The new edition of the Whitebox Advisor, Andy Redleaf’s now quarterly market commentary, has been released. Below is an excerpt from “The Pastoral, the Earthquake, and the Avalanche.”

Investors and markets were on edge all year. To judge by Treasury prices, one might never suspect the U.S. had spent another year borrowing money that under plausible scenarios it would not be able to repay. Actually, Treasuries rose from already dizzying heights for two reasons. Nearly all the allegedly sovereign alternatives were even less attractive. And the Fed once again worked overtime to create the appearance of an alternate reality in which the U.S. government was not poised at the edge of a fiscal abyss.

Share prices might have suggested a calm but enthusiastic investor base; in reality institutional investors were making multi-generational lows for the percentage of their assets held in U.S. stocks. Measured purely against earnings, stocks were reasonably priced. Measured against discount rates, i.e., against the paltry competition from bond yields, stocks were cheap. And yet not only institutional but retail investors continued to prefer fixed income.

Retail investors seemed infatuated with high yield bonds and drove explosive growth in high yield ETFs creating a noticeable bifurcation in the high yield market. Large liquid issues of the sort ETF managers are allowed to buy pushed the yield on the Merrill Lynch High Yield Index down to a laughable 5.5%, while smaller, less liquid issues remained in the double-digits where dubious credits belong. Clearly, retail bond investors were not driven primarily by yield, or even the prospect of total return. (Who would have bet on prices going yet higher?) They were driven by fear.

Bond markets were overbought from top to bottom, not because the U.S. was fiscally healthy and not because the stock market did not offer attractive returns, but because investors, still traumatized by 2008 and the ongoing travails of Europe, valued what appeared to be security over yield.

For several years now the market has been saying it would rather bleed out slowly by investing in bonds with negative real yields than undergo a perhaps fatal electric shock as a result of investing in the real economy. Through this entire period, markets have been so transfixed by fears of collapse in equity markets they have steadfastly ignored the risks of overbought credit markets.

To read the entire commentary, click here.

In this dense and intriguing paper, the authors construct a novel investor risk aversion, or volatility risk premium index (VRP). Essentially, their index is a metric for implied and realized volatilities after adjusting for shocks to economic state variables. The measure allows the authors to link financial markets and the overall economy.

The math behind the construction of the VRP is highly technical, but in brief, the authors start by working under the assumption that they can estimate the VRP for a security from observed high-frequency intraday stock price returns and the prices of listed options. Based on a small-scale Monte Carlo experiment, they determined that a five-minute sample period for security prices in each month should be adequate for their purposes. They then applied their analysis to the S&P 500 and found that the estimate of a constant volatility risk from the basic dataset was statistically significant. They then created an enhanced estimator of a time-varying volatility risk premium by extending the dataset to include a number of macro-finance variables, including realized volatility, Moody’s AAA bond spread, housing starts, P/E ratio, industrial production, producer price index (PPI), and payroll employment.

The authors also used the index to predict stock market returns and find it has twice the predictive power of the best macro-finance variable (P/E ratio) and far outperforms industrial production, non-farm payrolls, and dividend yield (though some macro-finance variables are already incorporated in the volatility premium).

This paper was a finalist for the 2011 Whitebox Prize for the best financial research of 2011. To see the top 10, click here.

The paper is an integrated study of a variety of different methods for constructing new passive equity indices. The methods evaluated were: equal-weighting, risk-clusters equal-weighting, diversity-weighting, fundamentals-weighting, minimum-variance, maximum diversification, and risk-efficient strategies. By presenting these methodologies side-by-side, the authors provide the reader an opportunity to compare the varying features of these indices and better understand how they work. (more…)

Regulation Fair Disclosure (Reg FD) was implemented in August of 2000 to prohibit the intentional leakage of valuable information to selected analysts or investors. To measure the effect of Reg FD, Agapova and Madura created a test for abnormal returns both before and after public guidance announcements. The goal was to see whether information is being leaked before it is made public and to measure the effect that leakage has on cumulative abnormal returns. They determined… (more…)

*We are reposting an earlier analysis of a paper selected as one of the best financial research papers of 2011. Over the summer, we will post analyses of all of our top 10 papers of 2011, as well as others who didn’t quite merit a top 10 selection but were intriguing in their own right.

This is an admirably careful study of hedge fund performance from January 1995 through December 2009.  Using the Lipper TASS database of some 13,000 funds living and dead, and eliminating non-dollar funds, funds of funds, and funds that reported gross, pre-fee returns, Ibbotson and  colleagues were left with some 6,000 funds. Correcting for survivorship bias and backfill bias (the tendency for funds to start reporting returns after a hot year) the team found that hedge funds in the sample on average yielded… (more…)

The new edition of the Whitebox Advisor has been published. An excerpt: (more…)

Last week, at a luncheon in New York City, Whitebox Selected Research annouced the winner of the $25,000 prize for best financial research paper of 2011. The winners were Lubos Pastor and Robert Stambaugh for their paper “Are Stocks Really Less Volatile in the Long Run?”

The announcement was covered in a broad spectrum of print media, including:

• The New York Post
• HFM Week
• Absolute Returns (subscription required for full article)

Continue to check in with WhiteboxSelectedResearch.com for more analyses of contenders for the best financial research of 2011.

 Prize goes to Booth School of Business and Wharton School of Business Professors.

Minneapolis, MN June 19, 2012 – At a New York City luncheon earlier today, Whitebox Advisors, the $2.3 billion investment advisory based in Minneapolis, announced the winner of the $25,000 prize for the best financial research published in 2011: “Are Stocks Really Less Volatile in the Long Run?” by Lubos Pastor of the Booth School of Business and Robert Stambaugh of the Wharton School of Business.

“The belief that stock prices are more predictable over the long run than over the near term is a bedrock assumption for much of the investment world,” said Andrew Redleaf, Founder and CEO of Whitebox advisors, in remarks at the luncheon.  “After devoting years of research to the subject Professors Pastor and Stambaugh now make a powerful argument that this bedrock assumption may not hold.  Their paper serves as a bold bright neon sign proclaiming ‘investors beware!’”

“Most advisors work under the assumption that, while stocks may have their ups and downs, over the long run those ups and downs will cancel each other out,” said Professor Robert F. Stambaugh at the luncheon. “Our research, however, indicates the opposite; stocks actually become riskier to investors with long horizons.”

“Professor Pastor and I thank Mr. Redleaf and Whitebox Selected Research for this honor and for bringing attention to our paper.”

In addition, the following two papers were selected as runners up for a prize of $5,000:

•  “Is Momentum Really Momentum” – Journal of Financial Economics; Robert Novy-Marx
• “Under-/Over-Valuation of the Stock Market and Cyclically-Adjusted Earnings” – International Finance; Marco Taboga

Further, these remaining seven finalists will receive $1,500 for their efforts:

• “Information Leakage Prior to Company Issued Guidance” – Financial Management; Anna Agapova and Jeff Madura
•  “Dynamic Estimation of Volatility Risk Premia and Investor Risk Aversion from Option-Implied and Realized Volatilities” – Journal of Econometrics; Tim Bollerslev, Michael S. Gibson and Hao Zhou
• “The Implied Cost of Capital: A New Approach” – Journal of Accounting and Economics; Kewei Hou, Mathijs A. van Dijk and Yinglei Zhang
•  “A Survey of Alternative Equity Index Strategies” – Financial Analysts Journal; Jason Hsu, Tzee-man Chow, Vitali Kalesnik and Bryce Little
•  “The ABCs of Hedge Funds: Alphas, Betas and Costs” – Financial Analysts Journal; Roger G. Ibbotson, Peng Chen and Kevin X. Zhu
•  “Principal Components as a Measure of Systemic Risk” – Journal of Portfolio Management; Mark Kritzman, Yuanzhen Li, Sebastien Page and Roberto Rigobon
•  “Common Risk Factors in Currency Markets” – The Review of Financial Studies; Hanno N. Lustig, Nikolai L. Roussanov and Adrien Verdelhan

The Whitebox Advisors Selected Research prize committee was comprised of Whitebox Founder and CEO, Andrew Redleaf; Global Head of Equity Trading, Dr. Jason Cross; Senior Quantitative Strategist, Dr. Blaise Morton; Sr. Portfolio Manager, Dr. Chris Bemis; and Chief Communications Officer and Director of Whitebox Selected Research, Richard Vigilante.

The earnings/price (EP) ratio has long been used by analysts to identify times when a stock is overvalued or undervalued. More recently, some analysts have developed methods to separate out the cyclical portion of earnings and use the adjusted EP (based on earnings less the cyclical part) as a better measure of market value. Marco Taboga, in his paper “Under/Over-Valuation of the Stock Market and Cyclically-Adjusted Earnings,” has improved upon these efforts in a serious way that could be useful to financial analysts and policy makers alike. (more…)

Retirement planners and other investment advisers use a variety of mathematical tools to help formulate life-cycle investment strategies for their clients. One key problem is how to allocate client assets into different types of securities: cash, stocks, bonds, annuities, etc. To address that problem, the adviser needs (among other things) an estimate of stock volatility for the time period from today until the client’s planned retirement date.

In “Are Stocks Really Less Volatile in the Long Run?” Lubos Pastor of the Booth School of Business and Robert Stambaugh of Wharton take a new look at the problem of stock volatility over the long run and, after making certain assumptions, conclude… (more…)

*We are reposting an earlier analysis of a paper selected as one of the best financial research papers of 2011. Over the summer, we will post analyses of all of our top 10 papers of 2011, as well as others who didn’t quite merit a top 10 selection but were intriguing in their own right.

Momentum is thought of as an anomaly from efficiency whereby rising security prices are more likely to continue to rise, and falling prices more likely to continue to fall.  In his intriguing and potentially essential paper “Is momentum really momentum?” Robert Novy-Marx argues that’s wrong. The phenomenon we know as momentum is not manifested as a continuation of a security’s immediately prior performance but as a reversion toward the security’s performance 7-12 months prior. In other words, what researchers have been calling momentum actually has a “go, stop, go” pattern.  Newton would not approve.

Novy-Marx tested this hypothesis using U.S. equities, international equity indices, commodities, and currencies and found that strategies focusing on what he calls “intermediate horizon past performance” (7-12 months prior) significantly outperform strategies using recent past performance (1-6 months prior).

Whitebox’s own Dr. Chris Bemis elaborates on the significance and convincing nature of the study: “…Novy-Marx establishes the role of intermediate time horizon momentum as a factor not otherwise explained by well understood financial models; viz., CAPM and Fama-French.  The results obtained in the paper are robust and verifiable.  Further, these results are examined over many sub-periods of the author’s study, and the results are not seen to reduce in the current period; a feature of many other momentum strategies.”

Novy-Marx also upsets the common assumption that momentum is more significant for smaller stocks, finding that an intermediate horizon past performance strategy delivered more significant positive returns for the largest, most liquid stocks.

The new edition of The Whitebox Advisor by Andrew Redleaf has been released. An excerpt: (more…)

Writing again with Nardin Baker, Robert Haugen, a great name among dissenters from Modern Portfolio Theory, extends the already extensive evidence that, contrary to the CAPM and to MPT, low volatility stocks outperform high volatility stocks. Their current study reaches beyond US equity markets to markets for 21 developed nations and 12 emerging nations and finds that in every country low volatility stocks outperform high volatility stocks. The authors sum up the implications: (more…)

The Whitebox Multi-Strategy LP was ranked 22 on Barron’s list of the Top 100 Hedge Funds.

Twelve years ago Stanford professor Joseph Piotroski effectively demolished the Fama and French argument that the excess returns reaped by value investors should be thought of as a risk premium. Fama and French, like others before them, had rightly observed that a significant proportion of value stocks are actually “value traps”: bad firms headed for a worse future, cheap because they deserved to be. From this they concluded that value investors were simply being paid a higher return for the higher risks they incurred.

Piotroski dug deeper and found a very different story. (more…)