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Were markets efficient, past prices should not tell anything about the future

Were markets efficient, past prices should not tell anything about the future

12-06-2019 | Insight
What exactly drives factor premiums? Trying to gain a better understanding of well-known equity factor premiums has been at the heart of Milan Vidojevic’s research. Milan, who over the past five years has divided his professional time between VU Amsterdam, Columbia University and his work as a researcher at Robeco, recently defended his PhD dissertation. We talked to him about the main conclusions of his thesis, in particular concerning the Momentum, Quality and Low-Risk factors.
  • Milan Vidojevic
    Milan
    Vidojevic
    Quantitative Researcher

Speed read

  • The forces behind the residual momentum factor are behavioral in nature
  • The quality and low-risk premiums are distinct phenomena
  • Low-risk stocks move together with bonds, which has implications for investors

How would you explain, in a nutshell, the main focus of your research?
“Understanding where people’s expectations about the future come from is at the core of research in finance. We try to figure out what a company’s stock is worth by discounting its expected future cash flows. We decide whether to buy or rent a house based on the expectations of our future income, the expectations of where the housing market will be in the future and so on. So the question as to how people’s expectations come about and, consequently, how the prices that they are willing to pay for financial assets are determined, are of key importance.”

“When it comes to the theory, broadly speaking, there are two camps: one that argues that the market is fully efficient, meaning that all investors are rational in assessing the potential risks and opportunities of their investments. If this is true, then the only way to obtain high returns is to take on more risk. The other camp believes that investors are not fully rational and instead that their expectations are based on systematic mistakes. For instance, they can be overly optimistic about the future prospects of some firms and pessimistic about others. Because of this, certain assets can be incorrectly priced, which presents an opportunity to capture these inefficiencies without taking on additional risk.”

“Financial economists have documented a number of factors that have historically been associated with high returns. Some prominent examples are value, momentum, quality, size and low-risk. And yet, to date we have not been able to agree on whether these factors work because they are the compensation for risk or because they are a result of mispricing. My thesis is an attempt to contribute to this discussion. I study what drives these factor premiums.”

If we take momentum, for example, what are your main conclusions?
“The momentum effect represents one of the biggest challenges for financial economists and one of the biggest failures of the efficient markets hypothesis (EMH). The idea behind it is that if the recent returns of stocks have been strong, they will continue to do well in the near to intermediate future, and those with poor returns will continue to do poorly. If markets were efficient, past prices should not provide any information about the future, as the current price already does that.”

“And yet, momentum exists! Back in 2011, three Robeco researchers, David Blitz, Joop Huij and Martin Martens published a paper in which they showed that one can construct an even better momentum strategy than one that is based on past total stock returns. They called it the ‘residual’ momentum. This strategy has historically generated returns that are comparable to those based on the conventional momentum, but with half the risk! Their findings are used extensively in our quantitative strategies.”

“One of the papers in my dissertation builds on this research and tries to understand what market forces generate the residual momentum. It finds that they are behavioral in nature. In particular, market participants can be slow to process information about firms, and as a consequence it takes time for prices to adjust. That is why we observe that in the case of residual momentum, stock prices tend to steadily increase up to five years after a stock is bought. This is in stark contrast to the conventional price momentum, for which we observe an increase up to one year in the future and a strong reversal thereafter. The market mechanisms that drive these two factors are quite different.”

How about low-risk and quality? Some proponents of the EMH have argued that the low-risk effect could be explained rationally, that is, as quality in disguise. You’ve looked into that. What was your conclusion?
“Yes, my very first academic paper, which I did with David Blitz, addresses this question. This was in response to a recurring question we were getting from Robeco clients. Back in 2014 and 2015, academic research into the quality premium picked up. A flurry of studies were released presenting very compelling evidence that high-quality firms outperform low-quality firms. Around the same time, two papers came out claiming that ‘low-risk is just quality in disguise’ and people started wondering whether they should consider the low-risk factor at all.”

Tests we conducted showed that the quality and low-risk premiums are, in fact, different

“Low-risk firms tend to be very profitable, conservatively managed companies, and some preliminary tests showed that investors would not benefit from investing in the low-risk factor if they had already invested in the quality factor. Our work shows that this conclusion was quite premature, and the more comprehensive tests we conducted showed that the two premiums are, in fact, different. Investors can therefore benefit from allocating to both of them.”

You have also conducted research in the macrofinance area. What are your main conclusions?
“I know that one should not pick favorites when it comes to their papers, but for me it is hard to deny that my macro-finance paper was the one I had most fun writing. I am, in fact, an economist by training, and during my undergraduate program at the University of Toronto I studied macroeconomics and macroeconometrics extensively.”

“I am deeply interested in how certain macroeconomic events affect the returns of firms in general, and the returns of our favorite factors, in particular. In my paper, I examine why the low-risk stocks move together with bonds, and what the implications are for investors. These research questions were also inspired by the conversations I had with our clients who expressed concerns about these matters. Therefore, it is quite important for us to be able to effectively address them.”

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