Are good-news firms riskier than bad-news firms?

This paper examines the relative risk of good-news firms, i.e., those with high standardized unexpected earnings (SUE), and bad-news (low SUE) firms using a stochastic discount factor approach. We find that a stochastic discount factor constructed from a set of basis assets helps explain post-earnings-announcement drift (PEAD). The risk exposures on the pricing kernel increase monotonically from the lowest to highest SUE sorted portfolios. Specifically, good-news firms always have higher risk exposures than bad-news firms in both 10 SUE sorted portfolios and 25 size and SUE sorted portfolios. However, the estimated expected risk premium is too small to explain the observed magnitude of returns on the PEAD strategy. Our risk adjustment can explain only about one-fourth of the total magnitude of the average realized return to the PEAD strategy. As a result, the average risk-adjusted returns of earnings momentum strategies are mostly positive and significant. Overall, our results support the view that at least some portion of the returns to the earnings momentum strategies examined represent compensation for bearing increased risk.     

Momentum strategies based on reward–risk stock selection criteria

In this paper, we analyze momentum strategies that are based on reward–risk stock selection criteria in contrast to ordinary momentum strategies based on a cumulative return criterion. Reward–risk stock selection criteria include the standard Sharpe ratio with variance as a risk measure, and alternative reward–risk ratios with the expected shortfall as a risk measure. We investigate momentum strategies using 517 stocks in the S&P 500 universe in the period 1996–2003. Although the cumulative return criterion provides the highest average monthly momentum profits of 1.3% compared to the monthly profit of 0.86% for the best alternative criterion, the alternative ratios provide better risk-adjusted returns measured on an independent risk-adjusted performance measure. We also provide evidence on unique distributional properties of extreme momentum portfolios analyzed within the framework of general non-normal stable Paretian distributions. Specifically, for every stock selection criterion, loser portfolios have the lowest tail index and tail index of winner portfolios is lower than that of middle deciles. The lower tail index is associated with a lower mean strategy. The lowest tail index is obtained for the cumulative return strategy. Given our data-set, these findings indicate that the cumulative return strategy obtains higher profits with the acceptance of higher tail risk, while strategies based on reward–risk criteria obtain better risk-adjusted performance with the acceptance of the lower tail risk.     

The cost of overconfidence in public information

We investigate the effects of investor overconfidence in public information on cross-sectional asset returns. The results show that investors in the US equity market are overconfident about public signals for mature firms that are relatively easy to price—old, large, and dividend-paying firms, value firms, and firms with a higher proportion of tangible assets, little external financing, and low sales growth. However, the effects of the overconfidence on cross-sectional stock returns are reversed quickly and comprise more than half of the short-term return reversals. The risk-adjusted cost of being overconfident about the noisy public signals, measured by return reversals of hedge portfolios formed on unexpected responses, is over 1.1% per month in the first month after portfolio formation, and is still significant despite the active arbitrage trading in the 2000s.     

Cross-sectional learning and short-run persistence in mutual fund performance

Using monthly return data of more than 6400 US equity mutual funds we investigate short-run performance persistence over the period 1984–2003. We sort funds into rank portfolios based on past performance, and evaluate the portfolios’ out-of-sample performance. To cope with short ranking periods, we employ an empirical Bayes approach to measure past performance more efficiently. Our main finding is that when funds are sorted into decile portfolios based on 12-month ranking periods, the top decile of funds earns a statistically significant, abnormal return of 0.26 percent per month. This effect persists beyond load fees, and is mainly concentrated in relatively young, small cap/growth funds.     

Jump risk,stock returns,and slope of implied volatility smile

In the presence of jump risk, expected stock return is a function of the average jump size, which can be proxied by the slope of option implied volatility smile. This implies a negative predictive relation between the slope of implied volatility smile and stock return. For more than four thousand stocks ranked by slope during 1996–2005, the difference between the risk-adjusted average returns of the lowest and highest quintile portfolios is 1.9% per month. Although both the systematic and idiosyncratic components of slope are priced, the idiosyncratic component dominates the systematic component in explaining the return predictability of slope. The findings are robust after controlling for stock characteristics such as size, book-to-market, leverage, volatility, skewness, and volume. Furthermore, the results cannot be explained by alternative measures of steepness of implied volatility smile in previous studies.     

The return premiums to accruals quality

Using a battery of look-ahead-bias free measures of accruals quality (AQ), we find a strong and long-lasting negative relation between future returns and AQ. In decile portfolios that rank on AQ, a hedge portfolio that goes long in the lowest decile and short in the highest decile generates an annualized, risk-adjusted return of 4–12 % over 1-month to 5-year horizons, depending on the AQ measure and the portfolio weighting scheme. The return premiums associated with AQ are, (1) robust to a wide range of AQ measures, (2) robust to a battery of return-informative variables, and (3) not driven by low-priced or small stocks, earnings shocks, or the fourth-quarter effect. The documented premiums are consistent with the information uncertainty effect where firm uncertainty is negatively related to future returns.     

The Joint Cross Section of Stocks and Options

Stocks with large increases in call (put) implied volatilities over the previous month tend to have high (low) future returns. Sorting stocks ranked into decile portfolios by past call implied volatilities produces spreads in average returns of approximately 1% per month, and the return differences persist up to six months. The cross section of stock returns also predicts option implied volatilities, with stocks with high past returns tending to have call and put option contracts that exhibit increases in implied volatility over the next month, but with decreasing realized volatility. These predictability patterns are consistent with rational models of informed trading.     

“Hot Hands” in bond funds

We investigate persistence in the relative performance of 3549 bond mutual funds from 1990 to 2003. We show that bond funds that display strong (weak) performance over a past period continue to do so in future periods. The out-of-sample difference in risk-adjusted return between the top and bottom decile of funds ranked on past alpha exceeds 3.5 percent per year. We demonstrate that a strategy based on past fund returns earns an economically and statistically significant abnormal return, suggesting that bond fund investors can exploit the observed persistence. Our results are robust to a wide range of model specifications and bootstrapped test statistics.     

Liquidity risk,leverage and long-run IPO returns

We examine the risk-return characteristics of a rolling portfolio investment strategy where more than 6000 Nasdaq initial public offering (IPO) stocks are bought and held for up to 5 years. The average long-run portfolio return is low, but IPO stocks appear as “longshots”, as 5-year buy-and-hold returns of 1000% or more are somewhat more frequent than for non-issuing Nasdaq firms matched on size and book-to-market ratio. The typical IPO firm is of average Nasdaq market capitalization but has relatively low book-to-market ratio. We also show that IPO firms exhibit relatively high stock turnover and low leverage, which may lower systematic risk exposures. To examine this possibility, we launch an easily constructed “low-minus-high” (LMH) stock turnover portfolio as a liquidity risk factor. The LMH factor produces significant betas for broad-based stock portfolios, as well as for our IPO portfolio and a comparison portfolio of seasoned equity offerings. The factor-model estimation also includes standard characteristic-based risk factors, and we explore mimicking portfolios for leverage-related macroeconomic risks. Because they track macroeconomic aggregates, these mimicking portfolios are relatively immune to market sentiment effects. Overall, we cannot reject the hypothesis that the realized return on the IPO portfolio is commensurable with the portfolio's risk exposures, as defined here.     

Equity market valuation of human capital and stock returns

We investigate whether and how well firms’ stock market valuations reflect their employees’ collective skills and effectiveness relative to that of their industry peers and competitors. We devise a relative stock market valuation measure of human capital intangibles (EVHC) and find that portfolios of low EVHC firms systematically outperform portfolios of high EVHC firms by an average 1.34% per month. However, this is primarily a small firms effect, because for large firms the excess returns of the arbitrage portfolio that is long on the low EVHC stocks and short on the high EVHC stocks is zero. Our results suggest that reliance on human capital intangibles may proxy for risk not fully accounted for by conventional asset pricing models, or alternatively, that the market cannot correctly price human capital intangibles for small size firms.     

Profitability of momentum strategies in Latin America

This article examines performance of momentum portfolios in Latin America. Conventional momentum produces zero risk-adjusted returns. Residual and model-based momentum strategies are also unable to deliver positive and significant risk-adjusted performance. A third or absolute strength momentum strategy based on historical returns obtains positive and significant alphas only when controlling for market, size, and value factors. Nonetheless, when we control for country effects or expand the set of risk factors, abnormal returns to absolute strength momentum are also insignificant. In all, after accounting for risk, stock investors in the region were not able to profit from return continuation.     

Modeling time variation and asymmetry in foreign exchange exposure

Many recent studies suggest that exchange rate exposure is unstable over time and exhibits asymmetric behavior during currency appreciations and depreciations. This paper proposes a dynamic framework for the study of such questions and our empirical findings show that exchange rate exposure of U.S. stocks is time varying. Using decile and sector portfolios, we find asymmetric exposure to be pervasive across the decile portfolios as well as the financial and industrial sectors. Moreover, the response of return variance to past innovations is asymmetric for the majority of cases. The dynamic exchange rate exposure parameters are found to be mean-reverting with low persistence, generally ranging from 1 to less than 2 days. The average time-varying exposure is statistically significant for the size-based and sector-based portfolios. Lastly, the variability in the time-varying exposure is smaller (larger) for the largest (smallest) firms and for industrial (technology) firms.     

Risks and rewards for momentum and reversal portfolios

Rational asset pricing implies a positive relation between the expected risk-adjusted return and the volatility of a factor-mimicking portfolio. The relation for the momentum portfolio is weak after its return is adjusted for the risks associated with the market return, the size factor, and the book-to-market factor. However, the relation is significantly positive and captures most of the average return on the momentum portfolio after the return is adjusted for the market return and the risk associated with the short-term reversal portfolio return. The result supports the hypothesis that there is a common factor underlying both momentum and short-term reversal. The dynamics of the factor loadings and the correlation structure of the underlying factors have important implications for the risk prices associated with the factor-mimicking portfolios and the risk–return trade-off for momentum and reversal portfolios.     

Unsophisticated Arbitrageurs and Market Efficiency: Overreacting to a History of Underreaction?

Prior research has documented that arbitrage activity significantly reduces or eliminates stock market anomalies. However, if anomalies arise due to unsophisticated investors’ behavioral biases, then these same biases can also apply to unsophisticated arbitrageurs and thereby disrupt the arbitrage process. Consistent with a disruption in the arbitrage process for the post‐earnings announcement drift anomaly, I document that the historically positive autocorrelation in firms’ earnings announcement news has become significantly negative for firms with active exchange‐traded options. For these easy‐to‐arbitrage firms, the firms in the highest decile of prior earnings announcement abnormal return (prior earnings surprise), on average, underperform the firms in the lowest decile by 1.59% (1.43%) at their next earnings announcement. Additional analyses are consistent with investors learning about the post‐earnings announcement drift anomaly and overcompensating. This study suggests that unsophisticated attempts to profit from a well‐known anomaly can significantly reverse a previously documented stock return pattern.     

Trading strategies based on past returns: evidence from Germany

Among the various strategies studied in this paper, only momentum investing appears to earn persistently nonzero returns: From 1965 to 2014, the classical momentum strategy based on performance over the previous 2–12 months earned an average return of 1.57% per month (excluding microcap stocks and value-weighted returns). In the most recent 10-year period, this return was even larger—2.27%—which is much larger than in the USA. However, profitability net of transaction costs is weak because the strategy involves trading in disproportionately small stocks with high transaction costs, something that is particularly true for the loser portfolio. A strategy that concentrates only on the winner portfolio and thus avoids potential problems associated with (short) selling the costly loser portfolio appears to earn strong and persistently abnormal profits, even after transaction costs.     

Does it cost to be sustainable?

We investigate whether firms’ corporate social performance (CSP) ratings impact their performance (cost of capital) and risk. Using a proprietary CSP ratings database, we find no difference in the risk-adjusted performance of UK firms with high and low CSP ratings. Additionally, the firms do not differ in their amount of idiosyncratic risk. We find some evidence of high-ranked firms being larger. The empirical evidence therefore indicates that investors and managers are able to implement a CSP investment or business strategy without incurring any significant financial cost (or benefit) in terms of risk or return.     

Nonlinear mean reversion in stock prices

This paper provides new evidence on the time-series predictability of stock market returns by introducing a test of nonlinear mean reversion. The performance of extreme daily returns is evaluated in terms of their power to predict short- and long-horizon returns on various stock market indices and size portfolios. The paper shows that the speed of mean reversion is significantly higher during the large falls of the market. The parameter estimates indicate a negative and significant relation between the monthly portfolio returns and the extreme daily returns observed over the past one to eight months. Specifically, in a quarter in which the minimum daily return is −2% the expected excess return is 37 basis points higher than in a month in which the minimum return is only −1%. This result holds for the value-weighted and equal-weighted stock market indices and for each of the size decile portfolios. The findings are also robust to different sample periods, different indices, and investment horizons.     

On the Earnings and Price Momentum Strategies: Evidence from European Real Estate Firms

We test the performance and interaction between earnings and price momentum for European real estate companies by first making use of decile portfolios sorted on the previous 3- to 12-month returns, standardized unexpected earnings and a combination of both. Then, the relation is tested on a risk-adjusted basis employing a 3-factor asset pricing model and Fama and Macbeth (1973) cross-sectional regression analyses. Our analyses reveal several critical findings: (1) both price and earnings momentum are effective for European firms, the effect being stronger for the UK than EU firms; (2) unlike U.S. REITs, price momentum seems to dominate drift for European firms; (3) there is weak evidence for positive interaction between drift and price momentum, contrary to the U.S. evidence; (4) the performance of momentum strategies depends on the state of the economy, while controlling for systematic factors; (5) idiosyncratic risk of real estate property firms may influence the returns on drift and momentum factors.     

Structural and Return Characteristics of Small and Large Firms

We examine differences in structural characteristics that lead firms of different sizes to react differently to the same economic news. We find that a small firm portfolio contains a large proportion of marginal firms-firms with low production efficiency and high financial leverage. We construct two size-matched return indices designed to mimic the return behavior of marginal firms and find that these return indices are important in explaining the time-series return difference between small and large firms. Furthermore, risk exposures to these indices are as powerful as log(size) in explaining average returns of size-ranked portfolios.     

Book Assets,Real Estate,and Returns on Common Stock

Since real estate is common to most firms, this study examines whether there is a real estate factor in common stock returns that is not completely captured by existing asset pricing models. The three-factor model of Fama and French (1993), hereafter FF, is extended to incorporate a unique real estate factor. Using his extended-FF model, we examine the returns on 53 industry portfolios of common stocks over the 1972 through 1995 time period. The results indicate that a significant 19 percent of the industries are systematically related to the real estate factor. Most interestingly, we show that the loading of the real estate factor in common stock return is related to the loading of the book-to-market equity factor in these returns. We also construct decile portfolios of common stocks based on historical sensitivities of common stock returns to the real estate factor. The coefficients on the real estate factor vary systematically across the decile portfolios. The results of our analysis suggest that portfolio managers should manage their exposure to real estate.