6.4. Market Efficiency and Investment Strategies

Question 1

“Cookbook” for implementing investment strategies

Answer 1

1. Use historical stock market data and select a stock characteristic you want to test
2. Sort stocks into different portfolios based on the characteristic of interest
3. Track the portfolios return over the holding period
4. Test whether there is a significant return difference between the bottom (first quantile/decile) and the top (fifth quintile/tenth decile) portfolio
5. If so, is the return difference explained by systematic risk factors and/or known return anomalies?
   - Yes: Bad luck. Try different characteristic
   - No. Congratulations, you discovered a new return anomaly

Question 2

Why are “cookbook” strategies zero net investments?

Answer 2

The strategy is self-financing as
• the bottom portfolio is short sold
• the proceeds are used to buy the stock in the top portfolio

Question 3

Critical comments on the “cookbook”

Answer 3

• may be simple, but it describes the essential steps of how return anomalies are discovered
•one should check for a plausible economic link between the characteristics and the stock return
- Momentum: investors overreacting to good or bad news
- shoe size of CEO: ???

Question 4

Factor investing

Answer 4

• selecting a portfolio based on stock characteristics
• rank all stocks in the investment universe on a set of factors
• stocks with the highest ranking across all factors are chosen

Question 5

Factor investing and mutual funds

Answer 5

• Mutual funds are heavily regulated, may have self-imposed restrictions, and have some benchmark objective
• They will restrict the underlying universe to stocks they are allowed to use
• hedge funds have fewer restrictions but they will also restrict their investment universe

Question 6

What happens if investment strategies become public?

Answer 6

• the price of the stocks in the top portfolio will increase
• as these stocks are undervalued, the mispricing will be corrected
• the more investors follow the strategy, the faster the price correction

-> the return anomaly will decrease/disappear

Empiricism: the return anomaly drops after publication

Question 7

Developing persistently profitable investment strategies

Answer 7

There are two potential approaches to develop new or to refine existing strategies:

1. Better models
   - build better than other investors on the same set of data
2. Data
   - use a standard model but apply with more informative data

Or combine both approaches

Question 8

Standard/traditional data sources for trading strategies

Answer 8

• Stock market data
• accounting data
• analyst data
• credit rating agencies
• insider trading
• institutional ownership and trading

Question 9

Alternative data sources for trading strategies

Answer 9

Qualitative information in standard data:
• text in analyst and credit rating reports
• management’s outlook in the company’s annual report
• discussions between company’s executives and analysts in earnings conference calls

Other qualitative information:
• newspaper articles
• press releases

Third party information:
• employee satisfaction
• customer’s product reviews

Manager characteristics

Social media

Question 10

Limits to arbitrage

Answer 10

In the real world:

1. arbitrage is risky
2. arbitrage is costly

• investors face a trade-off between the expected profits and the implementations costs and risks of the strategy

Question 11

Limits to arbitrage:

Fundamental risk

Answer 11

Risk of rational revaluation if new information arrives -> mispriced assets may no longer be mispriced

Fundamental risk can be reduced by:
• trying to hedge the arbitrage position
• zero net investment strategies provide some hedge to fundamental risk when the firms in the bottom and the ones in the top portfolio are comparable
• fundamental risk cannot be eliminated completely:
- firm-specific information
- industry-specific information

Question 12

Limits to arbitrage:

Noise trader risk

Answer 12

Risk that the exploitation by the arbitrageur worsens the mispricing of the assets in the short run.

If prices can deviate from fundamental value one must allow for more severe deviations

If mispricing worsens arbitrageurs may be forced to liquidate their arbitrage position early.

Question 13

Limits to arbitrage:

Implementation costs

Answer 13

• Transaction costs are influenced by:

• portfolio rebalancing
• persistence of a stock assignment to an anomaly portfolio
• type of stocks (S&P 500 vs. small cap stocks)
• Lending fee for borrowing a stock
• Security lender may call back his shares
• Capital requirements:
  • margin requirements
  • dividend payments of shorted stock

• Horizon risk:
- per period transaction costs