Quantpedia Premium Update – March 20th

New Strategies:

#980 – Factor Momentum in Commodity Futures

Period of rebalancing: Monthly
Markets traded: commodities
Instruments used for trading: CFDs, futures
Complexity: Complex strategy
Backtest period: 1985-2022
Indicative performance: 4.27%
Estimated volatility: 9.5%

Source paper:

Qian, Yiyan and Liu, Xiaoquan and Jiang, Ying: Factor Momentum in Commodity Futures Markets
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4678928
Abstract:
This paper examines the factor momentum in commodity futures markets. Using data from the developed markets from 1985 to 2022, we ﬁrst show that a commodity factor’s past returns positively predict its future returns. This predictability leads to sizable economic proﬁts in a factor momentum strategy, is at its strongest over the one-month horizon, and could be explained by mispricing. Moreover, we show that the factor momentum indicates mean-variance ineﬃcient common commodity factors, and negatively impacts the pricing eﬃciency of factor pricing models. We construct the time series of eﬃcient factors, which exhibit higher Sharpe ratios and help improve the pricing performance of factor models. Our results point to the potential to time commodity factors, and highlight the importance of conditional asset pricing in commodity futures markets.

#981 – Cross-ETF Loan Arbitrage Strategy

Period of rebalancing: Daily
Markets traded: ETFs
Instruments used for trading: bonds, commodities, currencies, equities, REITs
Complexity: Very complex strategy
Backtest period: 2012-2015
Indicative performance: 5.5%
Estimated volatility: 1.45%

Source paper:

Andrews, Spencer and Henderson, Brian Joseph and Reed, Adam V.: Cross-ETF Arbitrage
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4667997
Abstract:
We find that Exchange-Traded Funds (ETFs) are more expensive to borrow than stocks, and we provide an explanation for this difference. This phenomenon is due to features specific to the ETF lending market rather than due to the stocks the ETFs hold, as ETF loan fees tend to be higher than the average of their constituent stocks. We find that for most indices, one ETF tends to capture the majority of the short interest. This “short favorite” ETF tends to have low loan fees, while the “non-favorite” ETFs tend to be much more expensive to short and are less liquid. Demonstrating the magnitude of ETF loan fee differences within each index, we examine the returns to a within-index, cross-ETF arbitrage strategy which is profitable due to persistent loan fee differences across ETFs tracking the same index. Cross-ETF arbitrage returns are quite high and stable. Even when we partially constrain an investor’s ability to fully lend out their long position, we still find that the cross-ETF arbitrage strategy is profitable for about 2/3 of the indices in our sample. The results shed light on limits to arbitrage in the market for exchange-traded funds and provide an explanation for the high ETF loan fees that we observe.

#982 – Market Power and the Profitability Premium

Period of rebalancing: Yearly
Markets traded: equities
Instruments used for trading: stocks
Complexity: Complex strategy
Backtest period: 1963-2020
Indicative performance: 6.42%
Estimated volatility: 20.31%

Source paper:

Deng, Yao and Luo, Ding and Tong, Jincheng: Market Power, Technology Shocks, and the Profitability Premium
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4714159
Abstract:
This paper studies how market power affects the well-documented positive relation between firms’ profitability and future stock returns in the cross-section. We find that this relation is significantly more pronounced among firms with high markup. A long-short portfolio sorted on profitability earns an average monthly return of 0.57% among firms with high markup, and only 0.05% among firms with low markup. Firms’ differential exposure to investment-specific technology shocks explains this gap. To understand these results, we introduce market power into a standard investment-based asset pricing model to study its impact on firms’ endogenous investment and risk exposures. Market power exacerbates the displacement risk faced by highly profitable firms.

#983 – Combined Momentum and Short Interest in Stocks

Period of rebalancing: Monthly
Markets traded: equities
Instruments used for trading: stocks
Complexity: Complex strategy
Backtest period: 1999-2022
Indicative performance: 8.2%
Estimated volatility: 10%

Source paper:

Buraschi, Andrea and Pellegrino, Filippo: From Extinction to Resurrection: Unveiling the Role of Short-Selling Frictions in Cross-Sectional Momentum
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4700511
Abstract:
An extensive literature supports that a cross-sectional momentum strategy, going long winners and short losers’ stocks, yields substantial abnormal returns. This evidence challenges conventional asset pricing theories and has been considered important evidence against the EMH. Our study reveals that the classic momentum effect has almost disappeared in the last 25 years. We collected data on short interest to investigate the role played by short-selling frictions in this market evolution. Controlling for short interest, the momentum effect re-emerges very persuasively, even in the latest period. These novel results align with the DSGE framework proposed by Scheinkman and Xiong (2003), linking short-selling constraints to the dynamics of asset pricing and aiding in the understanding of the economics of cross-sectional momentum.

New research papers related to existing strategies:

#22 – Term Structure Effect in Commodities

Adams, Zeno and Burdorf, Tom and Käfer, Niclas: Recovering from Shocks: Term Structure Signalling in Commodity Markets
https://ssrn.com/abstract=4692902
Abstract:
We examine the behaviour of commodity term structures following economic shocks. The response of the futures curve in the near term, relative to the front-month future reflects market expectations about the type, magnitude, and persistence of a shock.

These market expectations have predictive power for the recovery time after a shock. Our findings challenge the current view that term structures in commodity markets cannot contain market expectations due to arbitrage forces of the carry trade.

#75 – Federal Open Market Committee Meeting Effect in Stocks

Golez, Benjamin and Matthies, Ben: Fed Information Effects: Evidence from the Equity Term Structure
https://ssrn.com/abstract=3836206
Abstract:
Do investors interpret central bank target rate decisions as signals about the current state of the economy? We study this question using a short-term equity asset that entitles the owner to the near-term dividends of the aggregate stock market. We develop a stylized model of monetary policy and the equity term structure and derive tests of Fed information effects using the short-term asset announcement return. Consistent with the existence of information effects, we find that the short-term asset return in a 30-minute window around FOMC announcements loads positively on monetary policy surprises. Furthermore, the announcement return predicts near-term macroeconomic growth.

Mano, Nicola: Institutional Trading around FOMC Meetings: Evidence of Fed Leaks
https://ssrn.com/abstract=3830271
Abstract:
Fed leaks to the financial sector are actively exploited by institutional investors to trade ahead of the Federal Open Market Committee (FOMC) meetings. Using detailed transaction records from Ancerno, I find evidence consistent with informed institutional trading on the stock market on the days before FOMC scheduled announcements. The institutional trading imbalance on highly exposed stocks is in the same direction of the subsequent monetary policy surprise. The magnitude of this result is economically significant. I find that trades in anticipation of FOMC meetings are particularly strong before easing monetary policy shocks – when the aggregate market reaction is positive -, for the most-active traders, and for the hedge funds that are headquartered close to one of the regional reserve banks. Fed informal communication with the financial sector seems to be driven by the non-voting members of the Federal Open Market Committee. These findings contribute to an information-based explanation of the pre-FOMC drift and, from a policy perspective, suggest that any benefits of Fed unofficial communication must be balanced against the risk of giving some investors an unfair advantage.

And several interesting free blog posts that have been published during the last 2 weeks:

Systematic Hedging of the Cryptocurrency Portfolio

Cryptocurrencies are already one of the major asset classes. They fill the top pages of magazines and are a topic of a day to day conversation. There are a lot of ways to buy them through a lot of different channels. But some of the hardcore HODLers like to keep their coin portfolio safe – they buy a portfolio of cryptocurrencies and hold them in cold storage. It has a lot of advantages (you will probably not become a victim of hacking if your crypto coins are in cold storage in your wall safe) but also some disadvantages (your cold storage device can become unreadable or destroyed). One of the disadvantages of cold storage is that while you hold the cryptocurrencies in your cold storage, you are exposed to the price swings of the cryptocurrency market (which can be tremendous). But do you need to have this risk, especially when the market is at an all-time high? What if you smartly hedged a portion of your portfolio? The goal of this article is to serve as an inspiration for a hedging strategy for your cold storage cryptocurrency portfolio. We do not say this is the only way to run a hedging strategy, but we would like to inspire you to start thinking about this possibility even when you have not considered it yet. Are you ready? Then let’s go 🙂

Portfolio Diversification Including Art as an Alternative Asset

Alternative investment assets (also such as rare vintage and collectible items, expensive old high-quality alcohol, discontinued fashion, etc.) are a hit among wealthy investors, even though it is not easy to obtain direct or indirect exposure to diversified art investment(s) in a traditional finance kind of way. However, alternative assets are helpful in portfolio diversification as they last (if stored properly), usually appreciate in value (but sometimes not very predictably), and have a low correlation to traditional assets like stocks, real estate, gold, or fixed-income securities. Although alternative assets are highly illiquid and sometimes very challenging to value correctly, researchers are interested in them. We will closely look at one of the research papers that investigates the role of art in the portfolio, utilizing mean-variance optimization and less-used STL decomposition.

Which Stock Return Predictors Reflect Mispricing and Which Risk-Premia?

The degree of stock market efficiency is a fundamental question of finance with considerable implications for the efficiency of capital allocation and, hence, the real economy. Return predictability is a cornerstone that allows investors to estimate their returns with ranging precision. Some anomalies allow one to exploit loopholes in global markets and capture substantial alpha, which violates the Efficient Market Hypothesis (EMH). However, whether this alpha arrives from risk premia or its source is mispricing is still puzzling academics around the globe, and they wrap their head around solving these tricky question.