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Equity Premium

Governments are largely insulated from market forces. Companies are not. Investments in stocks therefore carry substantial risk in comparison with holdings of government bonds, notes or bills. The marketplace presumably rewards risk with extra return. How much of a return premium should investors in equities expect? These blog entries examine the equity risk premium as a return benchmark for equity investors.

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Do Widely Used Market Charts Obscure Reality?

Do widely used charts of equity and bond market performance inculcate harmfully false beliefs among investors? In his September 2017 paper entitled “Stock Market Charts You Never Saw”, Edward McQuarrie dissects some of these charts and outlines cautions to investors in interpreting them. Using very long-term data for U.S. stock and bond markets spanning hundreds of years, he concludes that: Keep Reading

Survey of Research on Investor Sentiment Metrics

How effective is investor sentiment in predicting stock market returns? In his October 2017 paper entitled “Measuring Investor Sentiment”, Guofu Zhou reviews various measures of equity-oriented investor sentiment based on U.S. market, survey and media data. He highlights the Baker-Wurgler Index (the most widely used), which is based on the first principal component of six sentiment inputs: (1) detrended NYSE trading volume; (2) closed-end fund discount relative to net asset value; (3) number of initial public offerings (IPO); (4) average first-day return on IPOs; (5) ratio of equity issues to total market equity/debt; and, (6) dividend premium (difference between average market-to-book ratios of dividend payers and non-dividend payers). Based on the body of research and using monthly inputs for the Baker-Wurgler Index during July 1965 through December 2016, three sets of investor sentiment survey data since inceptions (between Dec 1969 and July 1987) through December 2016 and two sets of textual analysis data spanning Jan 2003 through December 2014 and Jul 2004 through Dec 2011, he finds that: Keep Reading

Asset Class Momentum Faster During Bear Markets?

A subscriber asked whether the optimal momentum measurement (lookback) interval for the “Simple Asset Class ETF Momentum Strategy” (SACEMS) shrinks during bear markets for U.S. stocks. This strategy each month picks winners from the following set of exchange-traded funds (ETF) based on total returns over a specified lookback interval:

PowerShares DB Commodity Index Tracking (DBC)
iShares MSCI Emerging Markets Index (EEM)
iShares MSCI EAFE Index (EFA)
SPDR Gold Shares (GLD)
iShares Russell 2000 Index (IWM)
SPDR S&P 500 (SPY)
iShares Barclays 20+ Year Treasury Bond (TLT)
Vanguard REIT ETF (VNQ)
3-month Treasury bills (Cash)

To investigate, we compare SACEMS monthly performance statistics when the S&P 500 Index at the previous monthly close is above (bull market) or below (bear market) its 10-month simple moving average. We consider Top 1, equally weighted (EW) Top 2 and EW Top 3 portfolios of monthly winners for the baseline SACEMS lookback interval. In a robustness test for the EW Top 3 portfolio, we consider lookback intervals ranging from one to 12 months. Using monthly total (dividend-adjusted) returns for the specified assets since February 2006 (limited by DBC) and the monthly level of the S&P 500 Index since October 2005, all through September 2017, we find that:

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Average Call-Put Implied Volatility Spread and Future Stock Market Return

Does relative demand for call and put options on individual stocks, as measured by average difference in implied volatilities of at-the-money calls and puts (aggregate implied volatility spread), predict stock market returns? In their September 2017 paper entitled “Aggregate Implied Volatility Spread and Stock Market Returns”, Bing Han and Gang Li test aggregate implied volatility spread as a U.S. stock market return predictor. They focus on monthly measurements, but test the daily series in robustness test. They calculate monthly implied volatility spread for each stock with at least 12 daily at-the-money call and put option prices during the month as an average over the last five trading days. They then eliminate outliers by excluding the top and bottom 0.1% of all stock implied volatility spreads before averaging across stocks to calculate aggregate implied volatility spread. They compare the predictive power of aggregate implied volatility spread to those of 22 other predictors from prior research. Using daily at-the-money call and put implied volatilities for U.S. stocks, data for other U.S. stock market predictors and U.S. stock market returns during January 1996 through December 2015, they find that:

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How Best to Diversify Smart Betas

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

Factor Overoptimism?

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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Factor/Smart Beta Portfolio Implementation Details

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

Factor Tilts of Broad Stock Indexes

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

Global Smart Beta Strategy Diversification

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

Effects of Execution Delay on SACEVS

How does execution delay affect the performance of the Best Value and Weighted versions of the “Simple Asset Class ETF Value Strategy” (SACEVS)? These strategies each month allocate funds to the following asset class exchange-traded funds (ETF) according to valuations of term, credit and equity risk premiums, or to cash if no premiums are undervalued:

3-month Treasury bills (Cash)
iShares 20+ Year Treasury Bond (TLT)
iShares iBoxx $ Investment Grade Corporate Bond (LQD)
SPDR S&P 500 (SPY)

To investigate, we compare 21 variations of each strategy with execution days ranging from end-of-month (EOM) per the baseline strategy to 20 trading days after EOM (EOM+20). For example, an EOM+5 variation computes allocations baed on EOM but delays execution until the close five trading days after EOM. We focus on gross compound annual growth rate (CAGR) and gross maximum drawdown (MaxDD) as key performance statistics. Using daily dividend-adjusted closes for the above ETFs from late July 2002 through mid-September 2017, we find that:

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