Investing in Factors

Due to the risk aversion, investors need them to be exposed in assets which tend to fall in bad times

• Bonds-> High inflation hurts the value of bonds, because the value auf fixed payements are decreasing

• Stocks also perform poorly when inflation is high

Yes, there is a negative relation between them. If there is a big volatitly shock, the return will decrease

1. If the stock retursn drop, the financial leverage increases.

2. Stocks become riskier und volatilty increases.

3. If the Volatitly increases, the investors demand higher equity returns. This will also decline the stock return

If the productivity of an assets slows down, the stock return tends toward down

• Bonds and equity

• ETFs

Are we holding the secuirty for long or short?

The Market Portfolio does not have dynamic factors, so the average investor does not practicing dynamic investments. The average investor is holding the market, hence is not short selling assets.

• Small minus large (Size Premium)

• Values vs growth (Value-Growth Premium)

• Winning minus losing (Momentum Premium)

Stocks with a relatively low price compared to the book values. These stocks are producing above average dividends

Stocks with high growth potential due to the KPIs like revenues, earings and book values. These Stocksare not producing high dividends and tend to trade to high prices compared to their book values.

Its highly possible that we reject a true hypothesis. Also some factors could show us by chance, that they are performing superior, ecen if they dont.

The Size factor could be luck

• Value stock and Value stocks -> Positive Covariance

• Value stock and Growth stock -> Negative covariance

Due to the high covariance to other value stock, the riskiness of value movement cannot be diversified. So we have to price the risk in equilibrium -> Value Risk Premium

• Value stocks tend to lose money during bad times, so we need a high risk premium to compesate the losses -> High expected return -> more risky

• Growth stocks have low returns and tend to payoff during bad times -> less risky

During bad times the are

• burdened with more unproductive capital (PP&E)

• Grotwh stocks hold a lot of human capital and are more flexible

When a Stock had a high return in the past the momentum investor will continue buying them so the stocks continue to go up

• Productivity Risk

• Inflation

• Political Risk

• Demographic Risk

The Investor will hold a long and a short position from the opposite characterstic

Investors overreact on the past growth rates. Groth Firms had high rates and more investors di invest. But no Firm could be bigger than the entire market.

If the Growth stock does not peform as expected, the prices will fall. Value Investors on the opposite will outpeform

In the past, value stocks do not peform as good as growth stocks. Investors have a loss aversion and they will not invest in Value Stocks.

Value Stocks needs a Premium

• An Investor who overreacts tends to growth stocks

• An Investor who goes against the crowd is a Value Investor

For an older population, their is an excess consumption demand. They will sell their equity to fund their consumption. Therefore the equity price are declining

• Low volatility

  • Low minus high volatitlty

• Credit Risk

  • Sec. with high minus low default risk

We go long for one position and short for the opposite

• Value Stocks have a high cash-flow beta in terms of consumption

• Growth Stocks have a low cash-flow beta in terms of consumption

• Average Investors holds the market

• Value defines Bad times and the investor should question if these are really bad times

• Momentums is Positive Feedback

  • Stocks with high return are attractive and investor continue to buy them

• Value is Negative Feedback

  • Stocks with declining prices are falling far enough to be considered as value stocks

This strategy may destabilze the market and results to a crash

• Underreaction

  • Investor do not overreact good news, the prices a increasing slowly

• Overreaction

  • Investor overreacht good news, there is a momentum where the price is increasing fast, but it will return to the fundamental value

• Informed Investor (News Watcher) receive signals about the firm value and ignore information of the past

• Uninformed Investor (Momentum Trader) do not receive signals about the firm value but trade on the base of the past

Because the information are not integrated in the market prices, stocks which are already lower than the fundamental value will stay there and stocks which are already above the fundamental value. Uninformed Investor will continue buy stocks with high growth rates until it will concludde to mean reversion

• realized beta is negatively related to future returns

• volatility is negatively related to future returns

• Low Betas had better retruns than high betas -> Violation of the CAPM

• Therefore we go long with low beta stocks and short with high beta stocks.

There is no correlation between those factors. Therefore the returns of each factor are independent.

The Payoff for the momentum strategy is the payoff for bearing the systemtic risk. They have a big relationship, therefore if the sytematic risk is realizing, the momentum payoff is negative

• Convertasim

  • investors underreact to to information because the stick with their beliefs -> causes momentum

• Representative

  • Investors think high growth rates in the past will lead to high growth rates in the future -> leads to mean reversion if growth rates are not sustainable

We sell volatilty protection like sellung put options. But selling volatility is not a free lunch. In crash times volatility sellers suffer large losses

If the market declines, we go long on low betas and short high betas. But if the market is goind to rebound and will in arise again, holding the low beta stocks are not so profitable like the high beta stocks.

• Lotterey preferences

  • Investors buy more high beta stocks, beacause they want to receive the high returns but -> High Prices will lead to low returns

  • Therefore low beta stocks have low prices and high expected returns

• Leverage Constraints

  • Investors with leverage constraints bid up the price with build in leverage -> leading to flat SML

• Agency Problems