Quant Mashup - Alpha Architect Financial Media, Price Discovery, and Merger Arbitrage [Alpha Architect]This paper contributes to the literature on understanding the limits of arbitrage and the resulting dynamics of price discovery. Specifically, it studies the context of "merger arbitrage," which is a well-known investment strategy and unless there are limits to arbitrage, this market(...) Relative Sentiment and Market Returns [Alpha Architect]This paper studies the relationship between aggregate investor attention and subsequent market returns over the following week. The authors create two different investor attention indicators—one for aggregate retail attention (ARA) and one for aggregate institutional attention (AIA). ARA is found(...) Value Investing and the Role of Intangibles [Alpha Architect]Recent research, including the 2020 studies “Explaining the Recent Failure of Value Investing” and “Intangible Capital and the Value Factor: Has Your Value Definition Just Expired?,” have investigated the impact on U.S. value strategies of the increase in the relative importance of(...) The Active vs Passive: Smart Factors, Market Portfolio, or Both? [Alpha Architect]While there may be debates about passive and active investing, and even blogs about the numbers of active funds that were outperformed by the market, history taught us that the outperformance of active or passive investing is cyclical. As a proxy for active investing, the paper examines factor(...) Factor Investing and International Markets [Alpha Architect]nternational markets have been a fertile testbed for factor research because they offer an opportunity to test old ideas on new data. Much of the previous work studying factor structure and risk premia in international markets uses highly aggregated test assets, such as country portfolios, industry(...) The Benefits of Sin Stocks [Alpha Architect]While environmental, social, and governance (ESG) investing continues to gain in popularity, economic theory suggests the share prices of “sin” businesses (typically those involved in the gambling, tobacco, alcohol, guns, and defense industries) will become depressed if a large enough proportion(...) March for the Fallen 2021: Detailed Logistics Outline and What to Expect [Alpha Architect]March for the Fallen (#MFTF) will happen on September 25, 2021. COVID can't kill the event this year! Action Item: Please let us know your trip details so we can support you as much as possible. Here are the links to prior updates if you'd like to review: Footwear and foot care(...) The Role of Book-to-Market in Bond Returns [Alpha Architect]My August 17, 2020, article for Advisor Perspectives, “Factor-Based Investing Beats Active Management for Bonds,” provided the evidence from a series of academic papers on the ability of common factors to explain the variation of returns of bond funds, results which have important implications(...) Factor Investing in Sovereign Bond Markets: 221 years of evidence! [Alpha Architect]Despite government bonds being one of the major asset classes invested in global portfolios, 30% of overall market capitalization according to Doeswijk, et al. (2020), little work has been done to investigate whether factors are present in the sovereign bond market. (Here is a deep dive into fixed(...) The Misery Index and Future Equity Returns [Alpha Architect]Prospect theory was developed by Daniel Kahneman and Amos Tversky in 1979. The theory starts with the concept of loss aversion—the observation that people react differently between potential losses and potential gains. Thus, people make decisions based on the potential gain or loss relative to(...) Maximize ESG exposure or screen out sin stocks? [Alpha Architect]In a 2020 paper, the authors explore the side effects of applying ESG screens to a passive portfolio. While the ESG scores or tilt was improved and Sharpe ratios increased, significant regional, sector, and conventional risk factor exposures were magnified. While investors may be attracted and(...) Low Volatility Factor Investing: How Investment Horizon Affects Results [Alpha Architect]Two of the more interesting puzzles in finance are the high beta anomaly (high beta stocks have lower returns) and the IVOL anomaly (stocks with greater idiosyncratic volatility have produced lower returns). These are anomalies because both beta and IVOL are viewed as risk factors and should be(...) Can Investors Beat Active Mutual Funds with Cheap ETFs, YUP! [Alpha Architect]The research (and the theory) has convincingly shown that mutual funds should and do underperform a passive index by an amount approximately equal to fees. However, no one has actually tried to construct the active mutual fund dominating passive strategy using commercially available products. It(...) Private Equity: Is There Anything Special There? [Alpha Architect]As the following table demonstrates, since its inception in the 1970s, the private equity industry has grown significantly. According to Preqin data, there are now more than 18,000 private equity funds, with assets under management exceeding $4 trillion. Source: NACUBO endowment studies, FY(...) Factors Timing is a Difficult Practice [Alpha Architect]Last week Tommi looked into whether hedge funds could time factors. The conclusion? Probably. This week we're going to see if Mutual Fund managers have any skill at cracking the factor timing code. The conclusion? They aren't great factor timers! The authors of the paper study a large(...) The Performance of Volatility-Managed Portfolios [Alpha Architect]As far back as 1976, with the publication of Fischer Black’s “Studies of Stock Price Volatility Changes” financial economists have known that volatility and returns are negatively correlated. This relationship results in the tendency to produce negative equity returns in times of high(...) Can Hedge Funds Successfully Time Factors? [Alpha Architect]This study pulls together several threads in the academic literature: (1) the persistence of hedge fund outperformance; (2) the apparent use of time-varying beta exposures by hedge funds, where betas are predicated on conditions such as leverage, carry trade, major events and conditions in the(...) Combining Value and Profitability Factors: the International Evidence [Alpha Architect]My October 29, 2020, article for Alpha Architect examined the research on the profitability factor. I then reviewed the findings of the June 2020 study “On the Conjoint Nature of Value and Profitability,” which analyzed how combining the profitability factor with the value factor— tilting the(...) Still Using Book to Market for a Value Metric? Read This. [Alpha Architect]Book to Market (B/M) has been a prominent indicator used to construct "value" tilted portfolios. The love affair with B/M started with Graham and Dodd (1934), but became the gold standard after Fama and French (1992). Historically, B/M was a reasonable ratio to express the value factor and(...) This Time is Different? Consider Quantifying Subjective Priors [Alpha Architect]This time is different. --John Templeton "This time is different," is a sentiment that leads many investors to stray from using data analysis in their investment decision process and more towards discretionary judgment. The logic as to why data analysis techniques may not apply to(...) Get Green or Die Trying? [Alpha Architect]In 2015, 197 nations signed onto the Paris Agreement and committed to limiting global warming to less than 2 degrees C above preindustrial levels. Although the arguments are compelling, the drive to manage carbon risk presents quite a challenge for individual investors and portfolio managers.(...) The Explanatory Power of Factor Momentum [Alpha Architect]Momentum is the tendency for assets that have performed well (poorly) in the recent past to continue to perform well (poorly) in the future, at least for a short period of time. 1 In 1997, Mark Carhart, in his study “On Persistence in Mutual Fund Performance,” was the first to use a momentum(...) Value and Momentum Investing: Combine or Separate? [Alpha Architect]When it comes to Value and Momentum investing we often get asked the following set of questions: Should I use value and momentum, in one screen, to form a single portfolio of stocks? ("Blended", "combined", or "integrated") Or should I focus on the value and momentum(...) Predictability of the Value Premium Across Asset Classes [Alpha Architect]The value spread is the difference between the value signal in the long versus the short portfolio. This isn’t the first time we have hit on this topic. Wes and I have done several posts on the subject: Timing Value and Momentum with Valuation-Spreads The Returns to Value Strategies When Valuation(...) Are Ben Graham’s Disciples Value and Quality Factor Investors? [Alpha Architect]I examine the performance records of performance of Ben Graham's well-known disciples: Walter Schloss, Tom Knapp, Warren Buffett, Bill Ruane, Charlie Munger, Rick Guerin, and Stan Perlmeter. The research question I seek to address is the following: Do the academic "value" and(...) ESG Performance Breakdown by E, S, and G [Alpha Architect]The relationship among ESG ratings from third-party providers has historically produced conflicting results. Differences in sourced information and weighting schemes have produced low correlations between ratings and as a result, have handicapped the efforts to understand the relationship between(...) Fixed income when you’re between a rock and a hard place - Part 2 [Alpha Architect]In Part 1, we defined fixed income factors. But factors alone will not solve each investor’s problem. Below, we extend the discussion by walking through a case study that shows how an asset allocator might use factors to solve a common problem: how to invest in a low yield environment given the(...) Value Investing Still Beats Growth Investing, Historically [Alpha Architect]A few weeks ago I saw comments on Twitter regarding the Russell 3,000 Value and Growth indices having approximately the same returns since inception. For example, here is Ben Johnson from Morningstar 1 As viewed from this tweet, and is born out in the data for the Russell indices, it appears that(...) Text-Based Factor Investing [Alpha Architect]This is the first part of a series of guest posts by Kai Wu, the CIO & Founder of Sparkline Capital. The Factor Zoo As readers of Alpha Architect’s blog, you’re certainly familiar with factor investing. Factors are quantifiable firm characteristics that explain cross-sectional stock returns.(...) Resurrecting the Value Premium [Alpha Architect]The dramatic underperformance of value stocks as defined by the HmL (the return on high book-to-market stocks minus the return on low book-to-market stocks) since 2017 has led many to question the existence of the value premium. The recent drawdown has been by far the largest ever experienced. From(...) Market Timing Using Aggregate Equity Allocation Signals [Alpha Architect]When it comes to predicting long-term equity returns, several well-known indicators come to mind—for example, the CAPE ratio, Tobin’s Q, and Market Cap to GDP, to name a few. Yet there is another indicator without nearly as high of a profile that has outperformed the aforementioned indicators(...) Building a Better q-Factor Asset Pricing Model [Alpha Architect]Since the development of the first asset pricing model, the Capital Asset Pricing Model (CAPM), academic research has attempted to develop models that increase the explanatory power of the cross-section of stock returns. We moved from the single-factor CAPM (market beta), to the three-factor(...) Climate Change and Asset Allocation [Alpha Architect]This article focuses on “climate-aware” asset allocation and the associated impacts of higher temperatures on equity excess returns and risk. The objective of this research is to demonstrate how portfolios can incorporate climate change risk and rewards into the decision-making process. The(...) How Portfolio Construction Impacts the Reliability of Outcomes [Alpha Architect]We are proponents of focused (i.e., 50 stock) long-only value and momentum factor strategies. 1 There are also plenty of incredibly talented systematic investing shops that build highly diversified factor portfolios with 500+ stocks. We take no stance on the "best" approach because there(...) Inflation and the Value Premium [Alpha Architect]The grand experiment of combining massive fiscal and monetary stimulus at a time when the economy is already recovering strongly—the Fed’s latest forecast for 2021 GNP growth is 6.5 percent—has led many investors to begin to worry about the risks of rising inflation. And strong growth is(...) Trend-Following Filters – Part 3 [Alpha Architect]This is the third article in a series of three, the first two are available here and here. Those articles focus on examining from a digital signal processing (DSP) perspective 1 various types of digital filters that are designed to model trends in time series, in order to illustrate their properties(...) Estimating the Stock-Bond Correlation [Alpha Architect]The correlation between stock and bond returns is an integral component of hedging strategies, risk assessment, and minimization of risk in allocation decisions. In the context of those strategies, the stock-bond correlation is typically estimated using monthly return data over a recent previous(...) Fixed Income when you’re Between a Rock and a Hard Place - Part 1/2 [Alpha Architect]Investors are stuck between a rock and a hard place. On one hand, it is painful to buy bonds that deliver paltry yields near all-time lows (Figure 2). On the other hand, many investors’ risk tolerance, compliance guidelines or liabilities preclude them from reducing their fixed income allocations.(...) How Active Mutual Funds Use ETFs [Alpha Architect]As of 2017, and in spite of the documented negative relationship between fund performance and use of ETFs, approximately one-third of US-domiciled, actively managed mutual funds held ETFs at one time or another. Active managers justifiably make use of ETFs to improve their portfolio management(...) More on the Factor Investing Replication Debate [Alpha Architect]There has been a wave of articles (and press) suggesting that academic research suffers from a replication crisis. A “replication crisis” simply means that other researchers are unable to replicate the results from prior research using similar experimental conditions. Psychology seems to be the(...) Democratize Quant Conference Recap and Materials [Alpha Architect]COVID is killing conference mojo overall, but we were able to host a short and sweet “Democratize Quant” conference this morning. The speakers were terrific and I personally learned a lot from them. This post is a recap of what we heard and some resources we can make available to the public.(...) Is There a Replication Crisis in Finance? [Alpha Architect]In recent years the field of empirical finance has faced challenges from papers arguing that there is a replication crisis because the majority of studies cannot be replicated and/or their findings are the result of multiple testing of too many factors. For example, Paul Calluzzo, Fabio Moneta, and(...) An Economic Framework for ESG Investing [Alpha Architect]The 2018 Global Sustainable Investment Review reports over $30 trillion invested with explicit ESG goals as of the beginning of 2018. In the words of the authors: There is a clear tendency for many investors to own ethical companies in a saintly effort to promote good corporate behavior while hoping(...) Conditional Volatility Targeting [Alpha Architect]Financial economists have long known that volatility and returns are negatively correlated. Fischer Black documented this in his 1976 paper “Studies of Stock Price Volatility Changes.” This relationship results in the tendency to produce negative equity returns in times of high volatility. In(...) How to Predict Stock Returns (using a simple model) [Alpha Architect]Jack Bogle, the founder of Vanguard, created a simple explanation for predicting future stock returns. The so-called “Occam’s razor” (law of parsimony) approach is an attempt to explain projected returns as simple as possible. Mr. Bogle’s model is pretty simple: Expected returns (nominal,(...) How to Measure the Liquidity of Cryptocurrency? [Alpha Architect]n January 2020, trading in bitcoin exceeded $930 billion and has certainly grown over the past year. Unlike nearly any other asset, bitcoin can be traded 24 hours a day, 7 days a week on trading platforms around the globe. While trading cryptocurrencies has become relatively frequent, the high(...) Low Volatility Factor Investing: Risk-Based or Behavioral-Based or Both? [Alpha Architect]The low-risk effect (aka low volatility) is based on the empirical observation that assets with low risk have high alpha. Specifically in this research, the effect is defined as the risk-adjusted return spread between low-risk and high-risk portfolios and not just low-risk stocks. Since the low-risk(...) Momentum Factor Investing: What's the Right Risk-Adjustment? [Alpha Architect]The momentum factor represents one of our core investment beliefs: buy winners. So when research presents itself that may contradict our beliefs it provides the opportunity to dig deeper and think harder about the factors we hold so dearly. Erik Theissen and Can Yilanci begin their paper by warming(...) Does Crowdsourced Investing Work? [Alpha Architect]Historically, as Richard Thaler pointed out in his book Misbehaving, financial academics have looked at humans as “Econs.” An Econ, unlike a human, values everything down to a penny before they make a decision, knows all possible alternatives, weighs them accurately, and always optimizes. 1 In(...) The Forecasting Power of Value, Profitability, and Investment Spreads [Alpha Architect]Studies such as the 2019 paper “Value Return Predictability Across Asset Classes and Commonalities in Risk Premia,” have demonstrated that while it is difficult to time investments based on their value spreads 1 which we’ve covered occasionally here and here, value spreads do contain(...)