Long-short Strategy Research Articles

Geographic Links and Predictable Returns

Using detailed information on establishments owned by U.S. public firms, we construct a novel measure of geographic linkage between firms. We show that the returns of geography-linked firms have strong predictive power for focal firm returns and fundamentals. A long-short strategy based on this effect yields monthly value-weighted alpha of approximately 60 basis points. This effect is distinct from other cross-firm return predictability and is not easily attributable to risk-based explanations. It is more pronounced for focal firms that receive lower investor attention, are more costly to arbitrage, and during high sentiment periods. Sell-side analysts similarly underreact, as their forecast revisions of geography-linked firms predict their future revisions of focal firms. Further tests suggest that the lead-lag relation we document results from innovation spillover among geographic peers in addition to their common exposure to the local economy.

Sunshine vs. Predatory Trading Effects in Commodity Futures Markets: New Evidence from Index Rebalancing

Abstract Annual rebalancing of the S&P Goldman Sachs Commodity Index (S&P GSCI) provides a novel identification of the impact of predictable order flows from index investors in commodity futures markets. Using the 24 commodities included in the S&P GSCI for 2004–2019, we show that cumulative abnormal returns to a long-short strategy peaked at 72 basis points in the middle of the week following the rebalancing period, but the impact declines to near zero within the next week. The findings show that the impact of order flows from financial investors on commodity futures prices is modest and temporary, consistent with the prediction of sunshine trading theory.

Does short-term technical trading exist in the Vietnamese stock market?

The Vietnamese stock market provides an interesting and enriching test field for the application of trading expert systems as its economy is opening up, has high growth rate and may offer risk diversification opportunities. This paper examines the question of whether this frontier emerging market offers possibilities for statistical arbitrage through a financial expert system. Based on a sample of the most liquid stocks in the VN30 benchmark index, our results indicate that the index itself and some of its components offer moderate opportunities for statistical arbitrage even after considering transaction costs. It is also found that the purely momentum-based models already work satisfactorily for specific stocks, while the long-short strategies do not work more robustly than the long-only strategies. Overall, our findings hint into the direction of some exploitable inefficiencies, but the magnitude of the tradable volume is such that only comparatively small amounts can be traded.

When low beats high: Riding the sales seasonality premium

This paper examines whether predictable seasonal patterns in firm fundamentals generate time variation in stock returns. Our findings indicate that stock returns are counterseasonal. Specifically, a long-short strategy of buying low-sales season stocks and shorting high-sales season stocks produces an annual alpha of 8.4% (14.5% over the last decade). This seasonal effect has a relatively high Sharpe ratio and occurs independently of previously documented seasonal anomalies. We analyze several possible hypotheses for this phenomenon.

Understanding a Tax-Aware Defensive Equity Long-Short Strategy

We describe a Tax-Aware Defensive Equity Long-Short (TADELS) strategy, including its construction and pre-tax and after-tax performance. TADELS closely replicates the pre-tax performance of a similar tax-agnostic strategy and has the potential to achieve a meaningful tax benefit for a taxable investor. TADELS tax benefit remains even when accounting for liquidation taxes. We show that TADELS is attractive in both up- and down-market periods and can diversify typical hedge fund allocations. Moreover, TADELS tax benefit can make an investor’s entire portfolio more tax-efficient.

Riding the Nordic German Power-Spread: The Einar Aas Experiment

Inspired by the initial success and eventual failure of Einar Aas' trading strategy exploiting dynamical patterns in the spread between Nordic and German electricity futures, we investigate the question whether there is evidence for possible arbitrage from engaging in both markets simultaneously and the possibility of constructing a trading strategy that ultimately beats the markets. To do this, we first assess the risk premium and relevant Sharpe values for the two markets and observe significant differences. This is followed by a discussion as to how far the different risk premia and Sharpe values alone are evidence of arbitrage. The answer is, they are not. However, we then show that an intelligently chosen long-short strategy constructed in the Einar Aas spirit can generate a positive alpha in the CAPM sense, hence providing evidence of arbitrage.

Do Fund Managers Misestimate Climatic Disaster Risk

Abstract We examine whether professional money managers overreact to large climatic disasters. We find that managers within a major disaster region underweight disaster zone stocks to a much greater degree than distant managers and that this aversion to disaster zone stocks is related to a salience bias that decreases over time and distance from the disaster, rather than to superior information possessed by close managers. This overreaction can be costly to fund investors for some especially salient disasters like hurricanes and tornadoes: a long-short strategy that exploits the overreaction generates a significant DGTW-adjusted return over the following 2 years.

Networks, Linking Complexity, and Cross Predictability

This paper provides evidence that network complexity limits investors' ability to process non-local information, through the lens of return cross predictability. Using firm-to-firm citation networks, we find that the non-local indirectly-linked firms can well predict the return of the focal firm, while the predictability of the local directly-linked firms is weak. A long-short strategy using the indirect links yields a risk-adjusted monthly alpha of 198 (164) basis points with equal (value) weights. We further find that (i) the indirect citation links are much more complex than direct ones, (ii) the magnitude of cross predictability increases with the degree of link complexity, (iii) institutional investors don't adjust their positions in a stock with complex links, but in one with simple links immediately, (iv) firms with more complex links receive more public attention, are much larger in size, and exhibit less idiosyncratic volatility than those with simple links, (v) there is little role of the usual proxies for limited investor attention and arbitrage cost in explaining our anomalies, once controlling for the linking complexity, and (vi) there are no differences in expected returns of stocks with various link complexity.

U.S. Populist Rhetoric and Currency Returns

We develop a novel measure of U.S. populist rhetoric. Aggregate Populist Rhetoric (APR) Index spikes around populist events. We decompose the APR Index into sub-indices. We show that APR Index and International Relations sub-index are negatively priced in the cross-section of currency excess returns. Currencies that perform well (badly) when U.S. populist rhetoric is high yield low (high) expected excess returns. Investors require high risk premium for holding currencies which under-perform in times of rising U.S. populist rhetoric, especially in the post-crisis period. A long-short strategy that buys (sells) currencies with high (low) exposure to U.S. populism offers strong diversification benefits.

Short-selling Activity and Return Predictability: Evidence from the Chinese Stock Market

ABSTRACT We examine the informativeness of short selling in the Chinese stock market based on monthly and daily short-interest data from January 2011 to July 2018. We find that short selling negatively predicts future stock returns in China. The pattern is robust when controlling for firm size, book-to-market ratio, and liquidity. A long-short strategy using a short-interest ratio (SIR)—shares shorted to shares outstanding—generates a 0.865% monthly return. We also document that return predictability is stronger when short selling is restricted. Meanwhile, we examine the information content of short-selling activity, and we confirm that the significant negative relationship between preannouncement short activity and post-announcement period returns.

Equity Price Discovery with Informed Private Debt

AbstractEquity markets fail to account for the value-relevant nonpublic information enjoyed by syndicated loan participants and reflected in publicly posted loan prices. A long-short strategy that buys (sells) the equities of firms with recently appreciated (depreciated) loans earns large risk-adjusted returns, suggesting a surprising and economically important level of segmentation across the same firm’s capital structure. The information lag captured by trading strategy returns is not affected by drivers of firm-specific attention, including the publication of loan returns in the Wall Street Journal. Instead, returns to the strategy are eliminated among equities held by mutual funds also trading in syndicated loans.Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.

Biased short: Short sellers' disposition effect and limits to arbitrage

We investigate whether short sellers are subject to the disposition effect. Consistent with the disposition effect, short sellers are less likely to close a position after experiencing capital losses. This tendency is associated with lower profitability, suggesting a behavioral bias. Furthermore, this tendency is weaker when short sells are likely part of a long-short strategy. In addition, the closing pattern of short sellers exhibits a hump shape relative to capital gains, the opposite of what has been established for individual long-only investors. Overall, short sellers' behavioral biases limit their ability to arbitrage away mispricing caused by other traders' disposition effect.

Extrapolative Factor Momentum

Stock factor returns exhibit greater predictability from the weighted least squares (WLS) estimator of autoregressions with time-varying volatility. The predictability transmits into superior mean-variance optimal portfolio performance that is hardly achieved by other strategies that utilize volatility timing and return predictability. This outperformance can be interpreted through an empirically weak factor risk-return relation. A WLS-based systematic factor long-short strategy subsumes the stock momentum factor, industry momentum and factor momentum, and produces sizable excess returns. The outperformance is not limited to particular ways of portfolio formation, which testifies that the WLS-based strategy fully exploits predictability.

Machine Learning Portfolios with Equal Risk Contributions

We investigate the use of machine learning (ML) to forecast stock returns in the Brazilian market usinga rich proprietary dataset. While ML portfolios can easily outperform the local market, the performanceof long-short strategies using ML is hampered by the high volatility of the short portfolios. We showthat an Equal Risk Contribution (ERC) approach significantly improves risk-adjusted returns. We furtherdevelop an ERC approach that combines multiple long-short strategies obtained with ML models, equal-izing risk contributions across ML models, which outperforms, on a risk-adjusted basis, all individualML long-short strategies, as well as alternative combinations of ML strategies.

Do Fund Managers Misestimate Climatic Disaster Risk?

We examine whether professional money managers overreact to large climatic disasters. We find that managers within a major disaster region underweight disaster zone stocks to a much greater degree than distant managers and that this aversion to disaster zone stocks is related to a salience bias that decreases over time and distance from the disaster, rather than to superior information possessed by close managers. This overreaction can be costly to fund investors for some especially salient disasters like hurricanes and tornadoes: a long-short strategy that exploits the overreaction generates a significant DGTW-adjusted return over the following 2 years.

Information Glitters: Follow Northbound Investors on China’s Interconnected Market

The paper studies the role of information in cross-market trading by using Shanghai/Shenzhen-Hong Kong Stock Connect Program as a novel laboratory. With a complete history of daily stock-level holdings of all international (northbound) investors, we find that weekly changes in northbound shareholdings (CNS) have a cross-sectional predictive power for A-share returns. A long-short strategy based on CNS earns an excess return of 0.45% per week. We present evidence that northbound investors are well informed about firm fundamentals, especially for firms with higher global exposure. Besides, private information is incorporated into CNS by mainland insiders who take advantage of regulatory arbitrage by \homemade foreign trading. Attention-induced Copycats further confirm the informativeness of international participants in China. Our findings suggest the value of information possessed by newly introduced investors as well as the importance of international cooperative regulation during market liberalization.

A note on value investing in the UAE stock market

Value investing is one of the most popular stock-picking strategies employed in financial markets. We investigate its effectiveness in the United Arab Emirates. We examine the performance of 124 firms in the period from January 2004 to March 2019. We analyze portfolios from one-way sorts on several well-known valuation ratios: earnings-to-price, book-to-market, EBITDA-to-EV, and dividend yield. Our results demonstrate a powerful value effect in the UAE stock markets. The long-short strategies based on valuation ratios display high raw and risk-adjusted returns. Our results are robust to many considerations.

Common Risk Factors in Cryptocurrency

We find that three factors – cryptocurrency market, size, and momentum – capture the cross-sectional expected cryptocurrency returns. We consider a comprehensive list of price- and market-related return predictors in the stock market, and construct their cryptocurrency counterparts. Ten cryptocurrency characteristics form successful long-short strategies that generate sizable and statistically significant excess returns, and we show that all of these strategies are accounted for by the cryptocurrency three-factor model. Lastly, we examine potential underlying mechanisms of the cryptocurrency size and momentum effects.

Does Money Illusion Delude Investors?

This study investigates the role of money illusion in a broad set of anomaly-based strategies. To the extent that anomalies reflect mispricing, I examine whether money illusion predicts anomaly returns. I find that, following periods of high inflation, anomalies are stronger and returns in short leg portfolios are lower. However, following periods of deflation, returns in short leg portfolios are not lower and long-short strategies are not profitable. These findings indicate that money-illusioned investors excessively extrapolate the upside potential of stocks in short leg portfolios following periods of high inflation and, subsequently, experience negative returns. I find the effect of money illusion to remain largely unchanged after controlling for sentiment. Overall, this study presents evidence that money illusion leads to mispricing in the stock market.

Convergence of Expected Returns through Arbitrage: Beta Is Indifferent to Equity Valuation

The CAPM is commonly used for an introduction of the equity cost in practice to calculate the corporate value, which is composed by the risk-free rate, equity market return and each respective beta. However, there is a fundamental complication between the risk, cost and return for the equity valuation. In the fixed income investment, the excess risk is basically derived from the default probability, which corresponds to the excess cost and return onto the risk-free rate. On the other hand, the volatility is one of the compositions of equity cost, which is indifferent to the equity return. Theoretically, the return should match to the cost, which is not the case for the equity cost, as it represents the equity risk, not actually the cost. This confusion has to dissipate with arbitrage at the market where the short selling is institutionalized or the index future is easily available. When there is a difference of expected returns, it should be monetized through the arbitrage, which recurs to dissipate all the differences; i.e. the expected returns must be converged to the single rate and we can ignore the beta as a component of the equity cost. The arbitrage results in valuation differences in the end, such as P/E difference for each stock, though there should be short-term windows for the expected return deviation when the stock prices drop unexpectedly with some corporate events to provide return opportunities until narrowing down the gap of expected returns. The future information is always imperfect and the cost cannot indicate the future return in the equity market, therefore the converged expected return is the best effort at the spot through the market mechanism. There is no convergence across asset classes, mainly due to their low correlation, and the long-short strategy beyond the classes does not represent arbitrage, but a risky trade.