I haven’t read much interesting in the newsletter space lately. A few readers also let me know I send out too many emails, so I’ve tried to dial it back a bit. However, there have been a slew of interesting academic papers that came out this summer. Below are four of my favorites. And while they are long and dense, the four topics are really interesting and worth a read.
No charts this time, just title, abstract, and link:
Restoring Value to Minimum Variance
A long-only investable minimum variance strategy outperformed the S&P 500 over the four decades from January 1973 to December 2012. Through the lens of a factor model, we show this outperformance can be largely attributed to implicit style bets. Specifically, minimum variance has thrived by tilting away from size and volatility and toward value. As funds have poured into minimum variance in the wake of the financial crisis, and plausibly as a consequence of this trend, the value tilt has disappeared and a momentum tilt has emerged. This suggests that the cost of entry to minimum variance is at an historic high. We show how the value tilt can be restored to minimum variance by targeting specific exposures, and that there was a substantial long-term benefit to the restoration at most recent points of entry to the strategy
The Investment Performance of Emotional Assets
We assess the long-term financial returns from high-quality collectible real assets, and review the unique risks that are associated with such investments. Over the period 1900-2012, art, stamps, and musical instruments (violins) have appreciated at an average annual rate of 6.4%-6.9% in nominal terms, or 2.4%-2.8% in real terms. Despite the similarity in long-term returns, short-term trends can vary substantially across these different types of emotional assets. Collectibles have enjoyed higher average returns than government bonds, bills, and gold. However, it is important to recognize the quantitative importance of transaction costs in collectibles markets. In addition, price volatility is larger than is suggested by conventional measures of risk, and these assets are also exposed to fluctuating tastes and potential frauds. Yet, despite the large costs and many pitfalls, investment in emotional assets can pay off, because of the non-financial yield they provide.
Quality Minus Junk
We define a quality security as one that has characteristics that, all-else-equal, an investor should be willing to pay a higher price for: stocks that are safe, profitable, growing, and well managed. High-quality stocks do have higher prices on average, but not by a very large margin. Perhaps because of this puzzlingly modest impact of quality on price, high-quality stocks have high risk-adjusted returns. Indeed, a quality-minus-junk (QMJ) factor that goes long high-quality stocks and shorts low-quality stocks earns significant risk-adjusted returns in the U.S. and globally across 24 countries. The price of quality – i.e., how much investors pay extra for higher quality stocks – varies over time, reaching a low during the internet bubble. Further, a low price of quality predicts a high future return of QMJ.
Currency Risk Premia and Macro Fundamentals
Macroeconomic fundamentals have substantial predictive power for exchange rates. Adopting a multi-currency portfolio perspective, we show that currency excess returns are predictable out of sample conditioning on several standard macro fundamentals, including interest rate differentials, real GDP growth, real money growth, and real exchange rates. The predictability primarily derives from variation in fundamentals across countries and much less from variation of fundamentals over time. This explains why prior work focusing on the time-series behavior of bilateral exchanges rates generally had trouble establishing a robust link between economic variables and exchange rates. We further show that currency excess returns to portfolios sorted on fundamentals can be understood by their joint exposure to dynamic business cycle risks.