Luis García-Feijóo

Empirical evidence on capital investment, growth options, and security returns

Growth in capital expenditures conditions subsequent classification of firms to portfolios based on size and book-to-market ratios, as in the widely used Fama and French (1992, 1993) methods. Growth in capital expenditures also explains returns to portfolios and the cross section of future stock returns. These findings are consistent with recent theoretical models (e.g., Berk, Green, and Naik (1999)) in which the exercise of investment-growth options results in changes in both valuation and expected stock returns. Copyright 2006 by The American Finance Association.

The Limits to Arbitrage and the Low-Volatility Anomaly

We show that over a long study period (1963-2010), the existence and trading efficacy of the well-known low-volatility stock anomaly are more limited than widely believed. For example, we find that the anomalous returns are not found within equal weighted long-short (low minus high risk) portfolios. Within value-weighted portfolios, the existence of alpha is largely eliminated when omitting low priced (less than

The Low-Volatility Anomaly: Market Evidence on Systematic Risk vs. Mispricing

5) stocks. Furthermore, extracting any excess returns associated with a long-short portfolio is meaningfully hampered by high transaction costs reflecting the finding that the abnormal returns are concentrated among low liquidity and smaller stocks. Adding to the challenge, the anomalous excess returns quickly reverse requiring traders to rebalance frequently in attempting to extract profits, thus amplifying liquidity needs. Our findings are unchanged for various approaches to measuring the low-volatility anomaly.We show that over a long study period (1963-2010), the efficacy of trading the wellknown low-volatility stock anomaly more limited than widely believed. In particular, extracting excess returns associated with a zero-cost portfolio is meaningfully hampered by high transaction costs reflecting that the abnormal returns are concentrated among low liquidity stocks. Adding to the challenge, the anomalous excess returns quickly reverse requiring traders to rebalance frequently in attempting to extract profits, thus amplifying liquidity needs. Our findings are unchanged for various approaches to measuring the low-volatility anomaly.

Low-Volatility Cycles: The Influence of Valuation and Momentum on Low-Volatility Portfolios

We explore whether the well publicized anomalous returns associated with low-volatility stocks can be attributed to market mispricing or to compensation for higher systematic risk. Our results, conducted over a 46 year study period (1966-2011), indicate that the high returns related to low-volatility portfolios cannot be viewed as compensation for systematic factor risk. Instead, the excess returns are more likely to be driven by market mispricing connected with volatility as a stock characteristic.

The Effectiveness of Asset Classes in Hedging Risk

Research showing that the lowest risk stocks tend to outperform the highest risk stocks over time has led to rapid growth in so-called low-risk equity investing in recent years. We examine the performance of the low-risk strategy previously considered in the literature and of a beta-neutral low-risk strategy more relevant to practice. We demonstrate that the historical performance of low risk investing, like any quantitative investment strategy, is time-varying. We find that both of our low-risk strategies exhibit dynamic exposure to the well-known value, size, and momentum factors and appear to be influenced by the overall economic environment. Our results suggest time-variation in the performance of low-risk strategies is likely influenced by the approach to constructing the low-risk portfolio strategy and by the market environment and associated valuation premia.

Can you capitalize on the turn-of-the-year effect?

Garcia-Feijoo, Jensen, and Johnson evaluate the effectiveness of several asset classes in the hedging of portfolio risk over the 1970–2010 period. Of the alternative assets examined, commodities offer the greatest diversification potential due to their very low correlation with stock and bond returns. Furthermore, while the diversification benefits of many asset classes diminish during periods of extreme market movements, the benefits of commodities remain strong. Overall, they find robust support for the hedging potential of commodities, but they present three caveats to this view. First, relative to the other commodities, industrial metals offer much less diversification potential for equity investors. Second, commodities serve as considerably more effective hedges during periods when Federal Reserve monetary policy is tight (i.e., when inflationary concerns are elevated). Third, relative to the other commodities, precious metals provide equity investors with a more consistent hedge across alternative inflationary environments.

Risk Changes Around Calls of Convertible Bonds

Previous research identifies evidence of a strong seasonal pattern in returns, whereby returns are systematically higher in January. The most widely advanced explanation for this turn-of-the-year (or January) effect relies on tax-based trading; however, researchers have proposed a variety of alternative explanations. The relevance of the January effect for investors has been questioned due to the inconsistency in the phenomenon. We find evidence indicating that a strategy that targets small, out-of-favour stocks allows investors to achieve superior performance in January. Furthermore, we find that market indicators can be used to improve the consistency of the strategy. Finally, we advance a theory to explain the observed superior performance of the proposed investment strategy.

What to expect when you’re electing

We examine changes in equity and asset betas around convertible bond calls and report two major findings. First, calling firms exhibit an increase in asset betas following the call. We argue that the finding is consistent with the implications of the sequential financing theory but not of the backdoor equity financing theory. Second, abnormal returns at call announcements are negative only for the subsample of firms that also exhibit an increase in equity beta. We conclude that risk changes help explain the market reaction to convertible bond calls.

Funding Conditions and the Long-Run Reversal in Stock Returns

Purpose - – The purpose of this paper is to analyze security-market returns relative to the political party of the president, the Federal Reserve’s monetary policy, the year of the president’s term, and the state of political gridlock. Contrary to prior studies, which evaluated the influences separately, the authors jointly evaluate these variables. Design/methodology/approach - – The analysis supports the notion that security returns are significantly related to shifts in Fed monetary policy, political gridlock, and the year of the presidential term; however, returns are generally invariant to the president’s political party affiliation. Overall, the findings suggest that investors should focus less attention on the party of the president and instead more closely monitor Fed actions. Findings - – It appears that political harmony should be welcomed by equity investors, but not debt investors. Finally, regardless of the political outcome, if the past serves as a guide, investors may have to wait until year three of the next presidential term to enjoy the fruits of the current political season. Originality/value - – The academic literature is rich with studies that consider the aforementioned political effects and the influence that monetary policy have on the markets. To date, however, these factors have not been jointly considered when examining returns. This paper considers several dimensions of the political landscape – the party of the president, the presence or absence of political gridlock, and the presidential term cycle effect – in conjunction with Fed monetary policy in examining long-term security returns. By examining the relationship between security returns and both political and monetary conditions, the authors provide robust evidence regarding the relationships.

Financial Contracting and Managerial Flexibility

Previous research attributes long-run reversals to investor over-reaction or tax-motivated trading; we offer an alternative explanation based on aggregate funding conditions. Our evidence shows that prices rebound for stocks that have performed poorly over the past several years (Losers); however, the rebound occurs only during favorable funding environments. In contrast, stocks exhibiting strong long-term past performance (Winners) only reverse course if funding conditions are unfavorable. Past research shows that the three-factor model explains long-run stock reversals; we find that funding conditions play an instrumental role in this observation. Specifically, small, distressed Losers reverse substantially, but only when funding conditions are unconstrained. In contrast, small Winners reverse significantly, but only when funding is constrained. Finally, we show that the reversal pattern is closely linked to both the funding environment and a firm’s level of financial constraints, which suggests that both factors influence investor pricing decisions for Losers and Winners.