Accidental Alpha

Posted in Big Ideas, Size Effect, Value Premium


How can equity weighting strategies and their opposites both outperform the stock market? In the October 2012 version of their paper entitled “The Surprising ‘Alpha’ from Malkiel’s Monkey and Upside-down Strategies”, Rob Arnott, Jason Hsu, Vitali Kalesnik and Phil Tindall challenge beliefs underlying a variety of stock investment strategies that beat a capitalization-weighted benchmark by examining the performance of portfolios based on opposite beliefs. If the original beliefs determine success, then their opposites should underperform. They limit their investigation to long-only stock weightings based on original beliefs and opposites based on inverse weights or complement weights. To ensure portfolio feasibility, they restrict U.S. and global universes to large-capitalization stocks. They reform portfolios at the end of each year. When needed in portfolio construction, they estimate historical parameters (such as volatility) using five years of lagged monthly data. They consider capitalization-weighted, equal-weighted and diversity-weighted benchmarks and use a conventional four-factor (market, size, book-to-market and momentum) model to calculate strategy alphas. They ignore trading frictions. Using monthly returns for the top 1,000 U.S. stocks by market capitalization during 1964 through 2010 and for large-capitalization global stocks during 1991 through 2010, they find that: (more…)

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