Value Premium

Do value strategy returns vary exploitably over time and across asset classes? In their October 2017 paper entitled “Value Timing: Risk and Return Across Asset Classes”, Fahiz Baba Yara, Martijn Boons and Andrea Tamoni examine the power of value spreads to predict returns for individual U.S. equities, global stock indexes, global government bonds, commodities and currencies. They measure value spreads as follows:

• For individual stocks, they each month sort stocks into tenths (deciles) on book-to-market ratio and form a portfolio that is long (short) the value-weighted decile with the highest (lowest) ratios.
• For global developed market equity indexes, they each month form a portfolio that is long (short) the equally weighted indexes with book-to-price ratio above (below) the median.
• For each other asset class, they each month form a portfolio that is long (short) the equally weighted assets with 5-year past returns below (above) the median.

To quantify benefits of timing value spreads, they test monthly time series (in only when undervalued) and rotation (weighted by valuation) strategies across asset classes. To measure sources of value spread variation, they decompose value spreads into asset class-specific and common components. Using monthly data for liquid U.S. stocks during January 1972 through December 2014, spot prices for 28 commodities during January 1972 through December 2014, spot and forward exchange rates for 10 currencies during February 1976 through December 2014, modeled and 1-month futures prices for ten 10-year government bonds during January 1991 through May 2009, and levels and book-to-price ratios for 13 developed equity market indexes during January 1994 through December 2014, they find that:

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Is it better to build equity multifactor portfolios by holding distinct single-factor sub-portfolios, or by picking only stocks that satisfy multiple factor criteria? In their September 2017 paper entitled “Smart Beta Multi-Factor Construction Methodology: Mixing vs. Integrating”, Tzee-man Chow, Feifei Li and Yoseop Shim compare long-only multifactor portfolios constructed in two ways:

1. Integrated – each quarter, pick the 20% of stocks with the highest average standardized factor scores and weight by market capitalization.
2. Mixed – each quarter, hold an equal-weighted combination of single-factor portfolios, each comprised of the capitalization-weighted 20% of stocks with the highest expected returns for that factor. 

They consider five factors: value (book-to-market ratio), momentum (return from 12 months ago to one month ago), operating profitability, investment (asset growth) and low-beta. They reform factor portfolios annually for all except momentum and low-beta, which they reform quarterly. Using firm data required for factor calculations and associated stock returns for a broad sample of U.S. stocks during June 1968 through December 2016, they find that: Keep Reading

How efficiently do mutual funds capture factor premiums? In their April 2017 paper entitled “The Incredible Shrinking Factor Return”, Robert Arnott, Vitali Kalesnik and Lillian Wu investigate whether factor tilts employed by mutual fund managers deliver the alpha found in empirical research. They focus on four factors most widely used by mutual fund managers: market, size, value and momentum. They note that ideal long-short portfolios used to compute factor returns ignore costs associated with real-world implementation: trading costs and commissions, missed trades, illiquidity, management fees, borrowing costs for the short side and inability to short some stocks. Portfolio returns also ignore bias associated with data snooping in factor discovery and market adaptation to published research. They focus on U.S. long-only equity mutual funds, but also consider similar international funds. They apply a two-stage regression first to identify fund factor exposures and then to measure performance shortfalls per unit of factor exposure. Using data for 5,323 U.S. and 2,364 international live and dead long-only equity mutual funds during January 1990 through December 2016, they find that:

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Which equity factors have high and low expected returns? In their February 2017 paper entitled “Forecasting Factor and Smart Beta Returns (Hint: History Is Worse than Useless)”, Robert Arnott, Noah Beck and Vitali Kalesnik evaluate attractiveness of eight widely used stock factors. They measure alpha for each factor conventionally via a portfolio that is long (short) stocks with factor values having high (low) expected returns, reformed systematically. They compare factor alpha forecasting abilities of six models:

1. Factor return for the last five years.
2. Past return over the very long term (multiple decades), a conventionally used assumption.
3. Simple relative valuation (average valuation of long-side stocks divided by average valuation of short-side stocks), comparing current level to its past average.
4. Relative valuation with shrunk parameters to moderate forecasts by dampening overfitting to past data.
5. Relative valuation with shrunk parameters and variance reduction, further moderating Model 4 by halving its outputs.
6. Relative valuation with look-ahead full-sample calibration to assess limits of predictability. 

They employ simple benchmark forecasts of zero factor alphas. Using 24 years of specified stock data (January 1967 – December 1990) for model calibrations, about 20 years of data (January 1991 – October 2011) to generate forecasts and the balance of data (through December 2016) to complete forecast accuracy measurements, they find that: Keep Reading

How should factor-based (style) investors proceed after picking a factor to exploit? In their September 2017 paper entitled “Craftsmanship Alpha: An Application to Style Investing”, Ronen Israel, Sarah Jiang and Adrienne Ross survey style portfolio implementation options. They start with a brief discussion of style portfolios types and then focus on portfolio design and implementation. They note trade-offs associated with many options. Based on past research and examples, they conclude that: Keep Reading

Does transient factor popularity drive factor/smart beta portfolio performance by pushing valuations of associated stocks up and down? In their February 2016 paper entitled “How Can ‘Smart Beta’ Go Horribly Wrong?”, Robert Arnott, Noah Beck, Vitali Kalesnik and John West examine degrees to which factor hedge portfolio and stock factor tilt (smart beta) backtests are attractive due to:

1. Steady and clearly sustainable factor premiums; or,
2. Changes in factor relative valuations, measured as average price-to-book value ratio of stocks with high expected returns (factor portfolio long side) divided by average price-to-book ratio of stocks with low expected returns (factor portfolio short side). This ratio tends to increase (decrease) as investor assets move into (out of) factor portfolios.

They consider six long-short factor hedge portfolios: value, momentum, market capitalization (size), illiquidity, low beta and gross profitability. They also consider six smart beta portfolios, which they (mostly) require to sever the relationship between stock price and portfolio weight and to have low turnover, substantial market breadth, liquidity, capacity, transparency, ease of testing and low fees: equal weight, fundamental index, risk efficient, maximum diversification, low volatility and quality. Using specified annual and monthly factor measurement data and returns for a broad sample of U.S. stocks during January 1967 through September 2015, they find that: Keep Reading

Do broad (capitalization-weighted) stock market indexes exhibit factor tilts that may indicate concentrations in corresponding risks? In their August 2017 paper entitled “What’s in Your Benchmark? A Factor Analysis of Major Market Indexes”, Ananth Madhavan, Aleksander Sobczyk and Andrew Ang examine past and present long-only factor exposures of several popular market capitalization indexes. Their analysis involves (1) estimating the factor characteristics of each stock in a broad index; (2) aggregating the characteristics across all stocks in the index; and (3) matching aggregated characteristics to a mimicking portfolio of five indexes representing value, size, quality, momentum and low volatility styles, adjusted for estimated expense ratios. For broad U.S. stock indexes, the five long-only style indexes are:

• Value – MSCI USA Enhanced Value Index.
• Size –  MSCI USA Risk Weighted Index.
• Quality – MSCI USA Sector Neutral Quality Index.
• Momentum –  MSCI USA Momentum Index.
• Low Volatility – MSCI USA Minimum Volatility Index.

For broad international indexes, they use corresponding long-only MSCI World style indexes. Using quarterly stock and index data from the end of March 2002 through the end of March 2017, they find that: Keep Reading

Does global diversification improve smart beta (equity factor) investing strategies? In their September 2017 paper entitled “Diversification Strikes Again: Evidence from Global Equity Factors”, Jay Binstock, Engin Kose and Michele Mazzoleni examine effects of global diversification on equity factor hedge portfolios. They consider five factors:

1. High-Minus-low Value (HML) – book equity divided by market capitalization.
2. Small-Minus-Big Size (SMB) – market capitalization.
3. Winners-Minus-Losers Momentum (WML) – cumulative return from 12 months ago to one month ago.
4. Conservative-Minus-Aggressive Investment (CMA) – change in total assets.
5. Robust-Minus-Weak Operating Profitability (RMW) – total sales minus cost of goods sold, selling, general, and administrative expenses and interest, divided by total assets.

They reform each factor portfolio annually at the end of June by: (1) resetting market capitalizations, segregating firms into large (top 90%) and small (bottom 10%); (2) separately for large and small firms, constructing high (top 30% of factor values) minus low (bottom 30%) long-short sub-portfolios; and, (3) averaging returns for the two sub-portfolios to generate factor portfolio returns. They lag firm accounting data by at least six months between fiscal year end and portfolio formation date. They define eight global regions: U.S., Japan, Germany, UK, France, Canada, Other Europe and Asia Pacific excluding Japan. When measuring diversification effects, they consider relatedness of country markets and variation over time. Using the specified firm accounting data and monthly stock returns during October 1990 through February 2016, they find that: Keep Reading

How many, and which, factors should investors include when constructing multi-factor smart beta portfolios? In their August 2017 paper entitled “How Many Factors? Does Adding Momentum and Volatility Improve Performance”, Mohammed Elgammal, Fatma Ahmed, David McMillan and Ali Al-Amari examine whether adding momentum and low-volatility factors enhances the Fama-French 5-factor (market, size, book-to-market, profitability, investment) model of stock returns. They consider statistical significance, economic sense and investment import. Specifically, they:

• Determine whether factor regression coefficient signs and values distinguish between several pairs of high-risk and low-risk style portfolios (assuming stock style portfolio performance differences derive from differences in firm economic risk).
• Relate time-varying factor betas across style portfolios to variation in economic and market risks as proxied by changes in U.S. industrial production and S&P 500 Index implied volatility (VIX), respectively.
• Test an out-of-sample trading rule based on extrapolation of factor betas from 5-year historical rolling windows to predict next-month return for five sets (book-to-market, profitability, investment, momentum, quality) of four style portfolios (by double-sorting with size) and picking the portfolio within a set with the highest predicted returns.

Using monthly factor return data during January 1990 through October 2016, they find that: Keep Reading

Are high-quality stocks worth the price? In the June 2017 update of their paper entitled “Quality Minus Junk”, Clifford Asness, Andrea Frazzini and Lasse Pedersen investigate whether high-quality stocks outperform low-quality stocks. They define high-quality stocks as those that are profitable, growing, safe and well-managed. Specifically, they compute a single quality score for each stock by averaging scores for three components calculated as follows:

• Profitability – average of rankings for (high) gross profits/assets, return on equity, return on assets, cash flow/assets, gross margin and fraction of earnings that is cash.
• Growth – average of rankings for (high) prior five-year growth rates for each of the six profitability measures.
• Safety – average of rankings for (low) market beta, idiosyncratic volatility, leverage, bankruptcy risk and volatility of return on equity.

They consider two modes of analysis: quality-sorted portfolios and quality-minus-junk (QMJ) long-short factor portfolios. Quality-sorted portfolios are by value-weighted tenths (deciles), reformed at the end of each calendar month. QMJ factor portfolio return is the average return on two value-weighted top 30% of quality portfolios (big stocks and small stocks separately) minus the average return on two value-weighted bottom 30% of quality portfolios (big stocks and small stocks separately), reformed monthly by sorting first on size and then on quality. For both modes, global portfolios are value-weighted composites of country portfolios in U.S. dollars. Using characteristics and returns for a broad sample of U.S. stocks since June 1957 and samples of stocks from 24 developed markets (including the U.S.) since June 1989, and contemporaneous U.S. Treasury bill yield as the risk-free rate, all through December 2016, they find that:

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