Does history offer a reason to be cautious on the outlook for stocks if inflation and interest rates are rising? Yes, sort of, according to a New York Times article published on Thursday. Hedging just a bit, the Times piece relates that “it’s long been a truism that higher inflation and its

The recent plunge in the US stock market ended the extended run of tranquility in equity returns. The media’s metric of choice to cite this change is the CBOE Volatility Index, or VIX, which surged earlier this week to the highest level in nearly three years, based on daily data. The upward

The 4.1% plunge in the S&P 500 yesterday looks ominous, all the more so since it follows last week’s hefty 3.8% decline. But focusing on what just happened distorts our capacity to maintain a healthy sense of historical perspective. As an antidote, let’s step back and consider the latest

How bad was last week’s rout in US equities? The slide is the biggest weekly drop for the S&P 500 Index in over two years. But that’s not saying much, given how calm the upside bias for the equity trend has been lately. Perhaps the bigger surprise is that we’ve gone so long without a

Momentum-based investing strategies may be one of the most reliable drivers of alpha, but like all sources of excess return this factor premium waxes and wanes through time. Accordingly, deciding when to exit the trade (or reduce exposure to it) is no less critical than determining when to jump on

Fama-French Factors and Business Cycles Arnav Sheth and Tee Lim (Saint Mary’s College of California) December 4, 2017 We examine the behavior of Fama-French factors across business cycles measured in various ways. We first split up the business cycles into four stages and examine the cumulative

So many research papers, so little time. How do you separate the wheat from the chaff? You might start with the following five economic and financial papers that appeared in The Capital Spectator’s Research Review column in 2017. In a sea of newly minted studies over the past 12 months, these

The US stock market has been on a tear lately. Has the party gone too far? A rising chorus of analysts say that caution is advised, citing several valuation metrics. The Shiller PE Ratio, for instance, is currently at its second-highest level since the late-1800s. Valuations appear stretched, but

Implementing Momentum: What Have We Learned? Adrienne Ross (AQR Capital Management), et al. December 2017 An abundance of academic evidence and theory exists on the efficacy and intuition behind momentum investing, yet a limited number of studies discuss the feasibility of running momentum

Momentum investing – betting on the persistence of price trends in the short to medium term — has captured the crowd’s attention in recent years. Consider, for instance, the strong growth in ETF assets in the niche. The first fund launched a bit more than five years ago; today, there are

Investing in a Multi-Asset Multi-Factor World Alexandar Cherkezov (Invesco), et al. August 31, 2017 In this article, we advance the use of factor investing across multiple asset classes. It turns out that style factors well established in the equity domain – such as value, momentum or quality –

In previous installments of replicating indexes I profiled the style-analysis methodology and presented an example using a hedge fund index. Now let’s turn to a strategy of replicating the S&P 500 Index with a handful of stocks that are considered socially responsible investments (SRI).

Imitation, Oscar Wilde famously observed, “is the sincerest form of flattery that mediocrity can pay to greatness.” The observation echoes the objective for using Professor Bill Sharpe’s style analysis to replicate investment indexes that, for one reason or another, can’t be purchased

The Most Dangerous (and Ubiquitous) Shortcut in Financial Planning John West and Amie Ko (Research Affiliates) September 2017 Using historical returns to forecast the future is one of the most common shortcuts in financial planning. Investment advisors who use only past returns to forecast future

In the quest for clarity in portfolio analytics, Professor Bill Sharpe’s introduction of returns-based style analysis was a revelation. By applying statistical techniques to reverse engineer investment strategies using historical performance data, style analysis offers a powerful, practical tool

Asset Allocation in a Low Yield Environment John Huss (AQR Capital Mgt.), et al. August 17, 2017 The year 2016 saw bond yields fall to unprecedented low levels in major developed markets, with nominal yields on 10-year German and Japanese government bonds even turning negative. While yields have

There are no silver bullets for profiling risk, but drawdown’s properties arguably give this metric a leg up over most of the competition. The combination of an intuitive framework, simplicity, and sharp focus on how markets actually behave is a tough act to beat. Perhaps the strongest argument in

Designing and managing asset allocation strategies based on factors is promoted in some corners as a better way to build portfolios. Not surprisingly, there’s no shortage of studies that support this view. But the jury’s still out on whether it’s prudent to throw out the standard asset-class

US Sector Rotation with Five-Factor Fama-French Alphas G. Sarwar (University of Greenwich), et al. June 16, 2017 In this paper we investigate the risk-adjusted performance of US sector portfolios and sector rotation strategy using the alphas from the Fama-French five factor model. We find that

Monetary Policy Uncertainty and Bond Risk Premium Fuwei Jiang (Central University of Finance and Economics) and Guoshi Tong (Renmin University) October 1, 2016 We show that uncertainty of monetary policy (MPU) commands a risk premium in the US Treasury bond market. Using the news based MPU measure

The astonishing bull market (bubble?) in Bitcoin has drawn attention to the cryptocurrency from all corners. One of the questions that’s reasonating: Should Bitcoin be treated as an asset class, on par with stocks, bonds, real estate and commodities? A Forbes article last year, citing a study by

How much higher can smart beta adoption climb? Now in its fourth year, FTSE Russell’s latest annual survey of global institutional asset owners indicates that smart beta adoption is at an all time high and that investors continue to find new applications for its use. The survey, Smart beta: 2017

Credit Spreads, Daily Business Cycle, and Corporate Bond Returns Predictability Alexey Ivashchenko (University of Lausanne) May 4, 2017 The part of credit spread that is not explained by corporate credit risk forecasts future economic activity. I show that the link with aggregate business risk and

Bubbles for Fama Robin M. Greenwood (Harvard Business School), et al. February 2017 We evaluate Eugene Fama’s claim that stock prices do not exhibit price bubbles. Based on U.S. industry returns 1926–2014 and international sector returns 1985–2014, we present four findings: (1) Fama is correct

Benchmarks are indispensable for investment analytics. The challenge is picking a relevant one. The stakes are high because the wrong benchmark can be worse than none at all. The good news is that the potential for error can be dramatically reduced by choosing a set of random benchmarks that are

Contrarian Factor Timing is Deceptively Difficult Clifford S. Asness (AQR Capital Management), et al. March 7, 2017 The increasing popularity of factor investing has led to valuation concerns among some contrarian-minded investors, and fears of imminent mean-reversion and underperformance. In this

Limited data is the financial modeler’s biggest challenge. Making assumptions about risk is tough enough under the best of circumstances. All too often it’s even tougher when the historical record is thin. There are several ways to manage this challenge, including bootstrapping, aka resampling

Liquid Alternative Mutual Funds versus Hedge Funds Jonathan S. Hartley (University of Pennsylvania) February 1, 2017 Despite the rapid rise of the number of liquid alternative mutual funds (LAMFs) available to retail investors in recent years, few studies have compared how their return and risk

The financial crisis of 2008 devastated portfolios far and wide and brought the global economy to the brink of collapse. It was a disaster, but there was at least one positive outcome from the debacle: a wider recognition that tail risk is a real and present danger that’s forever lurking. The

Most investment portfolios are a collection of risk factors, such as exposure to credit and equity risk. Monitoring and managing these factors is critical. The standard approach is reviewing portfolios through a plain-vanilla asset allocation lens – 60% stocks, 30% bonds, 10% cash, for instance.

Can you distinguish alpha from beta? Child’s play, right? Measure an investment portfolio against a relevant benchmark and, voila, all is clear. But as a new paper reminds, analyzing risk and return based on time horizon changes a black-and-white world of equity factors into 50 shades of gray.

Ben Carlson at Ritholtz Asset Management reminds us that backtesting offers no shortcuts to investment nirvana. As he correctly points out, there are numerous shortcomings in the art/science of reconstructing the historical results of an investment strategy. But it’s also true that backtesting, if

How Should Investors Respond to Increases in Volatility? Alan Moreira (Yale University) andn Tyler Muir (UCLA) December 2, 2016 They should reduce their equity position. We study the portfolio problem of a long-horizon investor that allocates between a risk-less and a risky asset in an environment

Measuring Factor Exposures: Uses and Abuses Ronen Israel and Adrienne Ross (AQR Capital Management) September 19, 2016 A growing number of investors have come to view their portfolios (especially equity portfolios) as a collection of exposures to risk factors. The most prevalent and widely harvested

Equal weighting asset allocation doesn’t look encouraging as a portfolio-design tool, based on last week’s preliminary analysis. Can we salvage equal weighting by expanding the opportunity set with a more granular mix of funds? In a word, no. As we’ll see, equal weighting across asset classes

Yesterday’s post on equal weighting for asset allocation motivated a reader to point out that equal weighting’s tendency to outperform in equity portfolios is due to frequent rebalancing events. A passively managed market-cap-weighted portfolio, by contrast, is allowed to drift, with weights

Equal weighting has an encouraging record as a design choice for earning a moderately higher premium in the stock market compared with the conventional weighting system of holding shares in proportion to their market-capitalization weight. A leading real-world example: the Guggenheim S&P 500

Ilya Kipnis at QuantStrat TradeR reminds us that the Hidden Markov Model (HMM), which can be a powerful tool for detecting regime change in markets and macro, has its limitations and pitfalls. In particular, Kipnis reports that HMM’s value as a prediction tool for the stock market is dubious.

Managed portfolios that take less risk when volatility is high produce large alphas, substantially increase factor Sharpe ratios, and produce large utility gains for mean-variance investors. We document this for the market, value, momentum, profitability, return on equity, and investment factors in

Morningstar tells us that efforts at taming volatility in a multi-asset class framework generally turns up mixed results among publicly traded funds. Studying 60 products that are labeled “multiasset volatility-protection funds,” a recent Morningstar article reports that “as a group,

A year ago, bear-market risk looked elevated for the US stock market, based on a Hidden Markov model (HMM). The warning, which was discussed on these pages at the time (see here, for instance), has had a mixed record. Although stocks swooned in late-2015 and early 2016, the growling was relatively

The world is awash with backtests that lay claim to new portfolio techniques that provide superior results for managing risk, juicing return, or both. What’s often missing is a robust stress test to confirm that the good news is more than a statistical anomaly. Crunching the numbers on a single

Do Stock Market Trading Activities Forecast Recessions? Ujjal Chatterjee (University of Wisconsin-Milwaukee, American University of Sharjah) August 9, 2016 This paper re-examines the existing recession forecasting models with stock market liquidity as an additional forecasting variable. We

The Sharpe ratio was introduced half a century ago and it’s still going strong. Although the world is now awash with competitors, the granddaddy of quantitative risk metrics endures. Its longevity and widespread use drives some analysts batty, but for good or ill the SR is deeply embedded into the

Asset Allocation: A Recommendation for Resolving the Collision between Theory and Practice Larry J. Prather (Southeastern Oklahoma State University), et al. April 26, 2016 We examine the creation of a low-cost optimal risky portfolio that individual investors can easily construct and manage. We

Vanguard founder John Bogle gave a powerful speech last month at the Q Group’s Spring Seminar that lays out the case (again) for favoring basic indexing and shunning complexity in matters of portfolio design and management. As Morningstar’s John Rekenthaler points out, Bogle wields the weapon of

The Market Portfolio is NOT Efficient: Evidences, Consequences and Easy to Avoid Errors Pablo Fernandez (University of Navarra), et al. March 16, 2016 The Market Portfolio is not an efficient portfolio. There are many evidences that tell us that: the equal weighted indexes have beaten their

Developing confidence about a portfolio strategy’s track record (or throwing it onto the garbage heap), whether it’s your own design or a third party’s model, is a tricky but essential chore. There’s no single solution, but a critical piece of the analysis for estimating return and risk,

Skill is a slippery concept in finance, courtesy of the shady influence of chance in asset pricing. It's also an awkward topic in just about every corner of money management because discussing it in detail invariably raises serious doubts about our ability to engineer investment results that

Last week’s post on analyzing US equity value and momentum risk premia ended with a question: How much, if any, improvement should we expect by adding a dynamic system for managing exposure to these risk factors vs. a buy-and-hold strategy? What follows is a preliminary effort in searching for an