New strategies:
#224 – Profitability Factor Combined with Value Factor
Period of rebalancing: Yearly
Markets traded: equities
Instruments used for trading: stocks
Complexity: Moderately complex strategy
Bactest period: 1963 – 2010
Indicative performance: 7.70%
Estimated volatility: 9.82%
Source paper:
Novy-Marx: The Other Side of Value: The Gross Profitability Premium
http://rnm.simon.rochester.edu/research/OSoV.pdf
Abstract:
Profitability, measured by gross profits-to-assets, has roughly the same power as book-to-market predicting the cross-section of average returns. Profitable firms generate significantly higher returns than unprofitable firms, despite having significantly higher valuation ratios. Controlling for profitability also dramatically increases the performance of value strategies, especially among the largest, most liquid stocks. These results are difficult to reconcile with popular explanations of the value premium, as profitable firms are less prone to distress, have longer cash flow durations, and have lower levels of operating leverage. Controlling for gross profitability explains most earnings related anomalies, and a wide range of seemingly unrelated profitable trading strategies.
New research papers related to existing strategy:
#12 – Pairs Trading with Stocks
Bock, Mestel: A Regime-Switching Relative Value Arbitrage Rule
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1213802
Abstract:
The relative value arbitrage rule ("pairs trading") is a well-established speculative investment strategy on financial markets, dating back to the 1980s. Based on relative mispricing between a pair of stocks, pairs trading strategies create excess returns if the spread between two normally comoving stocks is away from its equilibrium path and is assumed to be mean reverting. To overcome the problem of detecting temporary in contrast to longer lasting deviations from spread equilibrium, this paper bridges the literature on Markov regime-switching and the scientific work on statistical arbitrage.
#54 – Momentum and State of Market (Sentiment) Filters
Kim, Roh, Min, Byun: Time-Varying Expected Momentum Profits
http://www.apjfs.org/conference/2012/cafmFile/7-3.pdf
Abstract:
This paper examines the time variations of expected momentum profits using a two-state Markov switching model with time-varying transition probabilities to evaluate the empirical relevance of recent rational theories of momentum profits. We find that in the expansion state the expected returns of winner stocks are more affected by aggregate economic conditions than those of loser stocks, while in the recession state the expected returns of loser stocks are more affected than those of winner stocks. Consequently, expected momentum profits display strong procyclical variations. We argue that the observed momentum profits are the realization of such expected returns and can be interpreted as the procyclicality premium. We provide a plausible explanation for time-varying momentum profits through the differential effect of leverage and growth options across business cycles.
