Two essays on asset pricing

Abstract

The first essay examines whether an active fund manager can outperform the benchmark index using trading strategies based on asset pricing “anomalies.” I consider an active manager who faces the following constraints on his investment activity: abnormal performance and tracking error are measured relative to a benchmark index, performance is evaluated regularly, and short positions are prohibited. The manager implements size, book-to-market and momentum strategies by over-weighting small, value or winner stocks and under-weighting large, growth or loser stocks relative to the benchmark index. When the fund manager uses the Fama-French SMB, HML and UMD portfolio weights as the guide for implementing these size, book-to-market and momentum strategies the investment portfolio does not outperform the benchmark. However, alternative size, book-to-market and momentum strategies do outperform the benchmark in some circumstances. However, the performance is far less impressive than the performance of investment portfolios which include short positions. When the Russell 3000, a common real-world benchmark for fund managers, is used as the benchmark index, size and book-to-market strategies are unable to provide excess performance, while momentum strategies do. I furthermore find that performance is highly inconsistent form year-to-year, meaning that a fund manager who is evaluated on a regular basis is unlikely to show consistent performance. I conclude that a typical active manager would find it difficult to beat the benchmark index by implementing strategies based on well-documented anomalies in the academic literature. In the second essay I examine the relation between profits from book-to-market strategies and momentum strategies. Specifically, I test two time-series hypotheses which are not mutually exclusive, but do have opposite predictions for subsequent momentum profits. First, if periods of large book-to-market profits are indicative of a large dispersion in expected returns, then subsequent momentum profits are likely to be relatively high. Second, if shifts in book-to-market profits (a period of growth dominating value shifting to a period of value dominating growth, or vice versa) are associated with changes in the market state, then subsequent momentum profits are likely to be relatively low. My results provide no support for the first hypothesis. However, I do find support for the second hypothesis. Specifically, momentum profits are negatively and reliably related to changes in book-to-market profits prior to implementing the momentum strategy. The results are consistent with the propositions that: (1) changes in the state of the market across the ranking and holding periods are associated with lower subsequent momentum profits, and (2) price adjustments to changes in expected returns are important for understanding momentum profits.