Volume 9, No. 4, Fourth Quarter 2011

Another Look at Idiosyncratic Volatility and Expected Returns

by: Wei Huang, Qianqiu Liu, S. Ghon Rhee and Liang Zhang

We conduct comprehensive analyses of the return characteristics of stock portfolios sorted by idiosyncratic volatility. We show that the relationship between idiosyncratic volatility and expected stock returns depends on whether the portfolio is composed of stocks with extreme performance and whether the returns are computed over January and nonJanuary months. The dominance of loser stocks in December and a reversal effect in the subsequent month lead to a positive relation between idiosyncratic volatility and portfolio returns in January. Whereas for other months, the impact of past winner stocks dominates and a negative relation is observed due to the return reversal of these winner stocks. Our study contributes to the understanding of how January effect and short-term return reversal can lead to different relation between idiosyncratic volatility and expected returns.

Pairs – Trading on Divergent Analyst Recommendations

by: Susana Yu

Pairs-trading is a short-term, self-financing arbitrage strategy in which buy and sell positions are simultaneously placed on two stocks whose prices have moved temporarily apart after following a long parallel path. We develop a new pairs-trading rule based on financial analysts' buy/hold/sell recommendations from IBES Details Recommendation Database and test it for the period 1994 - 2009. On the basis of the Fama-French (1993) and Carhart [Journal of Finance 52(1), 57 - 82, 1997] four-factor models, we find that our trading rule generally results in positive risk-adjusted returns. It is more effective on small- and midcap pairs of stocks than on large-cap pairs, consistent with the hypothesis of information disparity in the stock market. It is more effective in the industries of mining, finance, and services than in others. In additional exploration of our strategy, we examine the correlation of analyst recommendations with past stock investment and corporate earnings performance in the past. We find significant positive correlation, lending new support to prior findings of the relation between recommendations and recent performance.

Managing the Volatility of Alpha Models

by: Tony Elavia and Migene Kim

After posting good performance for over two decades, quantitative equity investment managers have recently produced weak returns. We develop a measure of risk and show how changes in risk provide a common framework to explain factor returns and past underperformance. We find that the quantitative stock ranking models based upon factor weights that vary with their conditional (on risk) forecasted returns are superior to traditional models with fixed weights based upon unconditional historical averages. The suggested improvements to investment processes rely upon objective and well-defined relationships between factor returns and risk.

What Taleb Can Learn From Markowitz

by: Jack L. Treynor

Markowitz' 1959 book introduced a concept of value that could actually be tested. Markowitz's quite general conditions can lead to the Central Limit Theorem.
Consider weekly returns on Markowitz's random wheel. Then annual returns on actual prices would have 52 terms reflecting returns on value and 2 for microstructure noise. We can use such annual returns if

1) weeks are short enough that Markowitz's approximation to the log holds for a reasonable dispersion of weekly returns (on value only, with noise excluded).
2) 52 terms in the sum is enough.

And note: whether Markowitz is a Gaussian depends on the weekly returns - not the annual returns.

Efficient Indexation: An Alternative to Cap-Weighted Indices

by: Noël Amenc, Felix Goltz, Lionel Martellini and Patrice Retkowsky

This paper introduces a novel method for the construction of equity indices that, unlike their cap-weighted counterparts, offer an efficient risk/return trade-off. The index construction method goes back to the roots of modern portfolio theory and focuses on the tangency portfolio, the portfolio that weights index constituents so as to obtain the highest possible Sharpe ratio. The major challenge is to generate the required input parameters in a robust manner. The expected excess return of each stock is estimated from portfolio sorts according to the stock's total downside risk. This estimate uses the economic insight that stocks with higher risk should compensate their holders with higher expected returns. To estimate the covariance matrix, we use principal component analysis to extract the common factors driving stock returns. Moreover, we introduce a procedure to control turnover in order to implement the method with low transaction costs. Our empirical results show that portfolio optimization with our robust parameter estimates generates out-of-sample Sharpe ratios significantly higher than those of the corresponding cap-weighted indices. In addition, the higher risk-return efficiency is achieved consistently and across varying economic and market conditions.

Understanding the Middle East

by: Jack L. Treynor

“Case Studies” presents a case pertinent to contemporary issues and events in investment management. Insightful and provocative questions are posed at the end of each case to challenge the reader. Each case is an invitation to the critical thinking and pragmatic problem solving that are so fundamental to the practice of investment management.

Debunkery: Learn It, Do It, and Profit From It - Seeing Through Wall Street's Money-Killing Myths

by: Ken Fisher and Lara Hoffman • reviewed by: Bruce Grantier

“Book Reviews” identifies important, and often popular, new books from a wide range of investment topics. Beyond providing a summary and review of the content and style of the books, “Book Reviews” seeks to contribute to a conscious, critical, and informed approach to investment literature.

Practitioner’s Digest • Vol. 9, No. 4

The “Practitioners Digest” emphasizes the practical significance of manuscripts featured in the “Insights” and “Articles” sections of the journal. Readers who are interested in extracting the practical value of an article, or who are simply looking for a summary, may look to this section.