Volatility Effects

Are stock betas calculated with price jumps (arguably derived from informed trading) more useful than those calculated conventionally (arguably dominated by noise trading)? In the December 2014 version of their paper entitled “Roughing Up Beta: Continuous vs. Discontinuous Betas, and the Cross-Section of Expected Stock Returns”, Tim Bollerslev, Sophia Zhengzi Li and Viktor Todorov compare the powers of standard or “smooth” stock betas and jumpy or “rough” stock betas to predict stock returns. They measure smooth beta in two ways: from 75-minute returns during normal trading hours; and, from daily close-to-close returns. They measure rough beta also in two ways: from unusual jumps among 75-minute returns during normal trading hours; and, from close-to-open (overnight) returns. For all beta measurements, they employ the past year as the measurement interval. Using intraday prices and firm characteristics for the 985 stocks included in the S&P 500 Index during 1993 through 2010 (an average of 738 stocks per month), they find that: Keep Reading

How diverse are the beliefs of experts on the Capital Asset Pricing Model (CAPM)? In his November paper entitled “CAPM: The Model and 233 Comments about It”, Pablo Fernandez reproduces 52 largely disagreeing and 181 largely agreeing comments solicited from professors, finance professionals and Ph.D. students regarding his prior paper entitled “CAPM: an Absurd Model” (summarized in “Forget CAPM Beta?”). The range of beliefs in the comments is extreme, from

“I was shocked at how horrible your paper is. It is without a doubt the worst excuse for an academic study I have ever seen (and believe me that is saying a lot).”

to

“I totally agree with the absurdity of CAPM model.”

After reflecting on the body of comments, he concludes that: Keep Reading

Are gains from tax-loss harvesting, the systematic taking of capital losses to offset capital gains, additive to or subtractive from premiums from portfolio tilts toward common factors such as value, size, momentum and volatility (smart beta)? In their October 2014 paper entitled “Factor Tilts after Tax”, Lisa Goldberg and Ran Leshem look at the effects on portfolio performance of combining factor tilts and tax-loss harvesting. They call the incremental return from tax-loss harvesting tax alpha, which (while investor-specific) is typically in the range 1%-2% per year for wealthy investors holding broad capitalization-weighted portfolios. They test six long-only factor tilts based on Barra equity factor models: (1) value (high earnings yield and book-to-market ratio); (2) momentum (high recent past return); (3) value/momentum; (4) small/value; (5) quality (value stocks with low earnings variability, leverage and volatility); and, (6) minimum volatility/value (low volatility with diversification constraint and value tilt). Their overall benchmark is the MSCI All Country World Index (ACWI). Their tax alpha benchmark derives from a strategy that harvests losses in a capitalization-weighted portfolio (no factor tilts) without deviating far from the overall benchmark. The rebalancing interval is monthly for all portfolios. Using monthly returns for stocks in the benchmark index during January 1999 through December 2013, they find that: Keep Reading

Is the market beta of a stock stable across measurement frequencies and measurement intervals? In their October 2014 paper entitled “Which Is the Right ‘Market Beta’?: 1,385 US Companies and 147 Betas/Company in a Single Date”, Jose Paulo Carelli, Pablo Fernandez, Isabel Fernandez Acín and Alberto Ortiz present calculations of 147 betas relative to the S&P 500 Index for each of the S&P 1500 stocks with at least five years of return data on March 31, 2014. They calculate different betas based on monthly, weekly or daily returns over past intervals of one to five years. They then look at the dispersion of each stock’s beta and beta ranking across calculation methods (see the chart below for an example). In assessing dispersion, they focus on the difference between maximum and minimum values by stock. Using daily, weekly and monthly returns for 1,385 stocks and the S&P 500 Index during April 2009 through March 2014, they find that: Keep Reading

S&P 500 Index options data imply expected S&P 500 Index volatility (VIX) over the next month. In turn, VIX futures options data imply expected volatility of VIX (VVIX) over the next month. Does VVIX predict stock index option and VIX option returns? In their September 2014 paper entitled “Volatility-of-Volatility Risk”, Darien Huang and Ivan Shaliastovich investigate whether VVIX represents a time-varying risk affecting: (1) S&P 500 Index option returns above and beyond the risk represented by VIX; and (2) VIX futures option returns. They measure risk effects via returns on S&P 500 Index options hedged daily by shorting the S&P 500 Index and VIX futures options hedged daily by shorting VIX futures. Using monthly S&P 500 Index returns, VIX futures returns, VIX, VVIX, S&P 500 Index option prices and VIX option prices during February 2006 through June 2013, they find that: Keep Reading

Is the return on CBOE S&P 500 Volatility Index (VIX) futures predictable? In his preliminary paper entitled “The Expected Return of Fear”, Ing-Haw Cheng investigates whether the relationship between VIX futures prices and VIX level predicts the return on VIX futures. He focuses on monthly returns to a continuously-invested position in the nearest available VIX futures contract. He considers several different explanations for the behavior of VIX futures prices. Using VIX futures daily settlement prices during March 2004 through July 2014 (125 months), he finds that: Keep Reading

Are there times when investors should avoid low-volatility stocks? In their August 2014 paper entitled “Tactical Timing of Low Volatility Equity Strategies”, Sanne De Boer and James Norman investigate which factors predict the performance of low-volatility stocks relative to a capitalization-weighted index globally since 1980. They focus on two concerns: (1) will low-volatility stocks perform poorly when they are relatively expensive compared to the rest of the market; and, (2) will low-volatility stocks, which tend to pay high dividends, underperform when interest rates rise. Their low-volatility portfolio is a capitalization-weighted collection of country sectors processed quarterly in three steps designed to achieve a balance of low risk and sufficient diversification. They do not account for quarterly portfolio reformation frictions in return calculations. Using weekly data for all country sectors included in the MSCI Developed Markets Index during January 1975 through March 2014, they find that: Keep Reading

What is the best way to harvest asset mispricings derived from aggregate overreaction/underreaction by naive investors? In his July 2014 presentation package entitled “Betting On ‘Dumb Volatility’ with ‘Smart Beta'”, Claude Erb examines strategies for exploiting the “dumb volatility” arguably generated by naive investors who buy high and sell low, temporarily driving prices materially above and below fair values. These strategies generally involve periodically rebalancing portfolios to equal weights or some version of fair value weights (smart beta). Using monthly returns for a variety of indexes and funds during December 2004 through June 2014 (since the advent of smart beta research), he finds that: Keep Reading

Experts and pundits sometimes cite a high Chicago Board Options Exchange (CBOE) Volatility Index (VIX), the options-implied volatility of the S&P 500 Index, as contrarian indication of investor panic and therefore of pending U.S. stock market strength. Conversely, they cite a low VIX as indication of complacency and pending market weakness. However, a more nuanced conventional wisdom considers both very high VIX and very low VIX as favorable for future stock market returns. Does evidence support belief in either version of conventional wisdom? To check, we relate the level of VIX to S&P 500 Index returns over the next 5, 10, 21, 63 and 126 trading days. Using daily and monthly closes for VIX and for the S&P 500 Index over the period January 1990 through July 2014 (296 months), we find that: Keep Reading

Are widely used volatility-adjusted investment performance metrics, such as Sharpe ratio, robust to different measurement intervals? In the July 2014 version of their paper entitled “The Divergence of High- and Low-Frequency Estimation: Implications for Performance Measurement”, William Kinlaw, Mark Kritzman and David Turkington examine the sensitivity of such metrics to the length of the return interval used to measure it. They consider hedge fund performance, conventionally estimated as Sharpe ratio calculated from monthly returns and annualized by multiplying by the square root of 12. They also consider mutual fund performance, usually evaluated as excess return divided by excess volatility relative to an appropriate benchmark (information ratio). Finally, they consider Sharpe ratios of risk parity strategies, which periodically rebalance portfolio asset weights according to the inverse of their return standard deviations. Using monthly and longer-interval return data over available sample periods for each case, they find that: Keep Reading