Resource Library

Equity Returns at the Turn of the Month

Numerous studies on equity fluctuations have been performed over time and two conclusions are generally accepted: (1) stock markets do better from September to May “sell in May and go away“ and (2) small-capitalization stocks experience higher returns in January. In fact, all additional returns of small-capitalization stocks over large-capitalization stocks are concentrated in the month of January.

A study published in the March/April 2008 issue of the Financial Analysts Journal identifies another recurring pattern in stock market behaviour over time and the statistics are so compelling that they may indicate another constant which will generally be accepted by analysts.

The authors of the study have found that all long-term equity returns are generated during a four day turn-of-the-month interval: the last trading day of the month [T-1], the first trading day of the month [T+1], the second trading day of the month [T+2] and the third trading day of the month [T+3]. Returns over these four days average 0,15 % per day whereas returns on the other days are close to 0 %. This is just as true for small and large capitalization stocks in the U.S. as it is for 34 other stock markets around the world. The period analysed covers 1926 to 2005.

We have no idea why this pattern exists, at least for the moment, but one cannot just ignore it because the amount of data analysed is too great for it to be only a coincidence. Can such a study be of any use? Managers making changes in their portfolio could find it useful. For example, managers should buy towards the end of the month and sell after the 4th trading day of the month. For those who trade heavily, in particular long/short funds, this study shows that when planning their transactions, they should take these four days into account.

We have re-performed this study in-house to cover the last ten years of some thirty markets around the world and the results match: the equity returns over these four days at the turn of the month converge towards 7 % per annum.

Return to Buying Winners and Selling Losers: Implications for Stock Market Efficiency
Jegadeesh and Titman are the first to rigorously measure the momentum effect in the stock market. The analysed the returns of all stocks listed on the New York Stock Exchange and the American Stock Exchange over 20 years and found that strategies that buy stocks that have performed well and sell stocks that have performed poorly in the past year generate significant positive returns over 3 to 12 month holding periods. Following the publication of their article, other researchers (see Rouwenhorst in Europe and Cleary and Inglis in Canada, among others) have shown that the momentum effect exists in almost all markets.

International Momentum Strategies
Rouwenhorst shows that the momentum effect exists on European markets and that, from 1980 to 1995, an internationally diversified portfolio of past winners outperformed a portfolio of past losers by about 1% per month.

Momentum in Canadian Stock Returns
The authors conclude that momentum trading may have merit for more flexible traders facing lower transaction costs.

Are Investors Reluctant to Realize Their Losses?
In this study, Terrance Odean tests the tendency of investors to hold losing investments too long and sell winning investments too soon, by analyzing trading records for 10,000 accounts at a large discount brokerage house. These investors demonstrate a strong preference for realizing winners rather than losers. This is what is known as the « disposition effect ».

Does Disposition Drive Momentum?
Investors are subject to the Ç disposition effect È: they tend to hold loosing stocks too long and sell winners too soon.

In this study, the authors test the hypothesis that the disposition effect drives stock price momentum. The disposition effect should cause investors to under react to negative news on a losing stock. That should delay the impact of the news on the stock, which will only gradually decline, causing downward momentum. Similarly, investors will tend to sell too soon when good news comes out on a winning stock. That will again delay the impact of the news on the stock, which will rise only gradually, causing upward momentum.

Using data from a large Shanghai brokerage firm, the authors analyze a sample of more than 13,000 investors and firms. They conclude that a large majority of investors exhibit a disposition effect. They also conclude that the disposition does drive momentum.

The Disposition Effect and Underreaction to News
In this paper, Frazzini shows that the “disposition effect,” that is the tendency of investors to ride losses and realize gains, induces “underreaction” to news, leading to return predictability. She uses data on mutual fund holdings to construct a new measure of reference purchasing prices for individual stocks, and she shows that post-announcement price drift is most severe whenever capital gains and the news event have the same sign. The magnitude of the drift depends on the capital gains (losses) experienced by the stock holders on the announcement date. An event-driven strategy based on this effect yields monthly excess returns of over 2%.

Cognitive Biases Series
In this series of 6 articles, Meir Statman explains the principal cognitive biases exhibited by investors that have a negative impact on their portfolio returns:

• Availability bias
• Anchoring bias
• Confirmation bias
• Hindsight bias
• Mental accounting bias
• Fairness bias

Measuring the true cost of active management by mutual funds

Since the advent of exchange traded index funds (ETFs), investors can now obtain exactly the return of any broad index with an expense ratio often below 0.20%. In this context, one can reasonably ask whether investors are getting their money’s worth when they pay a 2.5% expense ratio for an actively managed mutual fund. If it can be demonstrated that the return of a fund essentially replicates the index – if it is in fact a “closet indexer” – investors are paying much more than 2.5% for the portion of the mutual fund that is truly actively managed.

An American academic, Ross Miller, recently published an article on the subject in the Journal of Investment Management. In his article, Miller analyses the universe of large cap US mutual funds on the Morningstar database. He derives a rigorous approach for allocating fund expenses between active (often less than 10% of a fund) and passive management that enables one to compute the implicit cost of active management. He concludes that the true active management expense ratio averages approximately 7%!

What must investors do then to optimize their portfolio return net of fees? Simply allocate a large portion, in fact most of their assets to passive ETFs with a low expense ratio and invest the rest in one or several truly actively managed funds.

On the Industry Concentration of Actively Managed Mutual Funds Funds Manager Use of Public Information: New Evidence on Managerial Skills

Mutual fund managers do not, on average, achieve returns that beat market indices. That is why exchange-traded index funds are gaining in popularity among individual investors.

However, a small number of managers do stand out and show an ability to persistently beat market indices. What sets these managers apart and what explains their ability to achieve superior returns? Marcin Kacperczyk, a Professor of Finance at the University of British Columbia in Vancouver has spent the better part of his career studying the subject and has published 2 interesting articles in the past few years, in which he identifies 2 key characteristics of successful managers:

Industrial concentration of the portfolio. Kacperczyk studied industry concentration among mutual funds and found that, on average, concentrated funds perform better than their more diversified counterparts. The corollary is that investment ability is more evident among managers who hold concentrated portfolios.

Less reliance on public information. Managers who rely more on public information – Kacperczyk uses analysts' past recommendations as a proxy for public information – perform more poorly. This implies that better performing managers rely more on their own internal research.

All Landry Morin momentum strategies are markedly more concentrated than their peers, do not rely on analysts' recommendations in their stock selection process and have beaten their respective benchmark since inception 5 years ago.