is a link to our podcast on Flirting with Models. Today I am speaking with Jack Vogel, co-CIO of boutique ETF issuer Alpha Architect. I’ve known Jack for some time now and was particularly excited to bring him on the show for two reasons. The first, which you will quickly learn in the(...) Explaining the Beta Anomaly [Alpha Architect]The superior performance of low-beta and low-volatility stocks was documented in the literature back in the 1970s — by Fischer Black (in 1972) among others — even before the size and value premiums were “discovered.” The low-beta/low-volatility anomaly has been demonstrated to exist in(...) Financial Constraints Generate a 6.5% 5-Factor Fama-French Alpha? [Alpha Architect]Farre-Mensa and Ljungqvist (2016) observe that many measures of financial constraints used in the literature are flawed. In fact, to date, it remains an empirical challenge to quantify them. The authors attempt at solving this problem by answering the following research questions: Can textual(...) Trust the Process [Alpha Architect]As a native Philadelphian and huge basketball fan, I fully agree with the 76ers fan’s rally cry — Trust the Process. Even the players, such as Joel Embiid, have echoed the sentiment of the fans: For those not in Philly and not too familiar with the NBA, “Trust the Process” explains the 76ers(...) A Smarter CAPE Ratio to Better Forecast Expected Stock Returns [Alpha Architect]What are the research questions? The authors propose and test an enhanced Shiller model that incorporates macroeconomic conditions, by modeling real bond yields and volatility, equity volatility and inflation, in a 2 step approach to forecasting equity returns. The underlying thesis is that the(...) The 52 Week High and the Q-Factor Investment Model [Alpha Architect]In the past, we have examined the following two topics: (1) stock performance & the 52-week high and (2) the investment CAPM. When examining the performance of stocks relative to their respective 52-week high (highlighted by us here), the authors (George and Hwang) find the following: When(...) Commodities for the Long Run [Alpha Architect]The paper investigates this issue by answering the following research questions: Are commodities returns positive on average? How do they vary in different economic states (backwardation/contango; expansion/recession periods; unexpected inflation) ? How have they contributed to a broad portfolio?(...) The Future for Factor Investing May Be Different Than its Backtested Past [Alpha Architect]We believe there are cause and effect relationships in the world — and in investing — that hold true over time. Many are common sense and easily observable – like fire creates smoke – while others are harder to see and understand. With factor investing, true relationships can be hard to see(...) Machine Learning for Financial Market Prediction With Sklearn and Keras [Alpha Architect]Recently, Wes pointed me to this interesting paper by David Rapach, Jack Strauss, Jun Tu and Guofu Zhou: “Dynamic Return Dependencies Across Industries: A Machine Learning Approach.” The paper presents a strategy that forecasts industry returns and shows excellent historical returns. In this(...)