Factor allocation

Hello ChatGPT, Can You Backtest Strategy for Me?

18.October 2023

You may remember our blog post from the end of March, where we tested the current state-of-the-art LLM chatbot. Time flies fast. More than six months have passed since our last article, and half a year in a fast-developing field like Artificial intelligence feels like ten times more. So, we are here to revisit our article and try some new hacks! Has the OpenAI chatbot made any significant improvement? Can ChatGPT be used as a backtesting engine? We retake our risk parity asset allocation and test the limits of current AI development again!

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What’s the Key Factor Behind the Variation in Anomaly Returns?

13.October 2023

In a game of poker, it is usually said that when you do not know who the patsy is, you’re the patsy. The world of finance is not different. It is good to know who your counterparties are and which investors/traders drive the return of anomalies you focus on. We discussed that a few months ago in a short blog article called “Which Investors Drive Factor Returns?“. Different sets of investors and their approaches drive different anomalies, and we have one more paper that helps uncover the motivation of investors and traders for trading and their impact on anomaly returns.

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Dissecting the Performance of Low Volatility Investing

28.August 2023

Low volatility investing is an appealing approach to compound wealth in the stock market for the long term. This particular factor investing style exploits the popular naive notion that lower (higher) risk must always equal lower (higher) overall returns. But in fact, this naive assumption is not true, as low-volatility investments often yield more than their high-volatility counterparts. While low-volatility investing has many advantages, it also results in some disadvantages. How to overcome them? Bernhard Breloer, Martin Kolrep, Thorsten Paarmann, and Viorel Roscovan, in their study Dissecting the Performance of Low Volatility Investing, propose a solution.

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Predicting Stock Market Performance with the Global Anomaly Index

22.August 2023

Today’s article focuses on investigating long-short anomaly portfolio return predictability in international stock markets, which often undergo mispricing due to investors’ sentiment. A paper by Jiang, Fuwei et al. (Apr 2023), suggests using the AAIG (Global Anomaly Index), and it examines the ability of the aggregate anomaly index to predict future returns in 33 stock markets. While previous research finds that a high aggregate anomaly measure predicts a low return in the U.S. market, this study further demonstrates that the global component of AAI (aggregate anomaly indices) is the key that drives international return predictability and reveals that the global anomaly index is a strong and robust predictor of equity risk premiums not just in the U.S. market but also in international markets, both in- and out-of-sample, consistently delivering significant economic values.

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Exploring the Factor Zoo with a Machine-Learning Portfolio

3.August 2023

The latest paper by Sak, H. and Chang, M. T., and Huang, T. delves into the world of financial anomalies, exploring the rise and fall of characteristics in what researchers refer to as the “factor zoo.” While significant research effort is devoted to discovering new anomalies, the study highlights the lack of attention given to the evolution of these characteristics over time. By leveraging machine learning (ML) techniques, the paper conducts a comprehensive out-of-sample factor zoo analysis, seeking to uncover the underlying factors driving stock returns. The researchers train ML models on a vast database of firm and trading characteristics, generating a diverse range of linear and non-linear factor structures. The ML portfolio formed based on these findings outperforms entrenched factor models, presenting a novel approach to understanding financial anomalies. Notably, the paper identifies two subsets of dominant characteristics – one related to investor-level arbitrage constraint and the other to firm-level financial constraint – which alternately play a significant role in generating the ML portfolio return.

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How Well Do Factor Investing Funds Replicate Academic Factors?

31.July 2023

Cremers, Liu, B. Riley (Apr 2023) share their view on and try to answer the question: how well do factor investing funds perform? They conclude that, on average, factor-investing funds do not outperform. But using active characteristic share (ACS)—an adaption of Cremers and Petajisto’s (2009) original active share measure—, the authors demonstrate that the factor investing funds that match indexes the most have significantly better performance. An equal-weighted portfolio of factor investing funds in the lowest tercile of ACS outperforms an equal-weighted portfolio of funds in the highest tercile by 3.82% per year (t-stat = 3.89) using the CAPM and by 1.08% per year (t-stat = 2.01) using the CPZ6 model.

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