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Investing Research Articles

Comprehensive Fundamental Factor?

Is there a single variable based on accounting data that reliably captures expected returns of individual stocks? In their October 2018 paper entitled “A Fundamental Factor Model”, Stephen Penman and Julie Zhu construct and test a fundamental expected returns factor based on array of accounting inputs, encompassing earnings, book value and items that sum to these income statement and balance sheet totals. They focus on a robust version of this factor incorporating eight of these inputs (ER8), but consider simpler versions relying on only four (ER4) or two (ER2) inputs. They calculate a premium based on a portfolio that is each month long (short) the equally weighted stocks of firms ranked in the top (bottom) three tenths, or deciles, of the fundamental factor. They update fundamentals yearly three months after firm fiscal year ends from numbers published in annual financial statements. In terms of smart beta terminology, their approach replaces market capitalization weights with fundamentals weights. Using monthly returns and annual financial statements for a broad sample of non-financial U.S. common stocks during April 1981 (or June 1975 or April 1966 for simplified factors) through December 2015, they find that:

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Separate vs. Integrated Equity Factor Portfolios

What is the best way to construct equity multifactor portfolios? In the November 2018 revision of their paper entitled “Equity Multi-Factor Approaches: Sum of Factors vs. Multi-Factor Ranking”, Farouk Jivraj, David Haefliger, Zein Khan and Benedict Redmond compare two approaches for forming long-only equity multifactor portfolios. They first specify ranking rules for four equity factors: value, momentum, low volatility and quality. They then, each month:

  • Sum of factor portfolios (SoF): For each factor, rank all stocks and form a factor portfolio of the equally weighted top 50 stocks (adjusted to prevent more than 20% exposure to any sector). Then form a multifactor portfolio by equally weighting the four factor portfolios.
  • Multifactor ranking (MFR): Rank all stocks by each factor, average the ranks for each stock and form an equally weighted portfolio of those stocks with the highest average ranks, equal in number of stocks to the SoF portfolio (again adjusted to prevent more than 20% exposure to any sector).

They consider variations in number of stocks selected for individual factor portfolios from 25 to 200, with comparable adjustments to the MFR portfolio. They assume trading frictions of 0.05% of turnover. Using monthly data required to rank the specified factors for a broad sample of U.S. common stocks and monthly returns for those stocks and the S&P 500 Total Return Index (S&P 500 TR) during January 2003 through July 2016, they find that: Keep Reading

U.S. Equity Turn-of-the-Month as a Diversifying Portfolio

Is the U.S. equity turn-of-the-month (TOTM) effect exploitable as a diversifier of other assets? In their October 2018 paper entitled “A Seasonality Factor in Asset Allocation”, Frank McGroarty, Emmanouil Platanakis, Athanasios Sakkas and Andrew Urquhart test U.S. asset allocation strategies that include a TOTM portfolio as an asset. The TOTM portfolio buys each stock at the open on the last trading day of each month and sells at the close on the third trading day of the following month, earning zero return the rest of the time. They consider four asset universes with and without the TOTM portfolio:

  1. A conventional stocks-bonds mix.
  2. The equity market portfolio.
  3. The equity market portfolio, a small size portfolio and a value portfolio.
  4. The equity market portfolio, a small size portfolio, a value portfolio and a momentum winners portfolio.

They consider six sophisticated asset allocation methods:

  1. Mean-variance optimization.
  2. Optimization with higher moments and Constant Relative Risk Aversion.
  3. Bayes-Stein shrinkage of estimated returns.
  4. Bayesian diffuse-prior.
  5. Black-Litterman.
  6. A combination of allocation methods.

They consider three risk aversion settings and either a 60-month or a 120-month lookback interval for input parameter measurement. To assess exploitability, they set trading frictions at 0.50% of traded value for equities and 0.17% for bonds. Using monthly data as specified above during July 1961 through December 2015, they find that:

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Weekly Summary of Research Findings: 11/19/18 – 11/23/18

Below is a weekly summary of our research findings for 11/19/18 through 11/23/18. These summaries give you a quick snapshot of our content the past week so that you can quickly decide what’s relevant to your investing needs.

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Investment Strategy Development Coursework

In a series of nine presentation slide sets (Lectures 1-9 of 10) on “Advances in Financial Machine Learning”, Marcos Lopez de Prado provides part of Cornell University’s ORIE 5256 graduate course at the School of Engineering (“Special Topics in Financial Engineering V”). The course description includes: “Machine learning (ML) is changing virtually every aspect of our lives. As it relates to finance, this is the most exciting time to adopt a disruptive technology that will transform how everyone invests for generations [see the chart below]. Students will learn scientifically sound ML tools used in the financial industry.” Key points in these slide sets include: Keep Reading

Leveraged ETF Pairs Performance

Are there long-term positions in leveraged index exchange-traded funds (ETF) that beat buying and holding the underlying index? In his October 2018 paper entitled “Leveraged ETF Pairs: An Empirical Evaluation of Portfolio Performance”, Stanley Peterburgsky examines the performance of simple strategies involving leveraged and inverse leveraged ETFs. Specifically, he tests whether the following leveraged ETF portfolios are likely to outperform underlying total return indexes:

  1. A long position in SSO or UPRO, compared to the S&P 500 Index.
  2. 1/3 short UPRO (URTY) and 2/3 short SPXU (SRTY), compared to the S&P 500 (Russell 2000) Index.
  3. 1/4 short SSO (UWM) and 3/4 short SDS (TWM), compared to the S&P 500 (Russell 2000) Index.
  4. Short SH (RWM), compared to the S&P 500 (Russell 2000) Index.

All short positions have matching long positions in 1-month U.S. Treasury bills that drive some trading. For example, at the end of each trading day, if the UPRO/SRTY portfolio value is less than 90% (more than 110%) of the short balance, the strategy buys (shorts additional) shares of UPRO and SPXU in equal proportions to restore long-short balance. In addition, strategies 2 and 3 require occasional rebalancing of ETF pairs. Baseline strategies allows pair members to drift up to 20% apart before rebalancing. Sensitivity tests evaluate effects of tightening the rebalancing threshold to 10%. Key performance metrics are average annualized return, average annualized standard deviation of daily returns and average annualized Sharpe ratio. Using daily total returns for the specified leveraged ETFs and underlying indexes during 2010 (2/9/2010 for Russell 2000-based funds) through 2016, he finds that:

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Most Effective U.S. Stock Market Return Predictors

Which economic and market variables are most effective in predicting U.S. stock market returns? In his October 2018 paper entitled “Forecasting US Stock Returns”, David McMillan tests 10-year rolling and recursive (inception-to-date) one-quarter-ahead forecasts of S&P 500 Index capital gains and total returns using 18 economic and market variables, as follows: dividend-price ratio; price-earnings ratio; cyclically adjusted price-earnings ratio; payout ratio; Fed model; size premium; value premium; momentum premium; quarterly change in GDP, consumption, investment and CPI; 10-year Treasury note yield minus 3-month Treasury bill yield (term structure); Tobin’s q-ratio; purchasing managers index (PMI); equity allocation; federal government consumption and investment; and, a short moving average. He tests individual variables, four multivariate combinations and and six equal-weighted combinations of individual variable forecasts. He employs both conventional linear statistics and non-linear economic measures of accuracy based on sign and magnitude of forecast errors. He uses the historical mean return as a forecast benchmark. Using quarterly S&P 500 Index returns and data for the above-listed variables during January 1960 through February 2017, he finds that: Keep Reading

Most Stock Anomalies Fake News?

How does a large sample of stock return anomalies fare in recent replication testing? In their October 2018 paper entitled “Replicating Anomalies”, Kewei Hou, Chen Xue and Lu Zhang attempt to replicate 452 published U.S. stock return anomalies, including 57, 69, 38, 79, 103, and 106 anomalies 57 momentum, 69 value-growth, 38 investment, 79 profitability, 103 intangibles and 106 trading frictions (trading volume, liquidity, market microstructure) anomalies. Compared to the original papers, they use the same sample populations, original (as early as January 1967) and extended (through 2016) sample periods and similar methods/variable definitions. They test limiting influence of microcaps (stocks in the lowest 20% of market capitalizations) by using NYSE (not NYSE-Amex-NASDAQ) size breakpoints and value-weighted returns. They consider an anomaly replication successful if average high-minus-low tenth (decile) return is significant at the 5% level, translating to t-statistic at least 1.96 for pure standalone tests and at least 2.78 assuming multiple testing (accounting for aggregate data snooping bias). Using required anomaly data and monthly returns for U.S. non-financial stocks during January 1967 through December 2016, they find that:

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Weekly Summary of Research Findings: 11/12/18 – 11/16/18

Below is a weekly summary of our research findings for 11/12/18 through 11/16/18. These summaries give you a quick snapshot of our content the past week so that you can quickly decide what’s relevant to your investing needs.

Subscribers: To receive these weekly digests via email, click here to sign up for our mailing list. Keep Reading

Moving Average Timing of Stock Fundamental Ratios

Can investors time premiums associated with widely used stock/firm fundamental ratios? In their September 2018 paper entitled “It Takes Two to Tango: Fundamental Timing in Stock Market”, Fuwei Jiang, Xinlin Qi, Guohao Tang and Nan Huang use a simple moving average (SMA) trend indicator to time premiums associated with four fundamental stock/firm ratios: book-to-market (BM), earnings-to-price (EP), gross profitability (GP), and return-on-assets (ROA). In calculating these ratios, they lag accounting variables by six months to avoid look-ahead bias. For each ratio, they:

  • At the end of each June, rank stocks into tenths (deciles).
  • Each day, calculate value-weighted average returns for the deciles with the highest (highest BM, EP, GP, ROA) and lowest (lowest BM, EP, GP, ROA) expected returns and maintain price indexes for these two deciles.
  • Each day, hold a long (short) position in the decile with highest (lowest) expected returns only when the decile price index is above (below) its 20-day SMA, indicating an upward (downward) trend. When not holding a decile, hold Treasury bills.

As benchmarks, they each year buy and hold four portfolios that are each long (short) the value-weighted deciles with the highest (lowest) expected returns for one of the fundamental ratios. While focusing on a 20-day SMA, for robustness they also test SMAs of 10, 50, 100 and 200 trading days. While focusing on value weighting, they also look at equal weighting. They run tests on both non-financial Chinese A-share stocks and non-financial U.S. common stocks. Using annual groomed fundamentals data and daily returns for Chinese stocks during January 2001-December 2017 and for U.S. stocks during July 1970-December 2017, and contemporaneous Treasury bill yields, they find that:

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