Equity Factors in Emerging Markets Thursday, 6 September, 2018

A new financial research paper has been published and is related to multiple equity factor strategies:

Author: Atilgan, Demirtas, Gunaydin

Title: The Cross-Section of Equity Returns in Emerging Markets

Link: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3225034

Abstract:

This study investigates the relation between a comprehensive set of firm-specific attributes and future equity returns for a sample of stocks from 27 emerging markets. Univariate analyses based on equal-weighted portfolio returns reveal that the low beta, firm size, book-to-market ratio, momentum and illiquidity anomalies are also observed in emerging markets whereas short-term reversal, left-tail risk and lottery demand effects manifest themselves in the opposite direction compared to U.S. studies. Value-weighted portfolio returns and bivariate analyses that control for firm size show that some of these results are driven by small stocks. After we control for all attributes simultaneously in a regression framework, we find that the most robust cross-sectional effects for emerging market equities are medium and short-term return momentum.

Notable quotations from the academic research paper:

"Although there is no shortage of research on the cross-section of equity returns in emerging markets, these studies are restricted in the sense that they only focus on a limited number of potential determinants of expected returns and/or they only conduct their analyses in a single country or a small group of countries. Our contribution is that we compile a large set of firm-specific attributes that can potentially impact equity returns and use a comprehensive sample of stocks from 27 emerging markets. Thus, we are able to investigate the independent information that a particular firm-specific attribute provides compared to other attributes and observe the generalizability of our results across all emerging markets. We should also note that we undertake a more modest task in this study by focusing on the potential return determinants that can be extracted from the empirical return distribution of individual equity returns. The U.S. literature also suggests various accounting-based variables as cross-sectional return determinants, however, accounting information is sparse for emerging markets and not easily comparable across countries in a large sample due to differences in accounting practices. The only exception we make is for book-to-market ratio of equity since this variable is included in all contemporary asset pricing models and book value of equity is relatively more available compared to other accounting variables for emerging markets.

To investigate the relation between each firm-specific attribute and expected stock returns, we conduct discrete univariate portfolio analyses by sorting stocks into deciles based on one firm-specific characteristic at a time. Next, we compare the one-month ahead returns of the portfolio that includes equities with the highest values of a firm-specific attribute and the portfolio that includes equities with the lowest values of a firm-specific attribute. For example, if the firm-specific characteristic under focus is market beta, Portfolio 10 contains the stocks with the highest sensitivity towards market movements and Portfolio 1 contains the stocks with the lowest sensitivity towards market movements. The decile portfolios are formed every month starting from January 1989 to December 2014. The main portfolio analysis used in this study combines all equities in the sample, therefore, stocks in each decile come from a multitude of countries.

Firm size is an important mediating variable in cross-sectional studies of equity returns. Many anomalies are driven by smaller stocks implying that some significant relations between firm characteristics and expected returns that manifest themselves in the full sample of equities may not be observed when one focuses solely on large stocks. We employ conditional (dependent) double sorts on firm size and various firm-specific attributes by grouping equities into deciles based on firm size and then into additional deciles based on a certain firm-specific attribute within each size decile. For each firm-specific attribute, this bivariate analysis provides 100 conditionally double-sorted portfolios. Portfolio 1 represents the combined portfolio of stocks with the lowest values of a firm-specific attribute in each size decile and Portfolio 10 represents the combined portfolio of stocks with the highest values of a firm-specific attribute in each size decile. We investigate whether the mean return or alpha differences between two extreme firm-specific attribute deciles is significantly different from zero. This type of analysis can also reveal whether the existence or non-existence of a relation between a certain attribute and expected returns is driven or masked by a significant correlation between the attribute and firm size.

Bivariate portfolio analysis

We find that the return pattern across the market beta deciles is relatively flat, however, the decile returns drop from 1.00% to 0.32% between Portfolio 9 and 10. Despite this sharp drop, the return and alphas to the zero-cost portfolio constructed based on market beta are insignificant. The book-to-market and momentum anomalies survive after controlling for firm size using bivariate sorts. The return and alphas to the zero-cost strategy based on BM are between 75 and 96 basis points with t-statistics of between 2.74 and 3.62. The zero-cost strategy based on momentum reveals even higher returns and alphas with values between 1.85% and 2.41% and t-statistics between 3.53 and 4.44. The short-term reversal strategy still translates as short-term momentum to the emerging market setting. The return difference between the extreme one-month-lagged return deciles is 2.28% with a t-statistic of 5.91 and significantly positive alphas.

The conflicting evidence regarding the illiquidity premium that was uncovered in the univariate analyses is absent when firm size is kept stable across the Amihud’s illiquidity ratio and Zeros deciles. None of the return or alpha measures based on these two metrics are statistically different than zero. We also had found no robust relation between attributes such as idiosyncratic volatility, co-skewness and skewness earlier and these results translate to the bivariate setting as well.

For the three stock-specific left-tail risk measures, we find that the return and alpha metrics for the zero-cost strategy are all positive but statistically insignificant with t-statistics between 0.47 and 1.66. For hybrid tail risk, we observe a generally decreasing pattern of returns across the deciles although the return increases from 57 to 86 basis points from Portfolio 9 to 10. Despite this increase, the returns and alphas to the zero-cost strategy are all negative and statistically insignificant except for AF alpha. Again, there is no relation between downside beta and expected equity returns. Finally, we observe that lottery-like stocks continue to demand higher one-month-ahead returns after the dependent sorts. The return and alpha measures for the zero-cost strategy based on MAX1 and MAX5 vary between 0.96% and 1.91% with t-statistics between 1.77 and 2.76.

Regional differences

We observed that the firm size, book-to-market and momentum anomalies presented themselves significantly in the overall sample of emerging market equities. By looking at each region separately, we see that these significant relations generally do not show up uniformly in each region and the results encountered in the overall sample are driven by specific regions. For example, although the zero-cost portfolio formed by sorting stocks based on their market value of equity generates a significant return of -1.16% per month with a tstatistic of -2.36 in Asia, no such pattern exists for the other regions. The book-to-market effect seems to be driven by equities in the Latin America and Africa regions. The momentum effect is robust across Europe, Asia and Africa with statistically significant monthly zero-cost portfolio returns of 2.18%, 2.06% and 2.48%, respectively. Table 3 also revealed that the shortterm reversal and lottery demand anomalies produced returns with opposite signs to those expected from U.S. studies in the overall sample. We find that both results are driven mostly by Asian and Latin American countries. The zero-cost portfolio strategy based on STR produces returns of 1.26% and 2.06% with t-statistics of 2.09 and 2.57 in Asia and Latin America, respectively. The zero-cost portfolio strategy based on MAX1 produces returns of 1.20% and 3.06% with t-statistics of 2.00 and 2.99 in Asia and Latin America, respectively.

Although we did not find significant relations between the other firm-specific attributes and future equity returns in our overall emerging market sample, it is possible to observe some predictive power associated with these attributes when we focus on individual regions. First, we find a significantly positive relation between market beta and one-month-ahead equity returns in Europe with a return of 1.59% (t-statistic = 2.08) to the zero-cost portfolio and significant alphas. Second, we find that the illiquidity measure based on non-trading days has a significantly negative relation with one-month-ahead returns in all regions except Africa and IVOL has a significantly positive relation with one-month-ahead returns in Latin America. Third, zero-cost portfolio strategies based on all three stock-specific left-tail risk measures produce significantly positive returns and alphas between 1.21% and 2.27% in Europe. A similar relation is observed in Latin America when LPM is used as the stock-specific left-tail risk measure. Finally, we find that hybrid tail risk is negatively priced in Europe and Latin America.

These results speak to the importance of accounting for regional differences in the patterns pertaining to the cross-section of equity returns."


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Enhanced Factor Portfolios Thursday, 30 August, 2018

Authors: Blitz, Vidojevic

Title: The Characteristics of Factor Investing

Link: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3206798

Abstract:

We dissect the performance of factor-based equity portfolios using a characteristics-based multi-factor expected return model. We show that generic single-factor portfolios, which invest in stocks with high scores on one particular factor, are sub-optimal, because they ignore the possibility that these stocks may be unattractive from the perspective of other factors. We also show that differences in performance between (i) integrated and mixed-sleeve multi-factor portfolios, (ii) small-cap and large-cap factor portfolios, and (iii) equal and value-weighted factor portfolios can be fully attributed to the differences in their factor characteristics. We conclude that efficient factor investing requires a recognition and understanding of how factor characteristics drive portfolio returns.

Notable quotations from the academic research paper:

"We show that generic single-factor portfolios, which are strategies that invest in stocks which score highly on one particular factor are generally sub-optimal, because they ignore the possibility that these stocks may be unattractive from the perspective of other factors. The negative contributions from other factors cause these strategies to have a substantial weight in stocks with negative expected and ex-post realized market-relative returns. We also show that some stocks have such poor factor characteristics that their expected returns end up being lower than returns on Treasuries. By simply removing those stocks from the market portfolio ex-ante, the realized market return increases by 16%, in relative terms, over the sample period that spans more than five decades.

We examine what happens to performance if, each month, we simply remove stocks that have a negative predicted market-relative return from generic factor portfolios. The performance of such enhanced factor strategies is shown in Figure 6. Compared to the generic factor strategies from which they are derived, the performance improvements are about 20% for the value, momentum and investment strategies and about 50% for the small-cap strategy. For the profitability strategy, performance more than triples, from 0.08% to 0.29% per month. This large improvement is not surprising, because a much bigger adjustment is made to this portfolio than to the other factor portfolios. These results imply that generic factor strategies are sub-optimal, and that, even when targeting one particular factor premium, investors should not ignore other established factor premiums.

enhanced premiums

Excluding stocks with expected underperformance helps to enhance a single-factor strategy, but the resulting portfolios can still have stocks with negative exposures to other factors that detract from their performance. We next examine how performance changes if in addition to removing stocks with expected underperformance, we also require stocks to have a non-negative exposure (z-score) to at least one, two, three or four other, non-targeted premiums. Figure 7 shows that realized, full-sample returns of each single factor strategy tend to increase as we require stocks in the portfolios to have non-negative exposures to more factors. For instance, our raw value strategy has a return of 0.23% a month, which increases to 0.28% per month if we ex-ante exclude stocks with negative expected excess returns. If in addition, at the time of portfolio formation, we require that stocks have non-negative exposures to at least two, three, four, and all five factor premiums, the strategy returns increase to 0.30%, 0.37%, 0.54%, and 0.69%, respectively. The number of stocks in the portfolio decreases as we impose more constraints from, on average, 302 with no constraints to 276, 273, 223, 96, and only 13. A similar pattern is observed for other factors, albeit not always monotonic.

enhanced factor premiums 2

Our model is also able to attribute performance differences between integrated and mixed-sleeve multi-factor portfolios to differences in their factor characteristics, and thus resolve the heated discussion in the literature over which approach is better for construction of portfolios with exposures to multiple factors. We further show that return differences between factor portfolios in the small-cap and the large-cap space, and between equally-weighted and value-weighted factor portfolios can also be explained by our model."


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What Works (and Doesn't Work) in Cryptocurrencies Thursday, 23 August, 2018

Authors: Yang

Title: Behavioral Anomalies in Cryptocurrency Markets

Link: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3174421

Abstract:

If behavioral biases explain asset pricing anomalies, they should also materialize in cryptocurrency markets. I test more than 20 stock return anomalies based on daily cryptocurrency data, and document strong evidence of price momentum. Unlike stock markets, price reversal and risk-based anomalies are weak, controlling for market and size. Cryptocurrency anomalies can be explained by behavioral theories that place more emphasis on the role of speculators than fundamental traders.

Notable quotations from the academic research paper:

"The speculative and hard-to-value nature makes the cryptocurrency market a novel environment that facilitates the study of behavioral impacts on asset prices. Because speculators account for the vast majority of cryptocurrency market participants, the behavioral impact can be stronger than traditional markets. Aside from this, cryptocurrency markets enjoy some good properties: the overall level of investor sophistication in cryptocurrency markets are much lower; there are only a few institutional investors until recently. Thus, mispricing can be severe. Above stylized facts of cryptocurrency markets fit well into many behavioral theories that particularly emphasize investor irrationality. Thus, if asset pricing anomalies can be explained by behavioral theories, they shall also be reflected in cryptocurrency markets.

Having this in mind, I test more than 20 stock price anomalies based on cryptocurrency data.

List of anomalies

 

Interestingly, anomalies that are commonly recognized as behavior-driven, in particular, price momentum, are also observed in cryptocurrency markets. Price momentum describes the phenomenon that past winner (loser) assets may continue to outperform (underperform) in the future. The momentum effect turns out statistically significant and robust in various aspects. In contrast, risk-based anomalies, for example, return moment risks, are insignificant. The results are not surprising, as if the incentive for holding cryptocurrencies is largely speculative, it is not expected that exposure to certain form of risk earns a premium.

Unlike stock markets, short-term price reversal in cryptocurrency markets is very weak at a daily frequency. No evidence of long-term price reversal is revealed. This empirical finding makes cryptocurrency anomalies distinct from stock market anomalies.

What works

The most plausible explanation of cryptocurrency momentum is given by De Long, Shleifer, Summers, and Waldmann (1990). Their model implies that overconfident noise traders push up the price and create risk that makes fundamental traders reluctant to combat mispricing. If noise traders dominate, overpricing can be even more severe, as is the case of cryptocurrency markets, where speculators play the role of overconfident noise traders. Further, their model does not predict a long-term reversal as long as noise traders remain overconfident. This situation is analogous to cryptocurreny markets and consistent with the empirical findings of this paper. Moreover, their model implies an excessive volatility, another empirical stylized fact of cryptocurrency markets."


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Size, Value and Equity Premium Waves Tuesday, 14 August, 2018

A new financial research paper has been published and is related to:

#25 - Small Capitalization Stocks (Size) Premium
#26 - Value (Book-to-Market) Anomaly

Author: Herskovic, Kind, Kung

Title: Size Premium Waves

Link: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3220825

Abstract:

This paper examines the link between microeconomic uncertainty and the size premium across different frequencies in an investment model with heterogeneous firms. We document that the observed time-varying dispersion in firm-specific productivity can account for a large size premium in the 1960's and 1970's, the disappearance in the 1980's and 1990's, and reemergence in the 2000's. Periods with a large (small) size premium coincide with high (low) microeconomic uncertainty. During episodes of high productivity dispersion, small firms increase their exposure to macroeconomic risks. Our model can also explain the strong positive low-frequency co-movement between size and value factors, but a negative relation with the market factor.

Notable quotations from the academic research paper:

"The relation between firm size and expected stock returns has varied signifi cantly over time in waves. Banz (1981) documented a size premium whereby firms with small market capitalizations earn higher expected returns than large ones before 1975, and that this size e ffect cannot be explained by market betas. The size e ffect subsequently vanished starting in the early 1980s to the late 1990s, before reemerging after 2000.

We also observe that measures of microeconomic uncertainty, such as the cross-sectional dispersion in plant- and firm-level total factor productivity (TFP), sales, and payouts, exhibit similar low-frequency patterns as the size premium.

size premium waves

Figure 1 illustrates that microeconomic uncertainty is strongly positively correlated with the size premium. In this paper, we demonstrate how persistent variation in microeconomic uncertainty can potentially rationalize the observed size premium waves.

To this end, we build a dynamic partial equilibrium production model with heterogeneous firms. The model has several distinguishing features. First, firms are subject to persistent idiosyncratic and aggregate TFP shocks with time-varying second moments. The second moment shocks to the idiosyncratic component capture time-varying cross-sectional dispersion in idiosyncratic productivity (microeconomic uncertainty) while the second moment shocks to the aggregate component capture fluctuations in macroeconomic uncertainty. Second, firms face quadratic adjustment costs and operating costs. Third, the representative household has recursive utility de fined over aggregate streams of consumption.

We find that our calibrated model produces a realistic size premium and captures the salient dynamics of the size premium across diff erent frequencies. Namely, the model generates a countercyclical size premium and reproduces the low-frequency wave patterns, including a large spread during 1960-1980, a disappearance between 1980-2000, and resurgence post-2000. The mean-reverting idiosyncratic TFP shocks helps to generate a negative relation between firm market capitalization and expected returns in the stationary distribution.

Small firms are those that have received a recent history of negative idiosyncratic shocks. Due to mean reversion, the shorter-term payouts of small fi rms therefore constitute a smaller share of aggregate payouts relative to their longer-term payouts. With a similar logic, the payout shares of large firms have the opposite pattern. Consequently, small firms are more exposed to aggregate long-run risks than large firms, which gives rise to a quantitatively signi ficant size premium.

The low-frequency fluctuations of the size premium in the model are driven by the persistent volatility process for idiosyncratic TFP shocks. When TFP dispersion is high, small fi rms are subjected to a larger history of negative idiosyncratic shocks that increases their exposure to longrun risks relative to periods with low TFP dispersion. As a result, the size premium is larger during periods of higher TFP dispersion. In the data, we find a very strong association between TFP dispersion and the size premium at low frequencies, consistent with the model predictions. Calibrating the idiosyncratic volatility process to our empirical measure, we show that our model can provide a quantitatively relevant account of the observed size premium waves.

equity premium

micro and macro uncertainity

The equity premium is strongly correlated with macroeconomic uncertainty, as measured by the realized volatility of consumption growth, output growth, and TFP, but negatively related to microeconomic uncertainty at low frequencies. The correlation between the equity premium and macroeconomic uncertainty is 0.76, while the correlation between the equity premium and microeconomic uncertainty is -0.64 (See Figures 3 & 4).

The model also generates signifi cant equity and value premia, inline with the observed magnitudes in the data. Persistent shocks to aggregate productivity growth are a source of long-run risk that help to generate a sizable equity premium when coupled with recursive preferences. Persistent second moment shocks to aggregate productivity growth generate a countercyclical equity premium.

equity premium

The size an value premia are strongly positively related at low frequencies (i.e., correlation of 0.66), but they are both negatively related with the equity premium at low frequencies (correlation between the size premium and the equity premium is -0.62 and the correlation between the value premium and the equity premium is -0.50). Figure 2 provides a visual depiction of these relations.

A value premium arises due to the combination of the asymmetric capital adjustment costs and operating costs, in a similar spirit as Zhang (2005). Firms with high book-to-market ratios have large stocks of capital, but have experienced a recent history of negative idiosyncratic shocks. Therefore, such firms have strong incentives to disinvest due to the low marginal product of capital and high operating costs, but the presence of capital adjustment costs prevents them from selling off their unproductive capital rapidly, which exposes high book-to-market (value) fi rms more to adverse aggregate shocks than low book-to-market (growth) firms. In particular, discouraging aggressive disinvestment policies prevents fi rms with large capital stocks from increasing payouts financed through capital sales in response to negative idiosyncratic shocks. The operating costs that are proportional to the capital stock of the firm reduce the funds available for payouts, especially for large fi rms. Therefore, these investment frictions imply that high book-to-market fi rms have low payout shares today, but higher payout shares at longer horizons due to mean reversion. Therefore, value firms are more exposed to long-run risks than growth firms, thereby generating a sizable value premium. The low-frequency fluctuations of the value premium are driven by the persistent idiosyncratic volatility process."


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SSRN Platform Upgrade Friday, 10 August, 2018

We would like to share an announcement from SSRN (Social Science Research Network) as we link a lot from Quantpedia to a research papers hosted on www.ssrn.com.

"SSRN Platform Upgrade Server Outage this Weekend

We wanted to let you know about a planned outage to SSRN this weekend, which will mean you will not be able to access the site during this period.

The outage will take place from 9am EST Friday 10th August until 9am EST Monday 13th August. Please ensure you download any papers you need before this planned site maintenance.

This outage is to improve the robustness and performance of the platform going forward.

Thank you,
SSRN Team

"