Once again, our favorite type of study – an out of sample research study based on data from 19th and beginning of 20th century.  Interesting research paper related to all equity momentum strategies …

Authors: Trigilia, Wang

Title: Momentum, Echo and Predictability: Evidence from the London Stock Exchange (1820-1930)

Link: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3373164

Abstract:

We study momentum and its predictability within equities listed at the London Stock Exchange (1820-1930). At the time, this was the largest and most liquid stock market and it was thinly regulated, making for a good laboratory to perform out-of-sample tests. Cross-sectionally, we find that the size and market factors are highly profitable, while long-term reversals are not. Momentum is the most profitable and volatile factor. Its returns resemble an echo: they are high in long-term formation portfolios, and vanish in short-term ones. We uncover momentum in dividends as well. When controlling for dividend momentum, price momentum loses significance and profitability. In the time-series, despite the presence of a few momentum crashes, dynamically hedged portfolios do not improve the performance of static momentum. We conclude that momentum returns are not predictable in our sample, which casts some doubt on the success of dynamic hedging strategies.

Notable quotations from the academic research paper:

"This paper studies momentum and its predictability in the context of the rst modern stock market, the London Stock Exchange (LSE), from the 1820s to the 1920s.

Factors' performance. Compared to the U.S. post-1926, we find that the market has been less profitable – averaging 5% annually (but also less volatile). Its Sharpe ratio has been 0.34, not too far from the 0.43 of CRSP. The Small-Minus-Big (SMB) factor delivered a 4.85% average annual return, much higher than that found in U.S. post-1926. The risk-free rate, as proxied by the interest on British Government's consols, has been close to 3.3% throughout the period, despite the many large changes in supply (i.e., in the outstanding stock of public debt). As for momentum (UMD), consistent with the existing evidence it has been the most profitable factor – with an average annual return close to 9% – and the most volatile – with 20% annual standard deviation.

Dissecting momentum returns. Recent literature debates whether momentum is long or short term. In our sample, UMD profits strongly depend on the formation period: they average at 10.6% annually for long-term formation (12 to 7 months) and 3.8% for short-term formation (6 to 2 months). So, our out-of-sample test confirms that momentum is better described as a within-year echo.

To investigate the role of fundamentals as drivers of price momentum, we construct two sets of earnings momentum portfolio. The first earnings momentum portfolio is constructed based on the past dividend paid by the firm relative to its market cap. The portfolio buys stocks of the highest dividend-paying firms over a 12 to 2 months formation period, and shorts the stocks of the lowest ones. We find strong evidence that our dividend momentum (DIV) strategy is profitable across our sample: it yields a 5% average annual return with a standard deviation of 12%.

The second earnings momentum portfolio is constructed based on the dividend innovations. Specically, we look at the change of dividend year to year, and construct the DIV portfolio. The portfolio buys stocks with the highest change in dividend paid and shorts the stocks with the lowest ones. The
DIV portfolio yield an over 24% return with a standard deviation of only 13.2%.

To discern whether price momentum seems driven by dividend momentum, we also test whether the alpha of the static UMD portfolio remains significant and positive after we control for the Fama-French three factors plus the dividend momentum portfolio. In the EW sample, price momentum delivers excess returns of about 8.8% after controlling for the Fama-French three factors, significant at the 1%. However, introducing DIV momentum reduces the alpha to 2.9%, and the alpha is insignificantly different from zero. As for VW portfolios, they deliver higher alphas but are less precisely estimated. In this case, the annualized alpha of price momentum drops by half from 11.2% to 5.8% after controlling for
DIV momentum.

Momentum crashes. We find that the distribution of monthly momentum returns is left skewed and displays excess kurtosis. Within the five largest EW (VW) momentum crashes, investors lost 18% (26%) on average. The difference between the beta of the winners and that of the losers has been -2.4 (-3.5), on average, and the losses stemmed mostly from the performance of the losers, which averaged at 24% (21%) monthly return. We find little action in the winners portfolio, which returned on average 2% (-6%).

Predictability and dynamic hedging. Dynamic hedging consists in levering the portfolio when its realized volatility has been low and/or the market has been under-performing, and de-levering otherwise. We begin our analysis by looking at whether set of variables helps predicting momentum returns in our sample, and we find that it does not. Probably, this is because the crashes in our sample are more heterogeneous both in terms of origins and in terms of length. In particular, they do not necessarily occur when the market rebounds after a long downturn, and they tend to last for shorter periods of time. As a consequence, our out-of-sample test of the dynamic hedged UMD strategy shows that either it underperforms static momentum, or it does not improve its returns.

"

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We at Quantpedia are continually building a database of ideas for quantitative trading strategies derived out of the academic research papers. Motivated by the recent fall of the S&P500 index at the end of 2018, we have added a new filtering field into our Screener, which you can use to find strategies that can be utilized as a hedge/diversification to equity market risk factor during bear markets. We would like to present one strategy that is profitable itself, but with an added value of negative correlation with the equity market, to be able to perform in the desired way also during the " bad" times.

The strategy we would be talking about can be found in our database under the name #281 – Skewness Effect in Commodities and is built on a research paper written by Fernandez-Perez, Frijns, Fuertes and Miffre – The Skewness of Commodity Futures Returns. Guys at AlphaArchitect have been really generous and they have provided a space for us to write a short article in which we 1) briefly discuss the lottery effect, 2) we discuss the research on this topic in the context of commodities, and 3) we conduct an independent replication effort of the commodity lottery effect identified in academic research.

Authors: Vojtko, Padysak

Title: Skewness Effect in Commodities

Link: https://alphaarchitect.com/2019/05/30/skewness-effect-in-commodities/

Shortly:

"Economies and markets have their seasonalities and cyclicality, where bull markets alternate with bear markets. Bull markets are connected with particularly good performance of the stocks and profiting investors. However on the other hand, during the bear markets, investors tend to lose in the falling equity market. Therefore, during these stressful times, it might be better for practitioners to invest in a portfolio that is negatively correlated with the equity market to gain profit instead of counting loses.

There is strong evidence that investors have a preference for lottery-like assets (the assets that have a relatively small probability of a large payoff or in other words, big skewness). Therefore, it should be profitable to not play the lottery, but rather be “the lottery ticket issuer“ by shorting the commodities with high skewness and going long commodities with low skewness. Additionally, commodities as an asset class are quite distinct from equities and therefore they can often be used as a diversifier to equities.

Clearly, the strategy is profitable, a dollar invested in 1991 would result in more than 9 dollars by 2019, which results in a yearly performance of nearly 8,5%. Moreover, the risk of the strategy is relatively low, with the maximal drawdown of around 16 %, which results in a return to a drawdown ratio of slightly more than 0,5.

Our research suggests that the performance of the equity market represented by the S&P500 index is negatively correlated with the performance of the skewness strategy. Therefore, if the equity market performs badly, our strategy should be still profitable.

What is more important, if we would look upon the worst months of S&P500 index (blue bars) and compare it with the performance of the strategy (orange bars), we would see the performance of the suggested strategy is at most times positive and therefore the investor would be able to hedge his equity portfolio.

To sum it up, the lottery anomaly in commodities is alive and performs in a desirable way also in the recent period. Moreover, the profitable strategy based on this anomaly could also serve as a hedge against equities and offer a profitable possibility to invest during times when equities are in bear markets.

Authors:
Radovan Vojtko, CEO, Quantpedia.com
Matus Padysak, Analyst, Quantpedia.com

"

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A new research paper related mainly to:

#77 – Beta Factor in Stocks

Authors: Novy-Marx, Velikov

Title: Betting Against Betting Against Beta

Link: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3300965

Abstract:

Frazzini and Pedersen’s (2014) Betting Against Beta (BAB) factor is based on the same basic idea as Black’s (1972) beta-arbitrage, but its astonishing performance has generated academic interest and made it highly influential with practitioners. This performance is driven by non-standard procedures used in its construction that effectively, but non-transparently, equal weight stock returns. For each dollar invested in BAB, the strategy commits on average $1.05 to stocks in the bottom 1% of total market capitalization. BAB earns positive returns after accounting for transaction costs, but earns these by tilting toward profitability and investment, exposures for which it is fairly compensated. Predictable biases resulting from the paper’s non-standard beta estimation procedure drive results presented as evidence supporting its underlying theory.

Notable quotations from the academic research paper:

" Frazzini and Pedersen’s (FP) Betting Against Beta (BAB, 2014) is an unmitigated academic success. Despite being widely read, and based on a fairly simple idea, BAB is not well understood. This is because the authors use three unconventional procedures to construct their factor. All three departures from standard factor construction contribute to the paper’s strong empirical results. None is important for understanding the underlying economics, and each obscures the mechanisms driving reported effects.

Two of these non-standard procedures drive BAB’s astonishing “paper” performance, which cannot be achieved in practice, while the other drives results FP present as evidence supporting their theory. The two responsible for driving performance can be summarized as follows:

Non-standard procedure #1, rank-weighted portfolio construction: Instead of simply sorting stocks when constructing the beta portfolios underlying BAB, FP use a “rank-weighting” procedure that assigns each stock to either the “high” portfolio or the “low” portfolio with a weight proportional to the cross-sectional deviation of the stock’s estimated beta rank from the median rank.

Non-standard procedure #2, hedging by leveraging: Instead of hedging the low beta-minus-high beta strategy underlying BAB by buying the market in proportion to the underlying strategy’s observed short market tilt, FP attempt to achieve market-neutrality by leveraging the low beta portfolio and deleveraging the high beta portfolio using these portfolios’ predicted betas, with the intention that the scaled portfolios’ betas are each equal to one and thus net to zero in the long/short strategy.

FP’s first of these non-standard procedures, rank-weighting, drives BAB’s performance not by what it does, i.e., put more weight on stocks with extreme betas, but by what it does not do, i.e., weight stocks in proportion to their market capitalizations, as is standard in asset pricing. The procedure creates portfolios that are almost indistinguishable from simple, equal-weighted portfolios. Their second non-standard procedure, hedging with leverage, uses these same portfolios to hedge the low beta-minus-high beta strategy underlying BAB. That is, the rank-weighting procedure is a backdoor to equal-weighting the underlying beta portfolios, and the leveraging procedure is a backdoor to using equal-weighted portfolios for hedging.

BAB achieves its high Sharpe ratio, and large, highly significant alpha relative to the common factor models, by hugely overweighting micro- and nano-cap stocks. For each dollar invested in BAB, the strategy commits on average $1.05 to stocks in the bottom 1% of total market capitalization. These stocks have limited capacity and are expensive to trade. As a result, while BAB’s “paper” performance is impressive, it is not something an investor can actually realize. Accounting for transaction costs reduces BAB’s profitability by almost 60%. While it still earns significant positive returns, it earns these by tilting toward profitability and investment, exposures for which it is fairly compensated."

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