A tale of two states: asymmetries in the UK small, value and momentum premiums. Sarwar et al (2017)

The authors are looking to explore the style premiums in the UK over the 1982 - 2014 period.  They also want to explore how the premiums are affected by various macroeconomic indicators in expansionary and recessionary regimes. 

First, they look at the size, value, and momentum premiums over the full period and find the momentum period to be 0.95%, followed by the value premium at 0.34%, and finally the size premium at 0.12%.  Next, they split the sample into expansion and recession regimes and find that the value and momentum premiums remain the same no matter if in an expansionary or recessionary regime; however, they find that the size premium actually goes negative during a recession.  They also find that the size premium is positively skewed, while the value and momentum premiums are negatively skewed, no matter the regime.

Next, the authors regress various macroeconomic indicators against the size, value, and momentum factor premiums.  They find that increases to the GDP growth rate, inflation, and money supply significantly explain increases to the size premium; increases to the short-term interest rates and credit spread significantly explain an increase to the value premium; and no macroeconomic indicators significantly explain the changes in the momentum premium.   However, the R^2 of the regressions are very small, so the regression equation likely does not provide a good enough fit.

Next, the authors split that sample into two regimes: expansion and recession; where they regress the same macroeconomic indicators against the same factor premiums in the two different regimes.  They find that the alphas in the regression equation are negative for the size and value premiums, so investors are likely better off owning large-gap growth companies during a recession; also, the factor premium for momentum is significantly less during a recession than in an expansion. 

An increase to the GDP growth rate positively explains the size and value premiums in an expansion; however, it negatively explains the value premium in a recession.  The authors suggest that value companies tend to be in certain industries that don't turn around until late in the economic cycle, thereby foregoing the benefits of GDP growth during the recession.

An increase to inflation positively explains the size premium in both regimes, but is insignificant for the other factors.  The authors suggest that it's easier for smaller companies to pass along price increases, so they would maintain their profitability.

An increase to the short-term interest rates positively explains the size premium in a recession; the authors suggest that small companies have a more difficult time obtaining capital, so an increase to interest rates hurts them more than large companies, and they therefore earn a premium for that risk.  An increase to short-term interest rates positively explains the value premium in both regimes; the authors suggest that value companies are much more leveraged than growth companies, and investors would require a higher premium over growth companies for taking on that risk during a rising rate environment.  An increase to short-term interest rates negatively explains the momentum premium in both regimes.

An increase to the term structure positively explains the size premium in a recession.  An increase to the term structure positively explains the value premium in an expansion and negatively explains the value premium in a recession; the authors suggest that growth companies don't pay as high a dividend, so when the credit spread increase, the investors require a higher premium to compensate them for the higher rate environment that they are foregoing.  An increase in the term structure negatively explains the momentum premium in a recession; the authors suggest that the past winner are typically higher beta, so as the term spread increases, the market price goes down and more severely affects the higher beta companies than the lower beta companies.

An increase to the credit spread positively affects the size and value premiums in both regimes.  An increase to the credit spread negatively affects the momentum premium in an expansion and positively affects the momentum premium in a recession.

An increase to the money supply does not significantly affect any of the factors in an expansion; however, it is positively related to the size factor and negatively related to the value factor in a recession.  The authors suggest that smaller companies do not have as easy access to the growth in the money supply that bigger companies do, so investors require a higher premium for not being relieved from the ongoing recession.

Sarwar, G., Mateus, C., & Todorovic, N. (2017). A tale of two states: asymmetries in the UK small, value and momentum premiums. Applied Economics, 49(5), 456–476.

Alphas in disguise: A new approach to uncovering them

The Carhart 4-factor model has become the academic standard for explaining returns; however, recently passive indices have been shown to have non-zero alphas in their 4-factor models, which should not be so for passive indices that represent the market.  Either the wrong factors are being selected or there are errors in the calculations of those factors used. 

Previous studies have suggested that one error may be the SMB calculation: some small funds may actually have big companies in them, because, since big companies are small relative to the whole market, causing a biased positive SMB estimate.  This goes for the other winner/loser, value/growth factors as well.  To mitigate that error, other studies have reduced alpha in indices by including only only US Equities in the market portfolio, make the HML and SMB portfolios be value-weighted instead of equal-weighted, separate value/growth stocks and small/big stocks, and make the sizes more granular (such as large-cap, mid-cap, small-cap, etc.).

The authors study 1,383 US equity mutual funds over the period January 1992 to October 2013, who designate the S&P 500 as their benchmark.  They then make adjustments to the Carhart 4-factors (obtained from Ken French's website) that will bring the alpha to zero.  In their calculations, they find both active and passive funds perform worse on an adjusted alpha basis than what is implied by the unadjusted Carhart 4-factor model. 

Also noted is that the passive tracker funds performed the worst over the period, showing significant negative alphas; which is counter-intuitive, considering a passive tracker fund should have a zero alpha.  Active mutual funds perform outperform in some periods and under-perform in others.

Chinthalapati, V., Mateus, C., & Todorovic, N. (2017). Alphas in disguise: A new approach to uncovering them. International Journal of Finance & Economics, 22(3), 234–243.

A tale of two states: asymmetries in the UK small, value and momentum premiums

The authors study the asymmetries in the value, size, and momentum factor premiums across expansionary and recessionary regimes in the UK over the period January 1982 - June 2014.  They find strong evidence for asymmetries across all three factors in the different regimes; the size premium showed the strongest asymmetry (even turning negative in the recessionary regime), and the momentum factor showed the least asymmetry.

The authors also corroborate US studies by finding that macroeconomic factors (such as GDP Growth, credit, inflation, etc.) are significant determinants of value/size/momentum factor premiums, especially in market downturns.  The authors also developed a Markov switching model and back-tested a portfolio, beating a buy and hold strategy across  8 size/value/momentum portfolios.

Sarwar, G., Mateus, C., & Todorovic, N. (2017). A tale of two states: asymmetries in the UK small, value and momentum premiums. Applied Economics, 49(5), 456–476.