Exploiting Market Anomalies to Enhance Investment Returns. CFA UK Society Masterclass

Transcription

1 Exploiting Market Anomalies to Enhance Investment Returns CFA UK Society Masterclass Richard J Taffler Professor of Finance and Accounting (Richard.Taffler@wbs.ac.uk) Nomura, One Angel Lane, London, EC4 Thursday 17 February

2 Road Map Stockmarket anomalies and the efficient market hypothesis Which ones work? The key role of market (and investor) underreaction to bad news a behavioural perspective How exploitable? What drives these anomalies financial distress risk? retail investor trading? Recent research evidence 2

3 Stockmarket Anomalies Trading strategies that violate the EMH ability to earn positive abnormal returns on a systematic basis Can you make money trading on these empirical regularities in practice after all costs? can you take short positions? Behavioural finance explanations? Investor clientele explanations? Anomalies based on observable firm characteristics Anomalies based on market under/overreaction to firm news ( event studies ) 3

4 Some Traditional Anomalies The size (small firm) effect The value (book/market) anomaly Price momentum continuation of prior returns Earnings momentum post-earnings announcement drift The accruals anomaly Many others Have these been arbitraged away? 4

5 Market Underreaction to Bad News-based Anomalies Behavioural and emotional finance explanations Bond downgradings Stock analyst new sell (and buy) recommendations Financial distress risk Corporate failure Post-going-concern announcement drift 5

6 Risk-based Anomalies The size anomaly exists but is concentrated within microcap (smallest 60%) stocks accounting for 3% of total market cap. highly volatile returns is this exploitable in practice? The value (book/market) anomaly exists but is less impressive for big stocks (largest 20%) account for 90% of total market cap. can be out of fashion for many years More interesting anomaly results control for these two key risk factors (source Fama and French, JF, 2008) 6

7 Price Momentum The premier anomaly Jegadeesh and Titman (JF, 1993) and later papers demonstrate medium term (3-12 months) momentum exists however, abnormal returns reverse after 12 months Recent empirical tests - controlling for size and book/market: market momentum hedge portfolio (Q 5 Q 1 ) earns around 100 bps/month largely driven by going short in loser stocks strongest results for micro stocks But highly volatile and can disappoint How directly exploitable as a trading strategy? Professional fund managers v private investors? - behavioural need for comfort? 7

8 Momentum and Trading Costs Lesmond, Schill and Zhou in The illusory nature of momentum profits (JFE, 2004) demonstrate such stocks have high trading costs apparent abnormal momentum returns create an illusion of trading profit opportunities Jegadeesh and Titman results are explained by understating trading costs, ignoring short-sale costs and high trading intensity (up to 30% stock turnover a month LBS/Credit Suisse) extreme performing portfolios comprise relatively illiquid stocks many of which cannot be borrowed High transaction costs also affect the exploitation of other anomalies? 8

9 Earnings Momentum the Postearnings Announcement Drift Subsequent to earnings announcements stocks drift upwards or downwards depending on difference between reported quarterly earnings and analyst earnings forecast figures Strong hedge portfolio (Q 5 Q 1 ) results 1.2% - 1.3% per month for micro stocks 0.6% - 1.0% per month for small stocks (20% and accounting for 6% of total market cap.) not significant for big stocks Again earned by going short in bottom quintile stocks Investor bias explanation market underreaction to new information? How exploitable in practice? 9

10 The Accruals Anomaly Accruals = change in working capital (net of cash and short term debt) operating cash flow = net income + depreciation accruals Are investors subject to functional fixation? stock prices act as if investors naïvely focus on reported earnings ignoring information provided by accounting accruals and cash flows with securities mispriced as a result An accrual hedge strategy earns 30 to 40+ bps/month in the US importantly, these abnormal returns are not concentrated in micro stocks Anomaly robust in the UK but not Japan (less accounting discretion) Evidence consistent with earnings management (discretionary or abnormal accruals) and barriers to arbitrage How can this anomaly be exploited in practice? 10

11 What Underpins Asset-pricing Anomalies? Is financial distress the underlying driver? Abramov, Chordia, Jostova and Philipov (WP, 2010) show credit risk (S&P rating) is a key explanator Anomalous pricing is concentrated among the bottom third S&P rated firms (average B+, non-investment grade) and micro and small firms Very large negative returns among these firms e.g. bottom quintile momentum micro (small) stocks underperform by -1.9% (-1.6%) per month largely driven by downgrade events high credit risk firms tend to have larger and more frequent downgrades Market underreaction to (denial of prospective) bad news? 11

12 Market Underreaction to Bad News Anomalies Anomalous market reaction to bad news Ability to tolerate loss is a key determinant of all financial decision making Prospect theory (Kahneman and Tversky, 1979) teaches us losses loom larger than gains a loss typically has about two and a half times the impact of a gain of the same magnitude people hate to lose! Bad news is directly associated emotionally with loss Investors are generally predisposed to sell their winners too soon but hold on to their losers too long the disposition effect 12

13 Dealing with Bad News: Loss Aversion Associated problems of guilt, regret and shame the pain not just of loss but responsibility for it regret minimisation strategy Psychoanalytic thinkers see the capacity to bear loss (accept bad news) as a critical stage in personal development We use many different (unconscious) strategies against mourning and bearing loss (dealing with bad news) including denial, blame, rationalisation and hope 13

14 Bond Rating Changes Moody s bond rating changes negative abnormal returns of between -10% and - 14% in the year following downgrades and further declines in the next two years v no reaction to upgrades (Dichev and Piotroski, JF, 2001) 14

15 Analyst Stock Recommendation Drift Anomaly Womack (JF, 1996) finds clear post-recommendation drift new buys: +2.4% over next month, only +0.1% over following 6 months new sells: -9.1% over the following 6 months Mokoaleli-Mokoteli, Taffler and Agarwal (JBFA, 2009) find 55% of new buy recommendations earn negative returns over 12 months and only 1/3 are successful 12-month mean (median) return for new sells = -13.6% (-19.9%) Ryan and Taffler find similar results in the UK (BAR, 2006) Classic loss aversion behaviour by investors it takes time for the bad news to be assimilated Analysts are prone to biases of overconfidence and representativeness the good management, good stock syndrome 15

16 Company Failure and Post-bankruptcy Drift Firms filing for Chapter 11 bankruptcy in the US subsequently underperform by 28% over the following 12 months on a risk adjusted basis (Coelho, John and Taffler, WP, 2011) should not happen if markets are efficient! Market is in denial ; it takes time to assimilate such acute bad news Anomaly driven by gambling behaviour of the retail investors trading in these stocks Strategic bankruptcies are tarred with the same brush - representativeness bias How can this anomaly be exploited? 16

17 Post-going-concern Announcement Drift Post-going-concern announcement drift of 31% over the next year in the UK (Taffler, Lu and Kausar, JAE, 2004) Parallel post-going-concern announcement drift of - 14% over the next year in the US (Kausar, Taffler and Tan, JAR, 2009) The anomaly is again driven by retail investors trading actively in these stocks However, subsequent going-concern liftings (good news) are fully anticipated with no post-event drift in aggregate How can this anomaly be traded upon? 17

18 The Financial Distress Anomaly Campbell, Hilscher and Szilagyi (JF, 2008) show financially distressed firms deliver anomalously low returns Z-scores accurately measure the risk of financial distress Stocks with greatest bankruptcy risk underperform those with low bankruptcy risk by 14% over the next year with further declines over the next 3 years (Dichev, JF, 1998) In the UK Agarwal and Taffler show bottom quartile (most financially distressed) firms underperform top quartile (least financially distressed) firms by 10% a year on a risk adjusted basis Financial distress also seems to be driving the momentum anomaly (Agarwal and Taffler, FM, 2008) The market is clearly mispricing financial distress risk Can the financial distress risk anomaly be exploited in pratice? 18

19 Exploiting the Financial Distress Anomaly Largest 300 UK stocks risk-adjusted buy-and-hold financial distress risk portfolio quartile returns ( = 100) Dec-99 Apr-00 Aug-00 Dec-00 Apr-01 Aug-01 Dec-01 Apr-02 Aug-02 Dec-02 Apr-03 Aug-03 Dec-03 Apr-04 Aug-04 Dec-04 Apr-05 Aug-05 Dec-05 Apr-06 Aug-06 Dec-06 Apr-07 Aug-07 Dec-07 Apr-08 Aug-08 Dec-08 Apr-09 Aug-09 Dec-09 Apr-10 Aug-10 Dec-10 Q4 Q1 All stocks 19

20 Why Does The Market Underreact to Financial Distress? General speculative behavioural finance reasons? Retail investor gambling on the market? is this the meta-narrative for the existence of market anomalies? Retail investors are very good at losing money Stocks they buy on average underperform those they sell by -3.2% over the next year and by -5.1% excluding trading for nonspeculative reasons (Barber and Odean, JF, 2000) Can one develop a trading strategy focused on stocks with high retail clientele? 20

21 Retail Investors and Lottery-like Stocks (Alok Kumar Who Gambles on the Stockmarket?, JF, 2009) Individual investors like lottery-like stocks i.e., low cost with low probability of winning a large amount of money (but high probability of loss) characterised by high volatility, high skewness and low price (penny stocks) Similar socio-economic characteristics as with lottery players Institutional investors are averse to such stocks 21

22 Retail Investors and Lottery-like Stocks (cont ) The more investors invest in lottery-like stocks the more they lose allocating at least a third of your portfolio to lottery type stocks leads to portfolio underperformance of - 2.5%/annum Overconfidence (trading activity) has an incremental effect on portfolio underperformance Grinblatt and Keloharju Sensation seeking, overconfidence, and trading activity (JF, 2009) similarly show overconfident investors and those most prone to sensation seeking trade most 22

23 Exploiting Market Anomalies: Limits to (or Costly) Arbitrage? Trading on most anomalies requires going short in losing stocks Can such typically small losing stocks be readily shorted? They need to be borrowed risk in a rising market as the lender has an option to cancel the loan ( recall a stock) D Avolio (JFE, 2002) shows: 16% of stocks are impossible to short (but small illiquid stocks only 1% by market value) 9 out of 10 stocks (91%) lent out cost <1%/annum to borrow 9% are special mean fee of 4.3%/annum but highly skewed 23

24 Summary The efficient market hypothesis and market anomalies The key role of behavioural finance Anomalies reviewed momentum post-earnings announcement drift Accruals financial distress risk Market underreaction to bad news: bond downgradings analyst stock recommendations financial distress risk corporate bankruptcy going-concern Retail investor gambling on the market? 24

25 Concluding Discussion How tradable on are such stockmarket anomalies and how can they be exploited in practice? for the overwhelming majority of conventional stocks do short interest and institutional ownership levels make short selling constraints unlikely? How useful is the research evidence on market anomalies in practice? Do different anomalies tend to interact and are conditional on each other (e.g., role of prior returns and analyst earnings forecasts )? multifactoral modelling approach of quantitative fund managers Do market pricing anomalies only exist for extreme poorly followed stocks? why should we expect free lunches? 25