Asset Pricing Anomalies &

Sources of Mutual Funds’ Value Added

Asset Pricing Anomalies
 Anomalies for Today

Hou, Xue and Zhang (2019) summarize 452 anomalies in the literature

 Value, Momentum, and Reversals

 Low-Vol Anomalies

1. Idiosyncratic volatility puzzle

2. Betting against beta

 Liquidity Risk

 Seasonality

3
 Portfolio Sorting

 Fama and French (1992): sort by Size and Book-to-Market ratio every year.

 Pastor and Stambaugh (2003): sort by liquidity betas every year.

4
 Risk and Return
40

35

30

25
Mean/Stdev (%)

20 Mean
Stdev
15

10

0
Market Small 1 Large 10 Growth 1 Value 10 Losers 1 Winners 10

Size Value Momentum

5
 A Value Investor’s Perspective

price

sell

Fundamental
value

buy

time
Value is essentially long-term reversal

6
 Value, Momentum, Short-Term Reversal

Value / Long-Term Reversal

 De Bondt and Thaler (1985)
 Return over past 36 - 60 months

Momentum
 Jegadeesh and Titman (1993), Asness (1994)
 Return over past 12 months

Short-Term Reversal
 Lehmann (1990), Jegadeesh (1990)
 Return over past month or week

7
 A Big Challenge to the Efficient Market Hypothesis

 Efficient markets hypothesis (EMH)

– states that markets are efficient, with market prices reflecting all
available information at any given time

1. Weak form – states that stock prices fully reflect all information
contained in past prices and volumes of trading (violated)

2. Semi-strong form – suggests security prices adjust rapidly reflecting

all available public information

3. Strong form – implies share prices reflect all information, public and
private, and no one can earn excess returns

8
 De Bondt and Thaler (1985): Long-Run Reversals

 On the portfolio formation date, compute any stock j’s

cumulative excess return over the past 36 months (=3 years)

CUj = Σj=-35,..,0 ujt = Σj=-35,..,0 (Rjt – Rmt)

 Buy “losers”: 35 stocks with lowest CU

 Sell “winners”: 35 stocks with highest CU

 Hold positions for the following 3 years

© Lasse H. Pedersen 9
Cumulative Abnormal Returns

© Lasse H. Pedersen 10
5-year Formation Period Using Overlapping Data

© Lasse H. Pedersen 11
 Jegadeesh (1990): Stock Momentum and Short-Term Reversal

Regress return (demean) on past 12 months returns:

© Lasse H. Pedersen 12
 Jegadeesh and Titman (1993): Momentum Strategy

 At the beginning of any month, compute the return of each stock for the
last J months, J = 3, 6, 9, 12

 Winners: top decile, i.e. top 10% stocks

 Losers: bottom decile, i.e. bottom 10%

 Buy winners and/or sell losers and hold for K months, K = 3, 6, 9, 12

© Lasse H. Pedersen 13
Return to Momentum Portfolios

14
 Stock Momentum

 Jegadeesh (1990), Jegadeesh and Titman (1993), Asness (1994)

 Possible explanations:
– Risk

– Initial under-reaction to news:

• Information flows slowly into prices

• Good news today leads to a price increase today – but, price move too small, so
price must continue to go up tomorrow!

– Delayed over-reaction:
• Good news leads to a price increase today, tomorrow people jump on the
bandwagon and the price goes up further

 How do we distinguish these hypotheses?

© Lasse H. Pedersen 15
 Momentum Reversals

 Jegadeesh and Titman (2001) track the returns of momentum portfolios up to 5 years
post-formation
 Momentum profits reverse in years 2-5.

16
 Reconciling Momentum and Reversal

 Short term reversal factor

– Return over past 1 month
– Buy losers, sell winners

 Momentum factor
– Return over past 12 months, excluding the last month
– Buy winners, sell losers

 Long-run reversal factor

– Return over past 60 months excluding the last 12 months
– Buy losers, sell winners

17
 Reconciling Momentum and Reversal

Source: Heston and Sadka (2008)

© Lasse H. Pedersen 18
Strange Seasonality

© Lasse H. Pedersen 19
 Value and Momentum Everywhere: Better Together
Value: book to market. Momentum: Return from 12 months ago to 1 month ago
Source: Asness, Moskowitz, and Pedersen (2013), “Value and Momentum Everywhere”

20
 Rational vs Behavioral

 Various anomalies have explanations that arise from a rational risk-based

story or a behavioral story
– Rational: high expected returns compensate for negative returns during
certain periods. The key is defining what those bad times are.

– Behavioral: high expected returns result from agents’ under- or over-reaction

to news and/or the inefficient updating of beliefs. Behavioral biases persist
because there are barriers to the entry of capital.

 For some anomalies, the explanations are largely rational, for others,
mostly behavioral
– Value/growth: rational and behavioral

– Momentum: behavioral, mostly

21
 Value, Momentum, Short-Term Reversal

Value / Long-Term Reversal

 De Bondt and Thaler (1985)
 Possible explanation: Over-reaction to news
– Stocks with good news: price pushed up too far
– Stocks with bad news: price pushed down too far

Momentum
 Jegadeesh and Titman (1993), Asness (1994)
 Possible explanations:
– Initial under-reaction to news.
• Information flows slowly into prices
– Delayed over-reaction.

Short-Term Reversal
 Lehmann (1990), Jegadeesh (1990)
 Possible explanation: Demand pressure and liquidity effects

22
 Low-Vol Anomaly

Volatility Portfolios
40% 1.00

0.90
35%

0.80
30%
0.70

25%
0.60

Raw Sharpe Ratio

Mean, Stdev

20% 0.50

0.40
15%

0.30
10%
0.20

5%
0.10

0% 0.00
1 Low 2 3 4 5 High

Raw Mean Stdev Raw Sharpe Ratio (RH axis)

23
 A Challenge to a Basic Principle of Finance

Risk-return tradeoff:
High risk should be compensated with high return.

This principle is used widely in finance, such as,

• risk aversion in utility function
• mean-variance framework
• CAPM etc.

Low-vol anomaly shows the opposite

24
 Low-Vol Anomalies

 Ang, Hodrick, Xing, and Zhang (2006): Idiosyncratic Volatility Puzzle

 Idiosyncratic volatility:

 Blitz and van Vliet (2007) started Conservative Equities Funds in Robeco

 Frazzini and Pedersen (2014): Betting against Beta Anomaly

25
Ang, Hodrick, Xing, and Zhang (2006)

26
 Frazzini and Pedersen (2014)

Beta Portfolios
40% 1.00

0.90
35%

0.80
30%
0.70

25%
0.60

Raw Sharpe Ratio

Mean, Stdev

20% 0.50

0.40
15%

0.30
10%
0.20

5%
0.10

0% 0.00
1 Low 2 3 4 5 High

Mean Returns Stdev Raw Sharpe Ratios (RH axis)

27
 Betting-Against-Beta

 Frazinni and Pedersen (2014) create a “betting against beta” factor

rL ,t +1 − rf rH ,t +1 − rf Standard CAPM
BABt +1
= − Long
β L ,t β H ,t E(r)

Data

Short
rf

Beta

28
 Low Volatility Factor vs Betting-Against-Beta

 Construct low volatility factor to have constant volatility (target volatility set at
15%)

 rL ,t +1 − rf rH ,t +1 − rf 
σ target × 
VOLt +1 = − 
 σ L ,t σ H ,t 

BAB VOL
Mean 5.5% 6.1%
Stdev 11.8% 9.5%
Raw Sharpe 0.46 0.64
Correlation -8.7%

29
 Beta and Volatility Cumulated Returns
5

0
1963 1968 1973 1978 1983 1988 1993 1998 2003 2008

-1
BAB (Betting-Against-Beta) VOL (Low minus High Const Vol)

30
 Leverage Constraints Story

 Frazzini and Pedersen (2014) argue that many investors are unable to lever, but
would like to lever, and so tilt their portfolios towards stocks with “built in”
leverage like high beta stocks.

● Investors bid up the price

of high beta stocks leading
to a flat SML

● Does not explain

underpricing of low beta
stocks

31
 Asness, Frazzini, and Pedersen (2013): Quality Minus Junk

𝐸𝐸𝑡𝑡 (𝐷𝐷𝑡𝑡+1 )
 Recall Gordon’s Growth Model: 𝑉𝑉𝑡𝑡 =
𝑘𝑘−𝑔𝑔
 Normalize the market value by book value and rearrange:
𝑉𝑉𝑡𝑡 𝐸𝐸𝑡𝑡 (𝑁𝑁𝑁𝑁𝑡𝑡+1 )/𝐵𝐵𝑡𝑡 � 𝐸𝐸𝑡𝑡 (𝐷𝐷𝑡𝑡+1 )/𝐸𝐸𝑡𝑡 (𝑁𝑁𝑁𝑁𝑡𝑡+1 ) profitability � payout
= =
𝐵𝐵𝑡𝑡 𝑘𝑘 − 𝑔𝑔 required return − growth
 Identifies the four main “quality” characteristics, i.e., characteristics that justify a
higher valuation ratio:
1. Profitability
2. Growing profits
3. Safety and stable profits, i.e. low required return
4. Profits are paid to shareholders

 See more details in Asness, Frazzini, and Pedersen (2013), “Quality Minus Junk”

32
 Compensation for Market Liquidity Risk

 Trader Talk: They’ll let you in, but they won’t let you out.

 Market liquidity risk: risk that you cannot get out (Pastor and Stambaugh
(2003))

 Investors want to be compensated for taking market liquidity risk

– Therefore, illiquid securities are cheap and earn higher average gross returns.

 Liquidity risk a reason why the standard capital asset pricing model (CAPM)
does not work well in practice.
– Investors care about a security i’s return Ri net of its transaction cost TCi

 Liquidity-adjusted CAPM (Acharya and Pedersen (2005)):

𝑖𝑖 𝑀𝑀 𝑖𝑖 ,𝑇𝑇𝑇𝑇 𝑀𝑀 𝑖𝑖 ,𝑅𝑅 𝑀𝑀 𝑖𝑖 𝑀𝑀
𝐸𝐸 𝑅𝑅𝑖𝑖 = 𝑅𝑅 𝑓𝑓 + 𝐸𝐸 𝑇𝑇𝐶𝐶 𝑖𝑖 + 𝛽𝛽𝑅𝑅 ,𝑅𝑅 + 𝛽𝛽𝑇𝑇𝑇𝑇 − 𝛽𝛽𝑇𝑇𝑇𝑇 − 𝛽𝛽𝑅𝑅 ,𝑇𝑇𝑇𝑇 𝜆𝜆

33
Sources of Mutual Funds’ Value Added
 Sources of Alpha

 Funds are interested in strategies that can be expected to continue to make

money
– a repeatable process that generates alpha
 To find such a repeatable alpha process, one must understand the economics
hiding behind the profits.
– For every buyer, there is a seller
 If you don't know who the sucker is, it's you

35
 How Good is Buffett’s Record?

 Information ratios (abnormal return / volatility) of all U.S. stocks 1926 – 2011
– with more than 30 years of history
80

70

60

50

40
Buffett

30

20

10

0
-0.40 -0.30 -0.19 -0.08 0.02 0.13 0.24 0.35 0.45 0.56 0.66

Question: There are 6 billion people in the world investing, is Buffett just the lucky one?
-- check Frazzini, Kabiller, and Pedersen (2013) “Buffett's Alpha” 36
 Decomposing Buffett: CEO or Stockpicker?

Assets Liabilities and Shareholders' Equity

Stock picker
Publicly traded equities Liabilities
Privately held companies Equity
Cash Berkshire stock
CEO

Total Assets Total Liabilities

 Returns of
– Berkshire stock: observed directly
– Publicly traded equities: observed via 13F filings and stock return data
– Privately held companies inferred:
𝑓𝑓 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑓𝑓
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃
𝑟𝑟𝑡𝑡+1 Liabilities𝑀𝑀𝑀𝑀
𝑡𝑡 + 𝑟𝑟𝑡𝑡+1 Equity𝑀𝑀𝑀𝑀
𝑡𝑡 − 𝑟𝑟𝑡𝑡+1 Public𝑀𝑀𝑀𝑀 𝑀𝑀𝑀𝑀
𝑡𝑡 − 𝑟𝑟𝑡𝑡+1 Cash𝑡𝑡
𝑟𝑟𝑡𝑡+1 =
Private𝑀𝑀𝑀𝑀
𝑡𝑡

 Return decomposition:
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑓𝑓 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑓𝑓 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑓𝑓
𝑟𝑟𝑡𝑡+1 − 𝑟𝑟𝑡𝑡+1 = 𝑤𝑤𝑡𝑡 𝑟𝑟𝑡𝑡+1 − 𝑟𝑟𝑡𝑡+1 + 1 − 𝑤𝑤𝑡𝑡 𝑟𝑟𝑡𝑡+1 − 𝑟𝑟𝑡𝑡+1 𝐿𝐿𝑡𝑡
Total Assets −Cash
– Leverage: 𝐿𝐿𝑡𝑡 =
Equity
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑀𝑀𝑀𝑀
– Share of private holdings: 𝑡𝑡
𝑤𝑤𝑡𝑡 = Private𝑀𝑀𝑀𝑀 +Public 𝑀𝑀𝑀𝑀
𝑡𝑡 𝑡𝑡

37
37
 Decomposing Buffett: CEO or Stockpicker?

 Historical performance of Buffett’s components:

Buffett Performance
Berkshire Public U.S. stocks Private Overall stock
Hathaway (from 13F filings) holdings market
performance

Sample 1976-2011 1980-2011 1984-2011 1976-2011

Beta 0.67 0.77 0.28 1.00
Average excess return 19.0% 11.8% 9.6% 6.1%
Total Volatility 24.8% 17.2% 22.3% 15.8%
Idiosyncratic Volatility 22.4% 12.0% 21.8% 0.0%
Sharpe ratio 0.76 0.69 0.43 0.39
Information ratio 0.66 0.56 0.36 0.00
Leverage 1.64 1.00 1.00 1.00
Sub period excess returns:
1976-1980 42.1% 31.4% 7.8%
1981-1985 28.6% 20.9% 18.5% 4.3%
1986-1990 17.3% 12.5% 9.7% 5.4%
1991-1995 29.7% 18.8% 22.9% 12.0%
1996-2000 14.9% 12.0% 8.8% 11.8%
2001-2005 3.2% 2.2% 1.7% 1.6%
2006-2011 3.3% 3.0% 2.3% 0.8%
38
 What Kind of Companies does Buffett Own?

 Buffett:“Buy companies with strong histories of profitability”, and “consistent operating

history”
 Regression to determine Buffett’s exposures:
𝑟𝑟𝑡𝑡 = 𝛼𝛼 + 𝛽𝛽1 MKT𝑡𝑡 + 𝛽𝛽2 𝑆𝑆𝑆𝑆𝑆𝑆𝑡𝑡 + 𝛽𝛽3 HML𝑡𝑡 + 𝛽𝛽4 UMD𝑡𝑡 + 𝛽𝛽5 BAB𝑡𝑡 + 𝛽𝛽6 𝑄𝑄𝑄𝑄𝑄𝑄𝑡𝑡 + 𝜀𝜀𝑡𝑡
BAB = Betting Against Beta (Frazzini and Pedersen (2014))
QMJ = Quality Minus Junk (Asness, Frazzini, and Pedersen (2013))

Berkshire stock 1976 - 2011 13F portfolio 1980 - 2011 Private Holdings 1984 - 20011

Alpha 12.5% 11.1% 7.0% 5.5% 4.7% 0.1% 5.8% 5.0% 4.9%
(3.28) (2.92) (1.79) (2.60) (2.26) (0.04) (1.39) (1.20) (1.12)

MKT 0.84 0.78 0.97 0.86 0.83 1.04 0.40 0.35 0.35
(11.49) (10.49) (10.62) (21.33) (19.86) (21.04) (4.92) (4.19) (3.33)
SMB -0.30 -0.39 -0.07 -0.18 -0.23 0.11 -0.29 -0.34 -0.33
-(2.91) -(3.61) -(0.52) -(3.16) -(3.97) (1.52) -(2.53) -(2.93) -(2.09)
HML 0.47 0.30 0.21 0.30 0.19 0.10 0.26 0.14 0.13
(4.24) (2.39) (1.72) (4.88) (2.74) (1.48) (2.19) (1.01) (0.97)
UMD 0.06 0.02 0.01 -0.02 -0.05 -0.06 0.08 0.05 0.05
(0.86) (0.29) (0.16) -(0.60) -(1.34) -(1.69) (1.13) (0.63) (0.63)
BAB 0.27 0.18 0.16 0.07 0.18 0.18
(3.12) (2.11) (3.50) (1.58) (2.07) (1.97)
Quality 1.40 1.49 0.04
(3.50) (7.12) (0.08)

R2 bar 0.24 0.26 0.28 0.56 0.57 0.62 0.07 0.08 39

0.08
 Mutual Funds’ Value Added from Exposures to Anomalies

Christiansen, Xing, and Xu (2022) investigate mutual funds’ value added from
their exposures to 234 pricing anomalies, and find that

 MFs add value through their positive exposures to anomalies based on

market information (e.g. momentum, liquidity risk, seasonality)

 They lose substantial value through their negative exposures to anomalies

based on accounting information (e.g. investment, profitability, accrual)

 They also profit from their private strategies.

40
 Mutual Funds’ Value Added from Exposures to Anomalies

-- from Christiansen, Xing, and Xu (2022) 41

 Specialization at Different Investment Horizons

Van Binsbergen, Han, Ruan, and Xing (2022a) decompose mutual fund value
added by the length of funds’ holdings using transaction level data, and find
that

 MFs specialize at different investment horizons. They choose their

turnovers based on their horizon-specific skill

 Holdings of high-turnover funds add substantial value in two weeks,

mainly on earnings announcement days and FOMC meeting days

 Holdings of low-turnover funds add most value beyond a year, largely

through the exposure to value factor;

42
 Alpha Opportunities of High-Turnover Funds (Quintile 5)

-- from Van Binsbergen, Han, Ruan, and Xing (2022) “A Horizon Based Decomposition of Mutual Fund
Value Added using Transactions”
43
 Alpha Opportunities of Low-Turnover Funds (Quintile 1)

-- from Van Binsbergen, Han, Ruan, and Xing (2022) “A Horizon Based Decomposition of Mutual Fund
Value Added using Transactions”
44
 Value Added of Low- vs. High- Turnover Funds (Quintile 1 vs 5)

-- from Van Binsbergen, Han, Ruan, and Xing (2022) “A Horizon Based Decomposition of Mutual Fund
Value Added using Transactions”
45
 Value Added of All Five Turnover Quintiles

-- from Van Binsbergen, Han, Ruan, and Xing (2022) “A Horizon Based Decomposition of Mutual Fund
Value Added using Transactions”
46
 Value Added of High-Turnover Funds from FOMC, Earning
Announcements, and M&A Days

-- from Van Binsbergen, Han, Ruan, and Xing (2022) “A Horizon Based Decomposition of Mutual Fund
47
Value Added using Transactions”
Distributions of Mutual Funds and Their
Value Added
 Number of Funds by Fund Turnover and Manager Tenure

49
-- from Van Binsbergen, Han, Ruan, and Xing (2022b)
 Total Net Assets by Fund Turnover and Manager Tenure

50
-- from Van Binsbergen, Han, Ruan, and Xing (2022b)
 Value Added by Fund Turnover

Manager Tenure: the number of years a manager has worked in this fund

51
-- from Van Binsbergen, Han, Ruan, and Xing (2022b)
 Gross Alphas by Fund Turnover and Manager Tenure

52
-- from Van Binsbergen, Han, Ruan, and Xing (2022b)
Fund Managers’ Career Concerns, Investment Horizons, and Value Added

Van Binsbergen, Han, Ruan, and Xing (2022b) extend the Berk and Green
model to investigate the effect of fund managers’ career concerns in their
investment horizons and value added, and find that

 Short-term investment strategies accelerate investors’ learning of

fund managers’ skill, because short-term opportunities realize faster

 A large number of new and unskilled managers invest in short-term

opportunities to speed up investors’ learning

 In equilibrium, long-term opportunities are more profitable because short-

term opportunities become too crowded

53
 Flow-Performance Sensitivity by Fund Turnover

We use flow-performance sensitivity as a measure for the speed of learning

Manager Tenure: the number of years a manager has worked in this fund

54
-- from Van Binsbergen, Han, Ruan, and Xing (2022b)
 Optimal Choice of Investment Horizon

55
-- from Van Binsbergen, Han, Ruan, and Xing (2022b)
 Distribution of Funds by Fund Size and Tenure

56
-- from Van Binsbergen, Han, Ruan, and Xing (2022b)
 Stationary Distribution of Funds

57
-- from Van Binsbergen, Han, Ruan, and Xing (2022b)
 Stationary Distribution of Funds (New Fund Managers)

58
-- from Van Binsbergen, Han, Ruan, and Xing (2022b)
 59
-- from Van Binsbergen, Han, Ruan, and Xing (2022b)
 60
-- from Van Binsbergen, Han, Ruan, and Xing (2022b)
 61
-- from Van Binsbergen, Han, Ruan, and Xing (2022b)
 62
-- from Van Binsbergen, Han, Ruan, and Xing (2022b)
 63
-- from Van Binsbergen, Han, Ruan, and Xing (2022b)
 Stationary Distribution of Funds (Old Fund Managers)

64
-- from Van Binsbergen, Han, Ruan, and Xing (2022b)
 Distribution of Funds: New vs. Old Managers

 Short-term funds are managed mostly by new managers

 Long-term funds have larger fund size and older managers

65
-- from Van Binsbergen, Han, Ruan, and Xing (2022b)
 Actual Distribution of Mutual Funds

66
-- from Van Binsbergen, Han, Ruan, and Xing (2022b)
 Equilibrium Value Added and Gross Alpha

 Long-term opportunities add more value (have higher alphas) than short-term
opportunities do in equilibrium
 Since short-term opportunity offers higher growth potential, managers are willing
to accept lower current value added
 Competition makes short-term opportunities less profitable
(i.e., prices are more efficient at higher frequencies)
67
Mutual Funds’ Value Added from
Hidden Services
 Value Added from Hidden Services

A new research agenda of Jules van Binsbergen and I is to investigate the

value added of mutual fund from their hidden services

 The literature measure funds’ skill/value added as an ability to outperform

the market or related benchmarks
e.g., Sharpe (1991), Fama and French (2010) and Berk and Green (2004)

 funds add value by providing services to investors as well, such as,

diversification, financial education, retirement savings, customization,
liquidity provision, and reducing searching frictions.

 It explains the persistently negative net alphas received by fund investors.

69
 Value Added from Hidden Services

 Fund investors have a payoff from both fund return and service

 The total amount of capital invested depends on the average utility of the
service and the dispersion of investors’ utility k

 The net alpha is negative because of the value of service

70
 Value Added from Diversification Service

million $s /month

-- from Berk and van Binsbergen (2015)

 Regressing the gross returns of index funds on net returns of Vanguard funds

 $110,000 per month of value added is from diversification service

71
 Value Added from Diversification Service

-- from Berk and van Binsbergen (2015)

 about 40% of the value added is due to diversification benefits ($110,000 per
month) and 60% ($160,000 per month) is due to active investment skill

72
 Spillovers of Senior Mutual Fund Managers’ Capital
Raising Ability

 When a junior fund manager has new senior colleagues in a fund, the
junior manager’s other funds also have substantial capital inflows

73
-- Xing and Xu (2022)
 Spillovers of Senior Mutual Fund Managers’ Capital
Raising Ability

-- Xing and Xu (2022)

74
 Understanding Funds: Role in the Economy

Funds are useful:

 Make markets more efficient
– Collect information
– Trading impounds information into prices
– Monitors managers of companies
– This could improve real outcomes, e.g.,
• CEO decisions
• real investment
• capital allocation
 Provide liquidity
– To investors who need to buy or sell (consumption smoothing)
– To investors who need to hedge
– To companies who need to issue securities
 Selecting skilled managers
 Provide hidden services

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Investment Strategies
 Steps to Design An Investment Strategy

1. Choose an investment universe (e.g. U.S. stocks)

2. Find an investment signal (e.g. B/M ratio; past returns etc.)

3. Make a trading rule (e.g. rebalance every month)

4. Backtesting (e.g. portfolio analysis, calculate cumulative returns)

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 Fund Strategies: Quant Equity Strategy

 Quant Equity
– Value, momentum, pairs trading, statistical arbitrage,
high frequency trading, index arbitrage

– Have a rule. Always follow the rule, but know when to break it.

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 Fund Strategies: Equity Strategies

 Equity long/short
– Discretionary trading
– Fundamental analysis and catalysts

– It’s easy to be a contrarian, except when it’s profitable.

– Buy on rumors, sell on news.

 Dedicated short bias

– Identifying frauds, forensic accounting
– While equity long/short is more long than short, the reverse is true for short biased funds

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 Fund Strategies: Macro Strategies

 Global macro
– Carry trades, central bank watching, devaluation, thematic, yield curve, country selection

– Soros: When you have tremendous conviction on a trade, you have to go for the jugular.
It takes courage to be a pig.
– Bulls get rich, bears get rich, but pigs get slaughtered.

 Managed futures
– Trading in trends and countertrends
– Equity, fixed-income, and commodity futures, currency forwards

– The trend is your friend.

– Show me the charts, I’ll tell you the news.
– Cut losses and let your profits run.

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 Fund Strategies: Arbitrage Strategies

 Event driven
– Merger arbitrage (risk arbitrage), distressed, carve outs, spinoffs, splitoffs,
when-issued, IPOs, SEOs, other corporate events, special situations

 Convertible bond arbitrage

– long converts, hedge with equity, credit, fixed income
– Gamma, busted, high-money

 Fixed income arbitrage

– swap spread, yield curve, butterfly, mortgage, CDS-bond basis, on-the-run/off-
the-run

– Keynes: The markets can remain irrational longer than you can remain
solvent.

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 Value Investing

“Intrinsic value is an all-important concept that offers the only logical approach to
evaluating the relative attractiveness of investments and businesses. Intrinsic value can
be defined simply: It is the discounted value of the cash that can be taken out of a
business during its remaining life.” — Warren Buffett
 Trade:
– Buy low (stocks with high intrinsic value / market value
– Sell high (stocks with low intrinsic value / market value)
 Example:
– Buy a company with more cash than the equity value and no debt – if you can
find it
 How to find the intrinsic value more generally:
– Valuation! Fundamental analysis.
– Talk to the firm and everyone involved in its “value chain”:
• Management, employees, unions,
• Customers
• Suppliers
• Competitors
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Prices an Fundamentals: A Value Investor’s Perspective

price

sell

Fundamental
value

buy

time

83
 Prices an Fundamentals: Margin of Safety

price

margin estimate of intrinsic value

of safety

buy

time

84
 Value Trap

 Does a stock look cheap because

– It is cheap?
– Or, because its fundamentals are collapsing?
 For instance, suppose a stock has a very high B/M
 What will adjust
– M?
– B?
How does this happen?

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 Quality Investing
𝐸𝐸𝑡𝑡 (𝐷𝐷𝑡𝑡+1 )
 Recall Gordon’s Growth Model: 𝑉𝑉𝑡𝑡 =
𝑘𝑘−𝑔𝑔
 Normalize the market value by book value and rearrange:
𝑉𝑉𝑡𝑡 𝐸𝐸𝑡𝑡 (𝑁𝑁𝑁𝑁𝑡𝑡+1 )/𝐵𝐵𝑡𝑡 � 𝐸𝐸𝑡𝑡 (𝐷𝐷𝑡𝑡+1 )/𝐸𝐸𝑡𝑡 (𝑁𝑁𝑁𝑁𝑡𝑡+1 ) profitability � payout
= =
𝐵𝐵𝑡𝑡 𝑘𝑘 − 𝑔𝑔 required return − growth
 Identifies the four main “quality” characteristics, i.e., characteristics that
justify a higher valuation ratio:
1. Profitability
2. Growing profits
3. Safety and stable profits, i.e. low required return
4. Profits are paid to shareholders

 See more details in Asness, Frazzini, and Pedersen (2019), “Quality Minus
Junk”

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 Growth

 Good growth:
– Same-store sales growth: more sales with the same expenses
– Growth in profits
– Growth that will continue
 Growth trap:
– Is the growth already priced in?
– Bad growth
• Growth in assets and/or sales that does not lead to growth in profits
• E.g. a merger without synergies
• Growth due to accounting changes

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Prices an Fundamentals: A Growth Investor’s Perspective

Fundamental
value sell

buy

price

time

88
 What do Great Investors Have in Common? Investment Styles

INVESTMENT STYLES RETURN DRIVERS

Ubiquitous methods used across trading The reason that these methods work in an
strategies and asset classes efficiently inefficient market

Value Investing Risk premia and overreaction

Trend-Following Investing Initial underreaction and delayed

(momentum and time series momentum) overreaction

Liquidity Provision Liquidity risk premium

Carry Trading Risk premiums and frictions

Low-Risk Investing Leverage constraints

(betting against beta)

Quality Investing Slow adjustment

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 Performance of Active Investors

 “Old consensus” in the academic literature:

– Active investors as represented by mutual funds have no skill: Jensen (1968), Fama
(1970), Carhart (1997)
 “New consensus” in the academic literature
– The average mutual fund underperforms slightly after fees, not before fees, but the
average hides significant cross-sectional variation across good/bad managers
– Skill exists among mutual funds and can be predicted: Kacperczyk, Sialm, and Zheng
(2008), Fama and French (2010), Kosowski, Timmermann, Wermers, White (2006), Berk
and van Binsbergen (2015):
“we find that a sizable minority of managers pick stocks well enough to more than cover
their costs. Moreover, the superior alphas of these managers persist”
– Skill exists among hedge funds: Fung, Hsieh, Naik, and Ramadorai (2008), Jagannathan,
Malakhov, and Novikov (2010), Kosowski, Naik, and Teo (2007):
“top hedge fund performance cannot be explained by luck, and hedge fund performance
persists at annual horizons… Our results are robust and relevant to investors as they
are neither confined to small funds, nor driven by incubation bias, backfill bias, or serial
correlation.”
– Skill exists in private equity and VC: Kaplan and Schoar (2005)
“we document substantial persistence in LBO and VC fund performance”
 Consistent with efficiently inefficient markets --- Lasse Pedersen