2017 HONORABLE MENTION
Kent Daniel, Ph.D., Columbia Business School and NBER, Alexander Klos, Ph.D., Kiel University and Kiel Institute for the World Economy, Simon Rottke, Ph.D., FCM, University of Münster
Stocks with low institutional ownership which, over a one-year period leading up to portfolio formation, earn strong positive returns and experience a simultaneous increase in short interest, subsequently earn strikingly low returns over the following five years. The authors argue that the high prices of this set of “overpriced winners” are a result of excessive optimism by a group of investors combined with arbitrage constraints for the rational investors.
The authors use data from CRSP, Compustat, and Thomson-Reuters Institutional 13-F filings over a sample period from 1989 to 2014 for U.S. common stocks. The authors first empirically confirm the literature on momentum — looking at the 20% of stocks with the highest and lowest cumulative returns over the past twelve months, excluding the most recent month, the past winners outperform the past losers, as expected. However, from that group of past winner stocks, the authors further identify a “constrained winners” portfolio consisting of those in the bottom 20% in terms of institutional ownership and in the top 20% in terms of their increase in short interest. These last two additional characteristics suggest these past winners have strong limits to arbitrage. The new finding here is that the constrained winner portfolio earns a meaningfully negative abnormal return of -2.47% in the first month after portfolio formation. Over the five years following portfolio formation, the overpriced winners lose a large share of their pre-formation gains relative to the market. Small and medium-cap momentum strategies, which exploit the fact that an asset’s relative performance tends to continue in the near future, can be enhanced by avoiding the small subset of overpriced winners.
The authors suggest that excessive optimism comes into play in that the constrained winners have experienced an irrational run up in price that implies a predictable strong decline, making them “overpriced winners.” Their argument requires an evolution of beliefs among investors. If institutional lending supply is high, then the price will adhere to the rational expected value and thus will be fairly priced, on average. However, if borrowing shares is difficult or costly, the views of a group of pessimistic investors are restricted and therefore cannot be expressed in prices. As disagreement falls over time, however, due to new information regarding the company’s financial health for example, the price converges to the rational price based on fundamentals.
Finally, the authors find that a “betting against winners” portfolio that buys a broad portfolio of past-winners and shorts a much smaller portfolio of constrained past winners earns a Sharpe ratio of 1.08 and a significant Fama-French three factor alpha of 2.71% per month over the sample period.
The authors propose a model that captures the effects of limits of arbitrage and excessive optimism or disagreement about the value of a stock. The results suggest that there is a subset of high past return stocks that earn strong negative post-formation returns. This small group of “overpriced winner” stocks has low institutional ownership, suggesting short-sale constraints, and has an increase in short interest consistent with their price increase being driven by increased optimism among a subset of investors. When new information reveals the true fundamental value, optimism wanes, and the stock price declines towards its fair value. This dynamic in beliefs among investors is consistent with the notion that short-sale constraints sideline more pessimistic market opinions, which when coinciding with excessive optimism, can result in temporary overpricing, followed by an eventual correction. Identifying these constrained or overpriced winners can help enhance a small-cap momentum strategy by either avoiding such stocks or actively trying to short them.
This document has been provided to you solely for information purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The factual information set forth herein has been obtained or derived from sources believed by the author and AQR Capital Management, LLC (“AQR”) to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. This document is not to be reproduced or redistributed to any other person. The information set forth herein has been provided to you as secondary information and should not be the primary source for any investment or allocation decision. Past performance is not a guarantee of future performance.
This material is not research and should not be treated as research. This paper does not represent valuation judgments with respect to any financial instrument, issuer, security or sector that may be described or referenced herein and does not represent a formal or official view of AQR. The views expressed reflect the current views as of the date hereof and neither the author nor AQR undertakes to advise you of any changes in the views expressed herein.
The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Charts and graphs provided herein are for illustrative purposes only. The information in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, neither AQR nor the author guarantees the accuracy, adequacy or completeness of such information. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. There can be no assurance that an investment strategy will be successful. Historic market trends are not reliable indicators of actual future market behavior or future performance of any particular investment which may differ materially, and should not be relied upon as such.
The information in this paper may contain projections or other forward-looking statements regarding future events, targets, forecasts or expectations regarding the strategies described herein, and is only current as of the date indicated. There is no assurance that such events or targets will be achieved, and may be significantly different from that shown here. The information in this document, including statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons.