The Cost of Trend Chasing and The Illusion of Momentum Profits

There is a large and growing literature documenting the relation between ex ante observable variables and stock returns. Importantly, much of the evidence on the relation between returns and observable variables like market capitalization, the ratio of price/book, and prior price change has been portrayed in the context of returns to simulated portfolio strategies. Often missing in these analyses is the distinction between realizable returns (i.e., the returns portfolio managers can realistically achieve in practice) and returns to simulated strategies. There is ample evidence that size and value strategies can be successfully implemented in practice; that is not the case for momentum strategies. This paper documents the costs of implementing actual momentum strategies. I examine the trade behavior, and the costs of those trades, for three distinct investor styles (momentum, fundamental/value, and diversified/index) for 33 institutional investment managers executing trades in the U.S. and 36 other equity markets worldwide in both developed and emerging economies. The results show: (1) that momentum traders do indeed condition their trades on prior price movements; and (2) that costs for trades that are made conditional on prior market returns are significantly greater than for unconditional costs, especially for momentum traders. The evidence that we report on the actual costs of momentum-based trades indicates that the returns reported in previous studies of simulated momentum strategies are not sufficient to cover the costs of implementing those strategies

Anatomy of the Trading Process Empirical Evidence on the Behavior of Institutional Traders

This paper examines the behavior of institutional traders. We use unique data on the equity transactions of 21 institutions of differing investment styles which provide a detailed account of the anatomy of the trading process. The data include information on the number of days needed to fill an order and types of order placement strategies employed. We analyze the motivations for trade, the determinants of trade duration, and the choice of order type. The analysis provides some support for the predictions made by theoretical models, but suggests that these models fail to capture important dimensions of trading behavior

The Relation Between Stock Market Movements and NYSE Seat Prices

Exchange seat prices are widely reported and followed as measures of market sentiment. This paper analyzes the information content of NYSE seat prices using: (1) annual seat prices from 1869 to 1998, and (2) the complete record of trades, bids and offers for the seat market from 1973 to 1994. Seat market volumes have predictive power regarding future stock market returns, consistent with a model where seat market activity is a proxy for unobserved factors affecting expected returns. We find abnormally large price movements in seats prior to October 1987, consistent with the hypothesis that seat prices capture market sentiment

Stale or Sticky Stock Prices? Non-Trading, Predictability, and Mutual Fund Returns

The observed predictability in indexes and domestic mutual funds has been attributed to stale prices. Market timing of mutual funds exploits this predictability. We show that there are few stale prices for stocks in the top few deciles of market value and that mutual funds concentrate their holding in these deciles. Still, we observe predictability in the returns of portfolios and mutual funds holding these stocks. Much of this predictability is due to stickiness, or momentum, in market returns and not stale prices. Thus, the often suggested use of “fairvalue” accounting will not eliminate the profitability of market timing

Simplifying Choices in Defined Contribution Retirement Plan Design

In view of the growth and popularity of defined contribution pensions, along with the government’s growing attention to retirement plan costs and investment choices provided, it is important to evaluate how people select their plan investments. This paper tracks how employees in a large firm altered their fund allocations when the employer streamlined its pension fund menu, tiering options in an easier-to-understand format. Using administrative data, we examine what investment choices the plan participants elected prior to and after the streamlining, and how they altered their equity share, risk exposure, fees paid, and turnover patterns as a result of the change. We also discuss what difference the changes might make for participants’ eventual retirement wellbeing. Specifically, we show that streamlined participants’ new allocations exhibited significantly lower turnover rates and expense ratios; based on reasonable assumptions, this could lead to additional aggregate savings for these participants over a 20-year period of $20.2M, or in excess of$9,400 per participant. Moreover, after the reform, streamlined participants’ portfolios held significantly less equity and exhibited significantly lower risks by way of reduced exposures to most systematic risk factors, compared to their non-streamlined counterpart

The Valuation of Callable Bonds

Callable bond indentures contain provisions that allow the issuing entity to retire the bond at a predetermined price before the maturity of the bond.1 As such a callable bond is often viewed as a combination of an otherwise identical but non-callable bond and an option to call that bond. The writer of the call option is the holder of the bond, and the buyer of the call is the stockholder of the issuing corporation. Thus, the price of a callable bond is the value of the straight bond less the value of the call provision

Packaging Liquidity: Blind Auctions and Transaction Efficiencies

The costs of implementing investment strategies represent a significant drag on the performance of mutual funds and other institutional investors. It is the responsibility of institutional investors, and in the interests of the individual investors they represent, to seek market mechanisms that mitigate trading costs. We investigate an example of one such liquidity provision mechanism whereby liquidity demanders auction a set of trades as a package directly to potential liquidity providers. A critical feature of the auction is that the identities of the securities in the package are not revealed to the bidder. We demonstrate that this mechanism provides a transactions cost savings relative to more traditional trading mechanisms for the liquidity demander as well as an efficient way for liquidity suppliers to obtain order flow. We argue that the cost savings afforded this new mechanism are due to the potential for low cost crosses with the bidder\u27s existing inventory positions and through the longer trading horizon, and superior trading ability, of the bidders. This research suggests that the ability to innovate via new liquidity provision mechanisms can provide market participants with transaction cost savings that cannot be easily duplicated on more traditional exchanges

Predicting Returns in the Stock and Bond Markets

Several predetermined variables that reflect levels of bond and stock prices appear to predict returns on common stocks of firms of various sizes, long-term bonds of various default risks, and default-free bonds of various maturities. The returns on small-firm stocks and low-grade bonds are more highly correlated in January than in the rest of the year with previous levels of asset prices, especially prices of small-firm stocks. Seasonality is found in several conditional risk measures, but such seasonality is unlikely to explain, and in some cases is opposite to, the seasonal found in mean returns