FINA 3010: FINANCIAL MARKETS

Wenxi JIANG
(Fall 2015)

Lecture Note 10:

The Cross-section of Asset Returns

© Wenxi Jiang

1
Outline

1. The methodology/trading strategy

2. Long-term reversal and value premium

3. Momentum

2
Course content

Part I: Financial Assets and Instruments

- Debt
- Stock
- Insurance, futures, and options
Part II: Investor in Financial Markets
- Individual investors
- Institutional investors
Part III: Prices of Financial Assets
- Efficient market hypothesis (EMH)
- Departure from EMH
- Aggregate asset market return
- The cross-section of asset return
- Bubbles

3
Overview

• Many hedge funds use computer algorithms to pick stocks to

buy or sell, holding the positions for weeks, months, or even
years
- E.g., D.E. Shaw, AQR, Citadel
• These funds are exploiting a set of robust facts about the
relative performance of different kinds of assets
• In this note, we review some of these facts
- The facts are widely agreed upon
- But their interpretation is still in dispute

Zero investment strategy

• Selection: based on some indicator, X, of assets’ future returns,
say, higher X indicates higher average future return.
• Portfolio: at beginning of each period, buy assets with high X
and sell short assets with low X, hold this portfolio for a period
of time, and rebalance
• Zero initial investment: use the proceeds from selling short to
finance the long positions
- If X is a valid indicator of future returns, theoretically the
portfolio would have capital gain with zero equity
- However, in reality, this portfolio does need some equity as
the collateral

4
Rational benchmark
In an economy with rational investors (and no frictions), the only
reason asset A would earn higher long-term average return than
asset B is if it is riskier
• In the basic rational model of stock returns, the CAPM, risk is
measured by beta, 𝛽
• According to CAPM
- Stocks with higher betas should have higher average returns
- Beta should be the only stock characteristics that predicts
the relative performance of stocks
- A zero-investment strategy based on beta should have
positive returns

• Unfortunately, we have shown that these predictions are

empirically false
- A zero-investment strategy based on beta is not profitable

• More importantly, lots of other stock characteristics have

predictive power of future returns
- Past long-term returns
- Price-to-fundamental ratio
- Past medium-term returns

5
Long-run reversal and value premium

Long-term reversals
A stock’s three-year past return negatively predicts its
subsequent return Does the Stock Market Overreact? 803

- Past “loser” stocks subsequently

Average of 46 Yearly outperform
Starting
Replications
Every January Between
past “winner”
1933 and 1978
Length of Formation Period: Five Years
stocks
- De Bondt and Thaler (1985)
0.4l

0.3. "st-

1 .1 K oK
02-1
W
" 4 Loser Portfolio

C 0.0

A ~ ~ *A J
n 1l
I

-0.2-1
Winner Portfolio
-0.2-
0 3 0 8 12 15 10 21 24 21 30 33 3U 30 42 4t5 48 bl 54 51 UU

MUN[IS AFIII U FFOLIOFUX)AT10t

Figure 3. CumulativeAverage Residuals for Winner and Loser Portfolios of 35 Stocks (1-60
months into the test period)

December in which he chose to try the strategy. The effect of multiplying the
numberof replications is to remove part of the random noise.
ValueThe premium
outstanding feature of Figure 3 is, once again, the January returns on the
loser portfolio. The effect is observed as late as five Januaries after portfolio
A stock’s price-to-fundamental
formation! Careful examination of Figureratio predicts
3 also reveals a the stock’s
tendency, on the part
of the loser portfolio, to decline in value (relativeto the market)between October
and December. This observation is in agreement with the naive version of the
subsequent return
tax-loss selling with aasnegative
hypothesis explained sign
by, e.g., Schwert [25]. The winner
portfolio, on the other hand, gains value at the end of the year and loses some in
E.g., P/E
- January ratio,
(for more market-to-book
details, see De Bondt [7]).ratio, price-to-sales ratio

B. Implicationsfor OtherEmpirical Work

The results of this study have interesting implications for previous work on
the small firm effect, the January effect and the dividend yield and PIE effects.
Blume and Stambaugh [6], Keim [16], and Reinganum [21] have studied the 6
 - Low P/E stocks (“value” stocks) outperform high P/E stocks
(“growth” stocks), on average
446 The Journal of Finance

Table V
Average Monthly Returns on Portfolios Formed on Size and
Book-to-Market Equity; Stocks Sorted by ME (Down) and then
BE/ME (Across): July 1963 to December 1990
In June of each year t, the NYSE, AMEX, and NASDAQ stocks that meet the CRSP-
COMPUSTAT data requirements are allocated to 10 size portfolios using the NYSE size (ME)
breakpoints. The NYSE, AMEX, and NASDAQ stocks in each size decile are then sorted
into 10 BE/ME portfolios using the book-to-market ratios for year t - 1. BE/ME is the book
value of common equity plus balance-sheet deferred taxes for fiscal year t - 1, over market
equity for December of year t - 1. The equal-weighted monthly portfolio returns are then
calculated for July of year t to June of year t + 1.
Average monthly return is the time-series average of the monthly equal-weighted portfolio
returns (in percent).
The All column shows average returns for equal-weighted size decile portfolios. The All row
shows average returns for equal-weighted portfolios of the stocks in each BE/ME group.

Book-to-Market Portfolios
All Low 2 3 4 5 6 7 8 9 High
All 1.23 0.64 0.98 1.06 1.17 1.24 1.26 1.39 1.40 1.50 1.63
Small-ME 1.47 0.70 1.14 1.20 1.43 1.56 1.51 1.70 1.71 1.82 1.92
ME-2 1.22 0.43 1.05 0.96 1.19 1.33 1.19 1.58 1.28 1.43 1.79
ME-3 1.22 0.56 0.88 1.23 0.95 1.36 1.30 1.30 1.40 1.54 1.60
ME-4 1.19 0.39 0.72 1.06 1.36 1.13 1.21 1.34 1.59 1.51 1.47
ME-5 1.24 0.88 0.65 1.08 1.47 1.13 1.43 1.44 1.26 1.52 1.49
ME-6 1.15 0.70 0.98 1.14 1.23 0.94 1.27 1.19 1.19 1.24 1.50
ME-7 1.07 0.95 1.00 0.99 0.83 0.99 1.13 0.99 1.16 1.10 1.47
ME-8 1.08 0.66 1.13 0.91 0.95 0.99 1.01 1.15 1.05 1.29 1.55
ME-9 0.95 0.44 0.89 0.92 1.00 1.05 0.93 0.82 1.11 1.04 1.22
Large-ME 0.89 0.93 0.88 0.84 0.71 0.79 0.83 0.81 0.96 0.97 1.18

Source: Fama and French (1992)

controlling for size, book-to-market equity captures strong variation in aver-
age returns, and controlling for book-to-market equity leaves a size effect in
average returns.
Note:
B. The Interaction between Size and Book-to-Market Equity
(1) Long-run reversals and value premium are largely correlated
The average of the monthly correlations between the cross-sections of
“Loser”
- ln(ME) andstocks tendfortoindividual
ln(BE/ME) be “value” stocks
stocks is - 0.26. The negative correla-
tion is also apparent in the average values of ln(ME) and ln(BE/ME) for the
(2) Long-run reversals
portfolios sorted on ME everywhere!
or BE/ME in Tables II and IV. Thus, firms with low
market equity are more likely to have poor prospects, resulting in low stock
Also and
- prices holdshighfor equity indices,
book-to-market bond
equity. indices,large
Conversely, currencies,
stocks are more
likely to be firms with stronger prospects, higher stock prices, lower book-to-
commodities
market equity, and (Asness, Moskowitz,
lower average Pedersen 2013)
stock returns.
The correlation between size and book-to-market equity affects the regres-
sions in Table III. Including ln(BE/ME) moves the average slope on ln(ME)
from -0.15 (t = -2.58) in the univariate regressions to -0.11 (t = -1.99)
in the bivariate regressions. Similarly, including ln(ME) in the regressions

7
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Explanations:
(1) Rational approach
• Low P/E stocks or past long-term losers have higher average
returns because they are riskier in some way
• But not on the dimension of beta, since these stocks do not
appear to have higher beta
• No widely-accepted evidence on what risk factor is

(2) Behavioral approach

• Low P/E stocks or past long-term losers are stocks that have
become undervalued
- Their high average returns represent a correction up to fair
value
• High P/E stocks or past long-term winners are stocks that have
become overvalued
- Their low average returns represent a correction down to
fair value
• The under/over-valuation may be caused by over-
extrapolation of past returns or past earnings

Note:
• How investors will react to the above fact depends on which
interpretation they believe

8
 - Under the behavioral interpretation, they will want to tilt
toward low P/E stocks and away from high P/E stocks
- Under the rational interpretation, they have no reason to tilt
strongly one way or the other

• Practitioners exploit this fact, suggesting a belief in the

behavioral interpretation
- The fact also offers a basis for “contrarian investing” more
generally
- E.g. Warren Buffett

Momentum
A stock’s six-month past return positively predicts its subsequent
return
- Past winner stocks subsequently outperform past loser
stocks (Jegadeesh and Titman 1993)
- Note the contrast with the long-term reversal effect

Momentum is also everywhere!

• Holds for equity indices, bond indices, currencies, commodities

9
 70 The Journal of Finance

Table I
Returns of Relative Strength Portfolios
The relative strength portfolios are formed based on J-month lagged returns and held for K
months. The values of J and K for the different strategies are indicated in the first column and
row, respectively. The stocks are ranked in ascending order on the basis of J-month lagged
returns and an equally weighted portfolio of stocks in the lowest past return decile is the sell
portfolio and an equally weighted portfolio of the stocks in the highest return decile is the buy
portfolio. The average monthly returns of these portfolios are presented in this table. The
relative strength portfolios in Panel A are formed immediately after the lagged returns are
measured for the purpose of portfolio formation. The relative strength portfolios in Panel B are
formed 1 week after the lagged returns used for forming these portfolios are measured. The
t-statistics are reported in parentheses. The sample period is January 1965 to December 1989.

Panel A Panel B
J K= 3 6 9 12 K= 3 6 9 12
3 Sell 0.0108 0.0091 0.0092 0.0087 0.0083 0.0079 0.0084 0.0083
(2.16) (1.87) (1.92) (1.87) (1.67) (1.64) (1.77) (1.79)
3 Buy 0.0140 0.0149 0.0152 .0156 0.0156 0.0158 0.0158 0.0160
(3.57) (3.78) (3.83) (3.89) (3.95) (3.98) (3.96) (3.98)
3 Buy-sell 0.0032 0.0058 0.0061 0.0069 0.0073 0.0078 0.0074 0.0077
(1.10) (2.29) (2.69) (3.53) (2.61) (3.16) (3.36) (4.00)
6 Sell 0.0087 0.0079 0.0072 0.0080 0.0066 0.0068 0.0067 0.0076
(1.67) (1.56) (1.48) (1.66) (1.28) (1.35) (1.38) (1.58)
6 Buy 0.0171 0.0174 0.0174 0.0166 0.0179 0.0178 0.0175 0.0166
(4.28) (4.33) (4.31) (4.13) (4.47) (4.41) (4.32) (4.13)
6 Buy-sell 0.0084 0.0095 0.0102 0.0086 0.0114 0.0110 0.0108 0.0090
(2.44) (3.07) (3.76) (3.36) (3.37) (3.61) (4.01) (3.54)
9 Sell 0.0077 0.0065 0.0071 0.0082 0.0058 0.0058 0.0066 0.0078
(1.47) (1.29) (1.43) (1.66) (1.13) (1.15) (1.34) (1.59)
9 Buy 0.0186 0.0186 0.0176 0.0164 0.0193 0.0188 0.0176 0.0164
(4.56) (4.53) (4.30) (4.03) (4.72) (4.56) (4.30) (4.04)
Explanations:
9 Buy-sell 0.0109 0.0121 0.0105 0.0082 0.0135 0.0130 0.0109 0.0085
(3.03) (3.78) (3.47) (2.89) (3.85) (4.09) (3.67) (3.04)

(1) Rational approach

12 Sell 0.0060 0.0065 0.0075 0.0087 0.0048 0.0058 0.0070 0.0085
(1.17) (1.29) (1.48) (1.74) (0.93) (1.15) (1.40) (1.71)
12 Buy 0.0192 0.0179 0.0168 0.0155 0.0196 0.0179 0.0167 0.0154
• Past winner stocks are riskier (on some dimension other than
12 Buy-sell
(4.63)
0.0131
(4.36)
0.0114
(4.10)
0.0093
(3.81)
0.0068
(4.73)
0.0149
(4.36) (4.09) (3.79)
0.0121 0.0096 0.0069
(3.74) (3.40) (2.95) (2.25) (4.28) (3.65) (3.09) (2.31)
beta)
- But there is not widely-accepted evidence of it This model is
vidual stocks to react instantaneously to factor realizations.
used to decompose relative strength profits into two components relating to
systematic risk, which would exist in an efficient market, and a third
component relating to firm-specific returns, which would contribute to rela-
(2) Behavioral/institutional
tive strength profits only if the approaches?
market were inefficient. The second return-
generating model relaxes the assumption that stocks react instantaneously to
the common factor. This model enables us to evaluate the possibility that the
relative strength profits arise because of a lead-lag relationship in stock
prices similar to that proposed by Lo and MacKinlay (1990) as a partial
explanation for short horizon contrarian profits.

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10
Note:
• Practitioners have long exploited this fact (“momentum
trading”), suggesting a belief in the behavioral interpretation
• Also, practitioners combine value and momentum strategies
and implement it on all financial assets, generating even higher
investment return
- See Asness, Moskowitz, and Pedersen (2013)

11
Suggested readings

Pages 1087-1091, Barberis, Nicholas, and Richard Thaler. "A survey of behavioral finance."
Handbook of the Economics of Finance 1 (2003): 1053-1128.

Asness, Clifford S., Tobias J. Moskowitz, and Lasse Heje Pedersen. "Value and momentum
everywhere." The Journal of Finance 68.3 (2013): 929-985.

Reference

Asness, Clifford S., Tobias J. Moskowitz, and Lasse Heje Pedersen. "Value and momentum
everywhere." The Journal of Finance 68.3 (2013): 929-985.

Bondt, Werner FM, and Richard Thaler. "Does the stock market overreact?." The Journal of
Finance 40.3 (1985): 793-805.

Fama, Eugene F., and Kenneth R. French. "The cross-section of expected stock returns." the
Journal of Finance 47.2 (1992): 427-465.

Jegadeesh, Narasimhan, and Sheridan Titman. "Returns to buying winners and selling
losers: Implications for stock market efficiency." The Journal of Finance 48.1 (1993): 65-91.

12
 U.S. Stocks U.K. Stocks
Value Momentum Combo Value Momentum Combo
2.50 2.50
Sharpe = 0.26 0.45 0.86 Sharpe = 0.38 0.48 1.07
Correla!on (value, momentum) = -0.65 Correla!on (value, momentum) = -0.62

2.00 2.00

1.50 1.50

1.00 1.00

0.50 0.50

Value and Momentum Everywhere

0.00 0.00

May-76

May-79

May-82

May-85

May-88

May-91

May-94

May-97

May-00

May-03

May-06

May-09

May-76

May-79

May-82

May-85

May-88

May-91

May-94

May-97

May-00

May-03

May-06

May-09
Dec-71

Dec-71
Jun-73
Nov-74

Nov-77

Nov-80

Nov-83

Nov-86

Nov-89

Nov-92

Nov-95

Nov-98

Nov-01

Nov-04

Nov-07

Jun-73
Nov-74

Nov-77

Nov-80

Nov-83

Nov-86

Nov-89

Nov-92

Nov-95

Nov-98

Nov-01

Nov-04

Nov-07
-0.50 -0.50

Europe Stocks Japan Stocks

Value Momentum Combo Value Momentum Combo
2.50 1.80
Sharpe = 0.54 0.75 1.20 Sharpe = 0.77 0.13 0.88
Correla!on (value, momentum) = -0.55 1.60 Correla!on (value, momentum) = -0.64

2.00
1.40

1.20
1.50
1.00

0.80
1.00

0.60

0.50 0.40

0.20

0.00
0.00
May-76

May-79

May-82

May-85

May-88

May-91

May-94

May-97

May-00

May-03

May-06

May-09
Dec-71
Jun-73
Nov-74

Nov-77

Nov-80

Nov-83

Nov-86

Nov-89

Nov-92

Nov-95

Nov-98

Nov-01

Nov-04

Nov-07

May-76

May-79

May-82

May-85

May-88

May-91

May-94

May-97

May-00

May-03

May-06

May-09
Dec-71
Jun-73
Nov-74

Nov-77

Nov-80

Nov-83

Nov-86

Nov-89

Nov-92

Nov-95

Nov-98

Nov-01

Nov-04

Nov-07
-0.20
-0.50

Figure 2. Cumulative returns to value and momentum strategies across markets and asset classes. Plotted are the cumulative (sum of
log) returns to value, momentum, and their 50/50 combination strategies in each of the eight asset markets considered: equities in the United States,
the United Kingdom, Europe, and Japan; equity index futures; currencies; bonds; and commodities. Returns are plotted for the rank weighted factor
portfolios, which are zero-investment portfolios that weight each asset in proportion to its rank based on either value or momentum, following equation
(2). Results are also reported for an average of all individual stock strategies across all stock markets (“Global stocks”), across all nonstock asset
classes (“Global other asset classes”), and across all markets and asset classes (“Global all asset classes”), where average return series are computed

953
using equal volatility weights across the markets and asset classes to account for differences in volatility across asset classes. All return series are
scaled to 10% annual volatility for ease of comparison. Reported on each graph are the annualized Sharpe ratios for each strategy as well as the
correlation between value and momentum in each market.
 0.00
0.50
1.00
1.50
2.00
2.50

-0.50

0.00
0.10
0.20
0.30
0.40

-0.50
-0.40
-0.30
-0.20
-0.10
Dec-71 Dec-71
Jun-73 Jun-73
Nov-74 Nov-74

Figure 2. Continued.
May-76 May-76
Nov-77 Nov-77
Sharpe =

Sharpe =
May-79 May-79
Nov-80 Nov-80
May-82 May-82
0.60

Nov-83

0.07
Nov-83

Value
Value

May-85 May-85
Nov-86 Nov-86
May-88 May-88
Nov-89 Nov-89
0.63

0.17

May-91 May-91
Nov-92 Nov-92
Momentum
Momentum

Fixed Income
Country Indices

May-94 May-94
Correla!on (value, momentum) = -0.37

Nov-95 Nov-95
Correla!on (value, momentum) = -0.35

May-97 May-97
1.00

0.20

Nov-98 Nov-98
Combo
Combo

May-00 May-00
Nov-01 Nov-01
May-03 May-03
Nov-04 Nov-04
May-06 May-06
Nov-07 Nov-07
May-09 May-09
0.50
1.50

-0.50
0.00
1.00
2.00
0.00
1.00
1.50
2.00

0.50

-0.50

Dec-71 Dec-71
Jun-73 Jun-73
Nov-74 Nov-74
May-76 May-76
Nov-77 Nov-77
Sharpe =

Sharpe =

May-79 May-79
Nov-80 Nov-80
May-82 May-82
0.44

Nov-83 Nov-83
Value
Value

0.31

May-85 May-85
Nov-86 Nov-86
May-88 May-88
Nov-89 Nov-89
0.32

May-91 May-91
0.51
Currencies

Nov-92 Nov-92
Momentum
Momentum

Commodi!es

May-94 May-94
Nov-95 Nov-95
Correla!on (value, momentum) = -0.43

Correla!on (value, momentum) = -0.46

May-97 May-97
0.69

Nov-98 Nov-98
0.77
Combo
Combo

May-00 May-00
Nov-01 Nov-01
May-03 May-03
Nov-04 Nov-04
May-06 May-06
Nov-07 Nov-07
May-09 May-09

The Journal of Finance⃝R 954

 0.00
0.50
1.00
1.50
2.00
2.50
3.00
3.50

-0.50
Dec-71
Jun-73
Nov-74
May-76
Nov-77
Sharpe =

Figure 2. Continued.
May-79
Nov-80
May-82
0.51

Nov-83
Value

May-85
Nov-86
May-88
Nov-89
0.59

May-91

-0.50
0.00
0.50
1.00
1.50
2.00
2.50
3.00
3.50
4.00

Nov-92
Momentum
Global Stocks

Dec-71
May-73 May-94
Correla!on (value, momentum) = -0.60

Oct-74 Nov-95
Mar-76 May-97
1.28

Aug-77 Nov-98
Combo

Jan-79 May-00
Sharpe =

Jun-80 Nov-01
Nov-81 May-03
Apr-83 Nov-04
0.72

May-06
Value

Sep-84
Feb-86 Nov-07
Jul-87 May-09
Nov-88
Apr-90
0.74
0.00
0.50
1.00
1.50
2.00
2.50
3.00
3.50

-0.50

Sep-91
Dec-71
Momentum

Feb-93
Jun-73
Global All Assets

Jul-94
Nov-74
Correla!on (value, momentum) = -0.60

Nov-95
May-76
Apr-97
Nov-77
1.59
Sharpe =

Sep-98
May-79
Combo

Feb-00
Nov-80
Jul-01
May-82
Nov-02
0.55

Nov-83
Value

Apr-04 May-85
Sep-05 Nov-86
Feb-07 May-88
Jul-08 Nov-89
Nov-09 May-91
0.62

Nov-92
Momentum

May-94
Global Other Assets

Nov-95
Correla!on (value, momentum) = -0.49

May-97
Nov-98
1.14
Combo

May-00
Nov-01
May-03
Nov-04
May-06
Nov-07
May-09

955 Value and Momentum Everywhere