Paper 
Working Papers 
Type: 

Date: 
20150503 
Categor 
Operating profitability, accruals, cash flows, anomalies, asset pricing 
y: 

Title: 
Accruals, Cash Flows, and Operating Profitability in the Cross Section of Stock Returns 
Authors 
Ray Ball, Joseph Gerakos, Juhani T. Linnainmaa and Valeri V. Nikolaev 
: 

Source: 
SSRN Papers 
Summa 
A cashbased operating profitability measure (i.e., excludes accruals) 
ry: 
outperforms other measures of profitability. A longshort strategy can yield a monthly threefactor alpha of 0.9% 
Intuition
Profitable firms earn higher average returns However, increases in profitability solely due to accruals have no relation with the cross section of expected returns Therefore, purging accruals from operating profitability should generate a stronger predictor of future stock performance Variables definitions
●
●
●
Cashbased operating profitability = sales  cost of goods sold – SG&A  accruals Or, Cashbased operating profitability = Revenue (REVT) − Cost of goods sold (COGS) − Reported sales, general, and administrative expenses (XSGA−XRD) − Δ(Accounts receivable (RECT)) − Δ(Inventory (INVT)) − Δ(Prepaid expenses (XPP)) + Δ(Deferred revenue (DRC+DRLT)) + Δ(Trade accounts payable (AP)) + Δ(Accrued expenses (XACC)) Portfolio formation
●
●
Each June, sort stocks into deciles based on their cashbased operating profitability Long stocks in the highest decile, short stocks in the lowest decile ● Rebalance annually Cashbased profitability measure outperforms operating profitability and accruals
●
●
Monthly threefactor alphas
Cashbased 
Operating 
Accruals 
operating 
Profitability 
profitability 

1 (Low) 
0.556% 
0.469% 
0.219% 
10 (High) 
0.347% 
0.284% 
0.208% 
High  Low 
0.903% 
0.752% 
42.700% 
Source: The Paper Cashbased profitability strategy generates higher Sharpe ratio:
●
Factors used to construct portfolio 
Sharpe 
ratio 

Market premium, size, value, momentum 
1.07 
Market premium, size, value, momentum, accruals 
1.13 
Market premium, size, value, momentum, operating profitability 
1.40 
Market premium, size, value, momentum, cashbased operating profitability 
1.70 
Source: The Paper ● Adding accruals factor after cashbased profitability only increases Sharpe ratio to 1.72 (Table 7) Cashbased profitability generated significantly higher cumulative returns:
●
Source: The Paper ● Less effective after 2004: similar to trends in momentum, the returns on the three profitability strategies have become less significant since 2004 (Figure 1) Cashbased profitability explains expected returns as far as ten years ahead (Figure 3) Cashbased profitability measure subsumes the effect of accounting accruals (Tables 2, 5) The results are robust to using a balance sheet or a cash flow statement for accruals calculation (Table 3)
●
●
●
Data
● 
U.S. stock data from The Center for Research in Security Prices (CRSP) 

● 
U.S. firm fundamental data from Compustat 

● 
Data range: 1963 – 2013 

Paper 
Working Papers 

Type: 

Date: 
20121231 

Catego 
Quality measures, accruals, global evidence 

ry: 
Title: 
Global Return Premiums on Earnings Quality, Value, and Size 
Author 
Max Kozlov and Antti Petajisto 
s: 

Source: 
SSRN Working Paper 
Summa 
Quality factor produces a higher Sharpe ratio than the market, size, or value 
ry: 
factors, and works in the period since 2005 despite its popularity. A composite quality strategy yields even better performance and generates a monthly threefactor alpha of 65 (64) bps in the global (U.S.) market 
Background Prior studies show that quality (e.g., accruals) works in US markets
●
This study serve as an outofsample test with almost a decade of new data across all developed markets Constructing quality portfolios
●
●
Define quality as the popular accruals measure
○ E.g., global CME has a negative correlation (32%) with HML Quality portfolio earns the highest Sharpe ratio
●
Highest Sharpe ratio (Table IV)
Annual 
Annualized 
Sharpe 

excess return 
volatility 
ratio 

Market 
4.0% 
16% 
0.25 
Value 
4.9% 
9% 
0.56 
Quality 
2.8% 
4% 
0.69 
Size 
0.1% 
8% 
0.06 
● Combining value and quality greatly helps (Table IV) ● 

○ A combined equalweighted (riskweighted) portfolio has a Sharpe ratio of 0.91 (0.99), a significant improvement over the Sharpe ratio of either factor alone Decent performance in recent 5 years (Figure 1) ○ Suggesting that globally, quality hasn’t been arbitraged away despite its popularity 
●
Industryadjusted quality, value, and sizeportfolios improve Sharpe ratios (Table VI) ○ Sharpe ratio improved to 0.8 (0.97, 0.1) for CME (HML, SMB) ○ Mostly due to the reduced volatility, though it also slightly
reduces its average return U.S. findings similar to results from global data (Figure 2 and Table VII) ○ U.S. market (value, quality, size) factor yields annual excess return of 5.5% (4.9%, 3.4%, 2.6%), with annual Sharpe ratio of 0.35 (0.44, 0.58, 0.22) Works in longonly and large cap stocks (Table IX and Figure 4) ○ Capweighted largecap stocks and longonly ○ Combining value and quality earns the highest return, which outperforms index by 3.9% (5.8%) per year among large (small) cap stocks Composite quality factors even better than individual quality factors
●
●
●
Alternative quality factors are:
○ Return on equity (ROE) ○ CF/A (cash flow to assets) ○ D/A (debt to assets)
● 
Composite quality metric by either (1) averaging raw score 
● 
(“averaging”), or (2) summing score ranking (“mix”) “Mix” quality factor works best (Table VIII and Figure 3) 
● 
○ “Mix” factor earns a threefactor alpha of 65 bps per month (t=9), higher than any of its components ○ By contrast, the “average” factor has an alpha (29 bps) Similar results for U.S. stocks (Table VIII) 
Data 
○ “Mix” (“average”) portfolios generate significant alphas of 64 (34) bps with t = 9.1 (9.7) ○ The “mix” portfolio has similar negative loadings on market, small size, and value 
● 
7/1988  6/2012 data for 23 developed markets (from four regions: 
● 
North America, Europe, Japan, and Asia Pacific) are from Worldscope/Barra 7/1963  6/2012 U.S. stock data are from CRSP and Compustat 
Paper Type: 
Working papers 
Date: 
20100719 
Category: 
Novel strategies, accruals 
Title: 
The Accrual Volatility Anomaly 
Authors: 
Sati P. Bandyopadhyay, Alan G. Huang, Tony S. Wirjanto 
Source: 
FMA conference paper 
Link: 

Summary: 
High accrual volatility predicts subsequent lower returns. In other words, for firms whose accruals/sales ratio is consistent historically, their future stock returns tend to be higher. A corresponding strategy generates 10% annual returns 
Definitions and intuition ● Accrual volatility (AV) = the standard deviation of the (accruals / sales) over the past 16 quarters AV measures how consistent earnings deviate from cash flows. That is, AV indicates a longterm earningscash flow deviation Intuition: investors on average are suspicious of and will punish stocks that show varying deviation of earnings from cash flows Portfolio results
●
●
● 
Sort stocks based on their AV and form two hedged portfolios: 

○ D1D10, i.e., low AV minus high AV, and 

○ 
D1 to D5 minus D6 to D10 

● 
When valueweighting stocks, and adjust returns for 

● 
usual known factors: market, size, value, and momentum ○ The riskadjusted return spread of D1D10 is 0.75% per month, (~10% annually) ○ The riskadjusted return spread of D1:5  D6:10 is 0.36% a month (~5% annually) Findings highly stable during 1980  2008 period: for the 

● 
valueweighted D1D10 portfolio, only 7 out of 29 years have negative return Findings similar at various horizons (6month, 1, 2 and 

5year) 

● 
Findings robust to transaction costs: after transaction cost, for the valueweighted D1D10 portfolio, the return D1D10 alpha spread degrades to 0.68% a month 

Data 

● 
1976 to 2008 quarterly data for NYSE/NASDAQ/AMEX stocks are from CRSP/Compustat 
Paper Type: 
Working papers 
Date: 
20100331 
Category: 
Novel strategy, accruals 
Title: 
Percent Accruals 
Authors: 
Nader Hafzalla, Russell J. Lundholm, Edmund Matthew Van Winkle III 
Source: 
SSRN working papers 
Link: 

Summary: 
This paper proposes a new accrual measure (“percent accruals”) which yields significantly higher returns than the conventional accruals measure. The new measure scale accruals by earnings (the absolute value of net income), instead of total assets. Such “percent accruals” are not dependent on the presence or absence of special items, and can differentiate loss firms as well as profitable firms, and the improvement comes mostly from the long position in low accrual stocks 
Definition and intuition ● Traditional Operating Accruals = (Net Income – Cash from Operations)/(Average Total Assets) Percent Operating Accruals = (Net Income – Cash from Operations)/(absolute value of Net Income) A “percent accruals” makes more sense since it directly measures how distorted a reported earning is from actual cashbased earnings ○ Specifically, stocks with extreme negative “percent accruals” tend to have large positive cash from operations, but then accrues cause net income to go down to close to zero
●
●
○ By scaling the accrual by the level of net income, “percent accruals” effectively pick out more extreme combinations of cash flows and accruals By contrast, the conventional accruals are scaled by assets, and the resulting measure is essentially the percentage change in operating assets This paper uses income statement to construct accruals, instead of balance sheet data Backtest results
●
●
● 
Better returns 
● 
○ An annually rebalanced portfolio based on “percent accruals” yields an annual return of 11.7% (vs 6.9% based on conventional measure) Returns more balanced 
● 
○ “Percent accruals” gives similar returns from long and short leg: long (5.5%) and short (6.2%) ○ For the conventional accruals measure, most profits are from the long leg (5.53%) than short (1.27%, and insignificant) Less sizebias 
● 
○ The bottom decile of stocks with lowest “percent accruals” is larger in size ($1.5 billion ) than those defined by assetscaled accruals ($474 million) Not sensitive to accruals definition 
● 
○ Return predictiveness of “percent accruals” exists, independent of whether there are special items, and whether earnings are positive or negative More stable yearly returns, much better returns in recent years ○ “percent accruals” outperforms conventional accruals in 15 of 19 years during 19892007 
Source: the paper Not sensitive to firm negative/positive earnings
● 
Earlier study show that conventional accruals have no 
● 
significant returns for any decile in firms with negative earnings Yet 34% of the observations in the population have 
● 
negative earnings By contrsast, the “percent accruals” can differentiate 
● 
stocks with negative earnings In fact, it worked better in the loss subsample than in the 
Data 
profitable subsample 
● 
1989 – 2008 stock prices and accounting data are from Compustat and CRSP US databases. Total firm year observations are 81,526 firmyears 
Paper Type: 
Working papers 
Date: 
20100130 
Category: 
Accruals 
Title: 
Going, Going, Gone? The Demise of the Accruals Anomaly 
Authors: 
Jeremiah Green, John R.M. Hand, Mark T. Soliman 
Source: 
SSRN working paper 
Link: 

Summary: 
The returns to the accruals anomaly have almost disappeared in U.S. markets. The reason maybe 1) investors are no longer mispricing accruals and 2) more quant managers are using this signal 
The returns to accruals have almost disappeared ● Before 2004, all but only one year during the 19892003 15year span see positive accrual returns Since 2004, only 1 of the 5 year see positive riskadjusted annual returns The tstatistic on the raw hedge return drops from 2.6 (19891996) to 1.4 (19962003) to 1.0(20032008) Such findings are robust when adjusting for booktomarket, size, alternative definitions of accruals, alternative scalars (total assets, total shareholder equity, and annual net income), etc
●
●
●
Reason1: in recent years investors are more aware of the mispriced accruals ● The proposed reason for accruals anomaly: investors wrongly believe that earnings with large portions of accruals will have similar level of persistency as earnings with large portions cash flows So to test this reason, one can measure the relative persistence of cash flows and accruals in the extreme
●
accrual deciles Per Fig. 3, there is a decline in the difference between the persistence of accruals versus cash flows the persistence of accruals versus cash flows Reason2: more quant money are exploiting this signal
●
● 
When more money are chasing any single strategy, its 
● 
profit will likely diminish and vanish The authors use the trading volume in extreme accrual 
Data 
firms to prove that quant hedge funds lead to the demise of accruals 
● 
1989  2008 stock data are from Compustat PointinTime database 
Paper 
Working papers 
Type: 

Date: 
20091230 
Catego 
Portfolio optimization, novel strategy, accruals, asset growth 
ry: 

Title: 
The Importance of Accounting Information in Portfolio Optimization 
Author 
John R. M. Hand, Jeremiah Green 
s: 

Source: 
UNC working paper 
Link: 

Summa 
This paper proposes a new stock optimization framework that may help avoid 
ry: 
quant crowdness. Weighting stocks as a linear function of certain accounting measures (e.g., change in earnings, asset growth) can yield a higher information ratio compared with pricebased measures (e.g., size, 
booktomarket, and momentum) Such weighting scheme also perform better during (1) the Quant Meltdown of
August 2007 and (2) the bear market in 2008 (it earns 12% compared during 2008 as compared to the 38% for the stock market index)
Background of the weighting scheme, Parametric Portfolio Policies (PPP)
● 
An earlier paper, “Parametric Portfolio Policies: Exploiting Characteristics in the Cross Section of Equity Returns”, 
● 
nov.pdf) proposes a simple parametric portfolio policy (PPP) technique, where stocks‘ weight is a linear function of firm characteristics For example, stock weight = weight in benchmark + coefficients * rank 
of asset growth In PPP, the accounting measure may lead to higher stock weight in two ways: (1) through generating alpha (2) through reducing portfolio risk When weighting stocks using firm size/booktomarket/momentum, PPP is shown to outperform valueweighted market index by 5.4% per year Definitions
●
●
● 
Price based portfolio (PBC): a portfolio that is optimized by weighting 
● 
stocks as a function of market capitalization (MV), booktomarket (BTM), and momentum (MOM) Accounting based portfolio (ABC): a portfolio that is optimized by weighting stocks as a function of accruals(ACC), change in earnings(UE), and asset growth(AGR) 
Two steps to construct the optimal portfolio Step1: The portfolio weight of each stock is set to be a function of the firm’s accounting measures. E.g., weight = weight in benchmark + coefficient * rank of asset growth Step2: Estimate the coefficients in step1 by maximizing a utility function (equation 11 in the paper). The investor is assumed to have constant relative risk aversion (CRRA) preferences Key findings (Table 2)
●
●
● 
In both insample and outof sample, weighting stocks using 4 factors 
● 
are shown to generate significant excess returns (BTM, MOM, UE and AGR) Accruals is not significant, suggesting that hedge returns to accruals 
have disappeared in recent years due to wider use of such strategy The PPP method yields reasonable misweights (maximum misweight 3.1% and minimum misweight 1%) ABC has twice as much shortselling than do pricebased characteristics Outofsample PBC portfolio 106% turnover per month, while the ABC portfolio generates more than double this at 216% No significance when shortsale not allowed: The outofsample Sharpe ratio of the ABC falls from a significant 1.71 to insignificant 0.48 When limiting the universe to the largest 500 stocks (Table 3)
●
●
●
●
● 
All three pricebased characteristics (market capitalization, 
● 
booktomarket, and momentum) are insignificant Change in earnings (UE) and asset growth (AGR) are still significant 
●
Accruals not significant
Considering transaction cost lowers returns and Sharpe Ratios(Table 5) The Sharpe ratio for the PBC+ABC outofsample portfolio was 1.89 (before transactions costs), but only 1.12 in the presence of variable transactions costs ABC portfolio more sensitive to transaction cost (due to higher turnover)
●
●
Performance during 200707200709 quant meltdown and 2008 crisis Suggesting that PPP is a less used strategy and avoided quant crowding effect
●
Paper Type: 
Journal papers 
Date: 
20091014 
Category: 
accruals, macro factors, market timing 
Title: 
Market timing with aggregate accruals 
Authors: 
Qiang Kang, Qiao Liu and Rong Qi 
Source: 
The Journal of Asset Management, Vol 10 
Link: 

Summary: 
We propose a markettiming strategy that aims to exploit aggregate accruals’ return forecasting power. Using several performance measures of the aggregate accrualsbased markettiming strategy, such as excess portfolio return, Sharpe ratio, and Jensen’s alpha, we find robust evidence that, relative to the passive investment strategy of buying and holding the stock market, the markettiming strategy delivers superior performance that is both statistically and economically significant. Specifically, on average, the markettiming strategy beats the S&P500 index by 6 to 22 percentage points (annualized) after controlling for transaction costs over the 1980–2004 period. 
Paper Type: 
Working papers 
Date: 
20091014 
Category: 
Novel strategies, accruals anomaly, macro factors 
Title: 
Two Accrual Anomalies: A Dichotomy of AccrualReturn Relations 
Authors: 
Qiang Kang, Qiao Liu and Rong Qi 
Source: 
FMA Conference 2009 
Link: 

Summary: 
The paper decomposes discretionary accruals into a firm specific and marketwide component: 
●
Firm specific component predicts future stock returns negatively
● Marketwide component predicts future stock returns positively A hedge strategy based on these two components yields a significantly higher return than that of a typical accrual strategy
There exist two accruals anomaly Negative predictability for single stocks: firms with high accruals on average earn lower future expected returns ● Positive predictability for aggregate market: valueweighted average of accruals in the market predicts future expected market returns positively (per Hirshleifer, Hou and Teoh (2008)) Intuition of the coexistence of these two accrual anomalies Firmlevel (discretionary) accruals is a proxy for firmlevel earnings
●
●
management ● However, on the market level, the higher accruals suggests that on average companies are expanding their business, which is a good sign for market returns Decomposing firmlevel discretionary accruals Step 1: estimating firmlevel discretionary and normal components of accruals
●
○ 
Run regression: Accruals(t)/total assets(t) = alpha + a * change in revenues/total assets(t) + b * gross property plant and equipment (t) / total assets (t) + residual (t) 
○ 
Normal accruals = The fitted part of the regression ■ Discretionary residuals = the regression residuals 
● Step 2: decomposing firmlevel discretionary accruals 

○ 
Aggregate accruals (AAC) is the valueweighted average 
○ 
discretionary accruals Run regression with 10year (t − 10 to t − 1) data: 
○ 
Discretionary_AC(t)= alpha + b * AAC (t) + residual Market component of discretionary accruals = The fitted value from the above regression ■ Firm level component = the regression residuals 
Constructing portfolios to verify the existence of two independent accruals Portfolio1: When sorting the stocks by coefficient b from step2 above, the average monthly fourfactor adjusted return is 0.105% ● Portfolio2: When sorting the stocks by on firmlevel component from step2, the average monthly fourfactor adjusted return is 0.159%
●
● Portfolio3: Double sorting first by the firmlevel component of discretionary accruals, and then by the market wide component ○ The positive return predictability of the market level component is highest for low firmlevel discretionary accruals firms (intuitively these tend to be more stable, value, big companies)
Paper Type: 
Working papers 
Date: 
20090803 
Category: 
Novel strategies, accruals, accruals quality, January effect 
Title: 
The Pricing of Accruals Quality: January vs. The Rest of the Year 
Authors: 
Christina Mashruwala and Shamin Mashruwala 
Source: 
SSRN Working Paper 
Link: 

Summary: 
The paper attributes the accruals quality (AQ) to a January effect. High AQ stocks are shown to outperform low AQ stocks only in January 
AQ effect is a welldocumented anomaly and is a measure of information risk
● 
High AQ means that company financial reporting standard 
● 
(and in particular reported accruals) is less predictable Estimating AQ step1: run the yearly regression on total 
● 
current accruals (TCA) ○ TCA=a + b1 *CFO (t1)+b2* CFO (t) + b3*CFO (t+1) + b4 change in revenues + b5*fixed assets ○ Where CFO=Net income before extraordinary items TCA +Depreciation ○ fixed assets = gross property, plant and equipment ○ Intuitively, this means that TCA is mainly driven by the cash flow balance, change in revenues and fixed assets ○ Size is not listed as an independent variable because fixed assets is used Estimating AQ step2: AQ is defined as the standard deviation of firmspecific residuals from year t4 to year t 
○ The firm specific residuals are defined as (the Actual TCA)  (the Expected TCA) from the regression above Return predictability of AQ only significant in January ● Similar findings for sorting stocks by AQ every month, and for doublesorting stocks first by size and then by AQ
The return of the zeroinvestment portfolio is shown to be highest during the first 5 days of each January (Table 5)47.79% of all the returns during the month of January occurs in the first 5 days Data ● The paper uses CRSP and COMPUSTAT for the time period 19712003 Discussions
The AQ return predictability is much higher for equalweighted returns (9.50% for equalweight, 3.79% for capweight, per table 2, 3), which suggests that the implementability may suffer from size bias and higher trading costs We would like to see more discussions on the reasons of the finding: Why January? This is particularly interesting since most companies do not file their annual financial reports in January ● Relationship with the discretionary accruals: some quant managers use the unexpected component of accruals (the residual after regressing accruals on factors such as size,growth, cash positions, etc) to forecast stock returns. AQ is an indication of the volatility of discretionary accruals, and seems to us to be a less direct measure
●
●
Paper Type: 
Working papers 
Date: 
20090803 
Category: 
Novel strategies, accruals, accruals quality, January effect 
Title: 
The Pricing of Accruals Quality: January vs. The Rest of the Year 
Authors: 
Christina Mashruwala and Shamin Mashruwala 
Source: 
SSRN Working Paper 
Link: 

Summary: 
The paper attributes the accruals quality (AQ) to a January 
effect. High AQ stocks are shown to outperform low AQ stocks only in January
AQ effect is a welldocumented anomaly and is a measure of information risk
High AQ means that company financial reporting standard (and in particular reported accruals) is less predictable Estimating AQ step1: run the yearly regression on total current accruals (TCA) ○ TCA=a + b1 *CFO (t1)+b2* CFO (t) + b3*CFO (t+1) + b4 change in revenues + b5*fixed assets ○ Where CFO=Net income before extraordinary items TCA +Depreciation ○ fixed assets = gross property, plant and equipment ○ Intuitively, this means that TCA is mainly driven by the cash flow balance, change in revenues and fixed assets ○ Size is not listed as an independent variable because fixed assets is used Estimating AQ step2: AQ is defined as the standard deviation of firmspecific residuals from year t4 to year t ○ The firm specific residuals are defined as (the Actual TCA)  (the Expected TCA) from the regression above Return predictability of AQ only significant in January ● Similar findings for sorting stocks by AQ every month, and for doublesorting stocks first by size and then by AQ
●
●
●
The return of the zeroinvestment portfolio is shown to be highest during the first 5 days of each January (Table 5)47.79% of all the returns during the month of January occurs in the first 5 days Data ● The paper uses CRSP and COMPUSTAT for the time period 19712003 Discussions
● 
The AQ return predictability is much higher for equalweighted returns (9.50% for 
● 
equalweight, 3.79% for capweight, per table 2, 3), which suggests that the implementability may suffer from size bias and higher trading costs We would like to see more discussions on the reasons of the finding: Why January? This 
● 
is particularly interesting since most companies do not file their annual financial reports in January Relationship with the discretionary accruals: some quant managers use the unexpected 
● 
component of accruals (the residual after regressing accruals on factors such as size,growth, cash positions, etc) to forecast stock returns. AQ is an indication of the volatility of discretionary accruals, and seems to us to be a less direct measure 
Paper 
Working Papers 
Type: 
Date: 
20080813 

Category: 
funds, asset allocation, earnings, accruals, Alpha Bubble, Quantitative 

Title: 
Strategies Alpha, Alpha, Who’s got the Alpha? 

Authors: 
Langdon B. Wheeler 

Source: 
CFA Institute conference 

Link: 

Summary 
.pdf This paper hypothesizes that today’s market is in an alpha (excess return) 

: 
bubble, gives reason for the bubble and suggests what managers should do now. 

● 
Alpha bubble starts with initial (late 1990early 2000’s) investors’ 

● 
profit from investing into quant equity strategy, and the subsequent investors’ excitement about the strategy’s potential This profit attracts new investors, especially naïve investors, who 

● 
drive the price up Eventually this excessive investment leads to alpha bubble burst, as 

● 
evidenced in the August 2007 quant meltdown The paradigms shifts in the market demand new innovations 

● 
Managers should focus on innovation 

● 
Either be big or be good: there should be a limit on assets under 

● 
management Alpha may not return until alpha bubble deflates 

● 
Some basic quant techniques remain valid irrespective of bubble: 

○ Buy more earnings or book per $ of share price ○ Buy clean earnings (avoid accruals) ○ Buy companies with improving earnings ○ Risk controlled portfolio 

Paper Type: 
Working Papers 

Date: 
20080813 

Category: 
novel strategy, Intangible Returns, Accruals, Return Reversal 

Title: 
Intangible Returns, Accruals, and Return Reversal: A MultiPeriod Examination of the Accrual Anomaly 

Authors: 
Robert J. Resutek 
Source: 
SSRN working paper series, 2008 

Link: 

Summary: 
This paper finds that the welldocumented accrual effect can be subsumed by "intangible returns" from the period prior to accrual formation. 

● 
Definition of intangible returns ○ Defined as the returns not explained by accounting measures ○ Intuitively, it reflects investors‘ anticipation of 

○ 
future growth not yet captured by accounting measures Study accruals in 3 periods, not 2 periods. PPIR is 

short for prior period (ie, year t5 to year t1) intangible return, CPIR is short for current period (ie, year t1 to year t) intangible return period 1 (prior 4 years return): 

ret (t5, t1) = book/market (t5) + log (change of book value) + issuance + PPIR period 2 (formation year return) : 

ret (t1, t) = book/market (t1) + total accruals (TACC) + nonaccrual growth (N_TACC) + issuance + CPIR period 3 (future 1 year return): ret(t, t+1) PPIR is driving previous accrual results ● 

○ 
Based on a regression of ret(t, t+1) = 

● ● 
Book/market components + PPIR ○ The return predicting power of current period accruals are due to the relations between prior period intangible return. ○ Once PPIR are controlled, the negative association between future returns and current period accruals disappears. Accrual anomaly is a derivative of value/growth anomaly 

○ Both anomalies are driven by the intangible returns. Likely reason: return maybe driven by factors orthogonal to accruals ○ Mechanically interpreting relationship between future returns and current period accruals ignores the fact that price can move for reasons that are orthogonal to that captured by accounting metrics. 

Comments: 
1. Discussions This paper is related to the “Market Reactions to Tangible and Intangible Information”, 
(http://faculty.fuqua.duke.edu/areas/finance/papers/daniel.pdf, reviewed in 2006/04/07 issue), where it is shown that changes in BM due to changes in book equity (socalled “tangible information”) do not predict returns, but changes in price unrelated to changes in book equity (“intangible information”) have marginal forecast power.
A logical question people may ask is: will PPIR predict formation year return, Ret(t1, t), as well? It would be see why not if the proposed reason is that stock return maybe driven by factors orthogonal to accruals.
2. Data Listed US firms from CRSP/Compustat merged dataset for the period of 1968 to 2005. Firms needs to appear on the CRSP/Compustat merged database and have positive book value of equity at fiscal year end for years t5, t1.
Paper Type: 
Working Papers 
Date: 
20080316 
Category: 
Accruals, UK market, Global markets 
Title: 
The Accruals Anomaly  Can Implementable Portfolio Strategies be Developed that are Profitable Net of Transactions Costs in the UK? 
Authors: 
Nuno Soares, Andrew W. Stark 
Source: 
SSRN working paper 
Link: 

Summary: 
• In short, No. The paper profit disappeared after “conservative estimates of transaction costs are taken into account”. • Moreover, accruals strategy profits significantly depend on long/short relatively small capitalization stocks, where trading cost and short cost can drastically lower profits 
Paper Type: 
Working Papers 
Date: 
20071203 
Category: 
Accruals 
Title: 
Repairing the Accruals Anomaly 
Authors: 
Nader Hafzalla, Russell Lundholm, Matt Van Winkle 
Source: 
Penn State University working paper 
Link: 

Summary: 
This paper finds that the accruals factor can be enhanced by 1) combining with firm financial health measure, or 2) measuring accruals by scaling earnings (instead of total assets). Piotroski‘s financial health measure was used. This measure simply gives one point for each one of eight attributes, such as: 
1) earnings is positive, 2) cash from operations is positive, 3) return on asset increases from the prior year, etc. Key findings:
● 
The traditional methods of calculating accrual strategy ○ Eg, a decile strategy based on Piotroski financial 
● 
profits are biased, since they inevitably select only those stocks whose next year’s stock returns are available (so a backtest can be done) ○ The sizeadjusted return of highest earning quality (lowest accrual decile) stocks is a significant 12.3% with the bias, but only an insignificant 2.7% without it. Both accruals and financial health factors work on 
standalone basis: health measure generates an average sizeadjusted annual return of 8.3% from 

19882004 

● 
Removing stocks with worst financial health scores helps 
● 
accrual strategy: when such stocks are removed, strategy that is long (short) the stocks with lowest (highest) 10% accruals generates an average sizeadjusted annual return of 13.6% (compared with 2.7% when all stocks are included) Twoway sort works even better: a strategy that is 
● 
long stocks with lowaccrual, high financial health short stocks with highaccrual, low financial health yields a sizeadjusted annual return of 24% Earning is a better denominator than total assets 
○ It yields a 23 percentage points higher returns ○ Using earning (instead of total assets) to scale accruals generates a similar portfolio fo high accruals stocks, but very different firms for the low accruals stocks.
Comments:
○
1. Discussion The socalled lookahead bias theory is valid only for smaller stocks. For largecap managers, this should be a nonissue since the likelihood of a large cap stock going bankruptcy is very limited.
The authors show that removing lookahead significantly changes accrual strategy profit, we think this merely illustrates that this paper, like many others, may have a strong size bias where some small/illiquid/distressed stocks largely drive paper profit.
This said, one possibility for managers covering small caps may be to use high (low) accruals in an opposite way for stocks with worst financial health measure.
Why earning is a better denominator? To us, we think it is a better measure since it directly measures the impact of accruals as a percentage of net earnings, which is what concerns and misleads most investors. An interesting quote by the authors is that “when accruals are scaled by assets, the resulting measure is essentially the percentage change in operating assets.”
Another insightful finding in the paper is that using earning essentially removes the impact of special items in balance sheet (which usually include restructuring charges, asset impairments and other onetime gain/losses), while using total assets will generate a list of stocks with large special items.
2. Data 19882004 stock data are from the 2004 merged Compustat/CRSP database, with financial firms excluded. A stock does not need to have next year’s return data to be included in the portfolio, the only requirements are that it has sufficient financial data to compute either operating accruals or total accruals, and that it has return data available at the portfolio formation date.
Paper Type: 
Working Papers 
Date: 
20071029 
Category: 
Accruals, earning surprises 
Title: 
Reconciling the Market’s Overreaction to (Abnormal) Accruals and Under reaction to Earnings 
Authors: 
Henock Louis, Amy X. Sun 
Source: 
London Business School working paper 
Link: 

Summary: 
This paper finds that the negative (positive) earning surprise drift effect is stronger for stocks with high incomeincreasing (decreasing) accruals. 
● 
The authors first make a general observation 


accruals 





● 
This may be due to investors’ failure to detect earning 
management: to mitigate shocks to investors, companies with large negative unexpected earnings surprises (standardized unexpected earnings, SUE) may have used income increasing accruals, while companies with large 

positive (SUE) may have used large income decreasing accruals 

● 
Hence the negative (positive) earning surprise effect 
should be stronger for stocks with high income increasing (decreasing) accruals. A strategy that is
 long stocks with positive surprise (ie, high SUE) / low
abnormal accrual / value (ie high E/P) firms
 short stocks with negative surprise (ie, low SUE) / high abnormal accrual / moderate E/P firms
earns an abnormal return of 46% annually (23% over the two quarters after earning announcement). In fact, there is virtually no earning surprise drift when such stocks are removed. ● Moderate E/P firms are used instead of low E/P firms to select stocks for short, because investors are less likely to be mistaken by the upward earnings management activities of the negative SUE, low(or negative) E/P firms, which tend to risky stocks.
●
This strategy is consistent across time, generating positive abnormal returns in every quarter in the sample period.
Comments: 
1. Discussions This paper gives a great example of factor interaction: 

conditioning stock ranking of one factor on otherfactor(s) may 

give improved results. 1 + 1 > 2. The profit of the strategy sounds real big and rather consistent (profitable very quarter during 1988 2004). The problem is 

● 
whether this is strategy is “outdated” given the bad performance of earningbased strategies since 2003 

● 
whether this strategy works in different universes. The authors, like many others, throw all the stocks in all exchanges in this study. The outsized profit may be due some small and illiquid stocks. 

2. Data 1987  2004 stock data are from Compustat quarterly files. 

Paper Type: 
Working Papers 

Date: 
20061217 

Category: 
Leverage, accruals 

Title: 
Leverage, Accruals, and Cross Sectional Stock Returns 

Authors: 
Ayla Kayhan, Adam Y.C. Lei, Ji Chai Lin 

Source: 
FMA 2006 conference paper 

Link: 

Summary: 
This paper defines two quarterly leverage measures: 
Market leverage = total debt divided by the sum of total debt and market equity Book leverage = total debt divided by the sum of total debt and the book value of shareholders' equity
It shows that:
● 
Financial leverage predicts lower stock returns. This result 
● 
is robust after controlling for many known factors The return predicting power of accruals becomes insignificant when leverage is controlled 
●
Leverage largely accounts for the finding that firms with higher financial constraints earn lower returns.
Comments: 
1. Why important This paper is interesting because it shows a surprisingly strong impact of leverage on stock risk adjusted returns and on other known return predicting factors, including accruals. 


2004 stock price data are from CRSP database, accounting data 

are from the Compustat database, and the institutional holdings data from the CDA/Spectrum database. 



If the paper is right and leverage subsumes accrual effect, what might be the reason? The author says that higher financial leverage firms "tend to be financially constrained and rely more o n outside equity capital, which raises incentives for managers to manage earnings through accruals". This makes sense, and it wouldbe interesting to directly test the correlation between accruals and leverage, i.e. do high leverage firms have high accrual Does accruals strategy give us a similar portfolio as when we use leverage? 

The result about the predicting power of leverage is different from those discussed in other papers, notably Fama and French (1992). We would like to see the authors explain more about why there is such difference. Knowing that they are studying a different set of data for different period, at least a study of same sub period plus a portfolio return can help comparing notes. 

Paper Type: 
Working Papers 
Date: 
20061020 
Category: 
Accruals, profitability 
Title: 
The Pricing of Accruals for Profit and Loss Firms 
Authors: 
Nicholas Dopuch, Chandrakanth Seethamraju, Weihong Xu 
Source: 
Olin School working paper 
Link: 
Summary: 
This paper finds that the accrual strategy is related to the companies profitability: 
● The accruals for profit firms are overpriced, with a hedged ● ● 

return ~15% The accruals for loss firms are slightly underpriced, with an 

insignificant hedged return ~6% Further, 

● Accruals for transitory loss firms (loss firms that are more likely to turn profitable ) are not mispriced Accruals for persistent loss firms (loss firms that are less likely to turn profitable are under priced 

Comments: 
1. Why important The conclusion of this paper makes intuitive sense since investors use accounting information very differently between profit and loss firms. For loss firm, stock valuation is based on a probability to reverse loss, and current accounting numbers are of less relevance. 


1988 2001 financial statement data are from COMPUSTAT/CRSP 

database. Financial firms were excluded in the study. 



This paper provides an interesting perspective by differentiating profit and loss firms, as well as "persistent loss" and "transitory loss" firms. It is interesting if one can expand this study to other strategies that use accounting data, e.g., p/e 

Paper Type: 
Working Papers 
Date: 
20060908 
Category: 
Strategy, accruals 
Title: 
Cash Flows, Accruals, and Future Returns 
Authors: 
Joshua Livnat, Massimo Santicchia 
Source: 
Financial Analysts Journal, Vol. 62, No. 4, pp. 4861, July/August 
2006
Link: 

Summary: 
This study finds that the accrual anomaly exists for quarterly accruals in addition to annual accruals. Also current net operating cash flows have higher forecasting power than accruals. 
Comments: 

Paper Type: 
Working Papers 
Date: 
20060908 
Category: 
Strategy, accruals 
Title: 
Cash Flows, Accruals, and Future Returns 
Authors: 
Joshua Livnat, Massimo Santicchia 
Source: 
Financial Analysts Journal, Vol. 62, No. 4, pp. 4861, July/August 
2006 

Link: 

Summary: 
This study finds that the accrual anomaly exists for quarterly accruals in addition to annual accruals. Also current net operating cash flows have higher forecasting power than accruals. 
Paper Type: 
Working Papers 
Date: 
20060810 
Category: 
Strategy, Asset Growth Effect, size, value, momentum, accruals 
Title: 
What Best Explains the CrossSection Of Stock Returns? Exploring the 
Authors: 
Asset Growth Effect Michael J. Cooper , Huseyin Gulen And Michael J. Schill 
Source: 
Purdue working paper 
Summary: 
This paper finds that a portfolio of long (short) stocks with lowest (highest) last year‘s asset growth rate generates 18% riskadjusted annual return. It also shows that such asset growth rate has a stronger effect on subsequent returns than other known factors (b/p, market cap, momentum, accruals, etc.) 
Comments: 
1. Why important This paper is unique in that it shows that asset growth, a factor that‘s so common to everyone, can predict returns better than other more "sophisticated" factors. It also suggests that the asset growth effect may dominate many other wellstudied balance sheet structure effects, e.g., new equity issuance effect (IPO) and external financing. 


19622003 All NYSE, AMEX, and NASDAQ nonfinancial stocks data are 

from CRSP/COMPUSTAT 



At the first glance, one can say that asset growth rate is correlated with 

everything: value/growth, market cap and also momentum. So people probably would care less about what‘s zerocost return, but more about how this new factor dominates other known factors (b/p, market cap, momentum, accruals, etc). Statistic robustness test is key here. The authors prove their point by (1) showing a much higher Sharpe ratio of zerocost portfolio based on asset growth (1.19) compared with other factors. (2) repeating the study for largest 80 percent of stocks only. (3) using 2way sort to show the dominance of asset growth rate. (4) using riskadjusted returns. The rather consistent hedged return time series on Figure 3 is very encouraging. 

Our concerns are that (1) this strategy may behave like value strategy, it works more often than not, but you don‘t know when. Many a times the profit is a function of business cycle and market sentiment. (2) 80% largest companies still include some small cap stocks. The performance in large cap will be very telling. 

Paper Type: 
Working Papers 
Date: 
20060727 
Category: 
Strategy, accruals, loan 
Title: 
Do Sophisticated Investors Understand Accounting Quality? 
Authors: 
Evidence from Bank Loans Sreedhar T. Bharath, Jayanthi Sunder, Shyam V. Sunder 
Source: 
BIS Conference on Accounting, Transparency and Bank Stability 
Link: 

Summary: 
Companies have to disclose more information to banks (when applying for loans) than to investor communities. This paper documents the relationship between bank loan terms and accruals: loans are more costly and stricter for companies with high abnormal operating accruals. 
Given the information advantages of banks, we think it would be interesting to test whether higher loan rate and stricter terms can lead to lower stock returns. 

Comments: 
1. Why important This is one of those few papers we reviewed that do not directly discuss trading strategies. It is thought provoking for a simple reason: loan rate/terms reflect more information than an investor could get, can this information predict stock returns? In other words, this paper shows that loan rate/terms are connected with stock accruals, and we know accruals can predict stock returns. Is there a link between loan rates/terms and stock returns? Hopefully the new information can predict returns better than accruals. 
We are always advocates of using new databases for new strategies. Currently most quant strategies in US are based on data from Compustat, in Europe from DataStream. These two have been thoroughly studied by thousands of researchers worldwide. We do believe that new data sources are more likely to yield new strategy.
2. Data
The loan information is from the Loan Pricing Company (LPC).
They do offer trial subscription to interested companies.
3. Discussions
The authors find a "Ushaped" relationship between signed abnormal accruals and loan terms, with firms having high positive or negative abnormal accruals facing the most stringent loan terms. This may be because banks seem to dislike companies with both growth uncertainties, whether it's high
positive growth or negative growth. Given what we know about accruals, quant researchers may want to compare stock returns between stocks with high accruals and stricter loan rates/terms, and stocks with average loan rates/terms.
Paper Type: 
Working Papers 
Date: 
20060629 
Category: 
Strategy, accruals, momentum, anomalies overview 
Title: 
Dissecting Anomalies 
Authors: 
Eugene F. Fama and Kenneth R. French 
Source: 
SSRN working paper 
Link: 

Summary: 
In this paper, the two renowned professors review some stock price anomalies, namely, net stock issues, accruals, momentum, profitability, and asset growth. They conclude that some anomalies (net stock issues, accruals, and momentum) are pervasive, as evidenced by the back testing portfolio results and crosssection regressions. Others (asset growth anomaly, profitability) are less consistent. 
Comments: 
1. Why important This paper is worth reading for two reasons: first, it gives an overview of some wellstudied anomalies from July 1963 up to December 2005. Second, it offers insights in terms of how to improve the robustness test in financial empirical research. 


The data are from CRSP and Compustat. 


The authors pinpoint two common problems with many empirical research studies:
1.) The big impact of the extreme (return) values of "tiny" stocks (defined as those with market cap below the 20th NYSE percentile). Many existing papers compare the performances of top and bottom segments, both of which tend to be filled with these tiny stocks whose extreme (return) values can be misleading.
2.) Different anomalies can be correlated. To address this issue, the authors examine “sorts of regression residuals” on each explanatory variable. In our view, a sound robustness test should answer the following questions:
● Is the anomaly real? Is it driven by certain size, style, sector, period (eg. internet bubble time)? Is the anomaly new? What‘s the correlation with other existing factors? What would be extra alpha if this new factor is added to the existing quant model?
●
●
●
Paper Type: 
Working Papers 
Date: 
20060421 
Category: 
Strategy, Repurchase, Accruals, Earnings 
Title: 
Share Repurchases as a Tool to Mislead Investors: Evidence from Earnings Quality and Stock Performance 
Authors: 
Konan Chan, David L. Ikenberry, Inmoo Lee, Yanzhi Wang 
Source: 
AFA 2006 Boston conference 
Link: 

Summary: 
This paper documents that companies with lower equity quality may be using share repurchase announcements to boost stock prices in the short term. 
Comments: 
1. Why important for practitioners With record high cash reserve, more companies are expected to make share repurchase announcements. A strategy based on stock repurchase has been shown to yield significant return historically, but recent performance is mixed. This paper can potentially improve this factor by combining with the earning quality. 
2. Data source The repurchase data is from SDC, and earning quality data are based on CRSP.
3. Next steps For practitioners, a key question is: will a strategy based on both repurchase announcements and earning quality provide better alpha than any of the single factor? What would be the performance after controlling for usual factors such as value, momentum, etc.?
Paper Type: 
Working Papers 

Date: 
20090201 

Category: 
130/30, alternative index 

Title: 
Benchmarking 130/30 strategies 

Authors: 
Srikant Dash and Philip Murphy 

Source: 
SSRN Working Paper 

Link: 

Summary: 
The paper claims that traditional market indices are the most appropriate benchmarks for 130/30 managers. 

● 
With the growth of the 130/30 strategy the need for an 

● 
appropriate benchmark has arisen ○ S&P 500 130/30 and Credit Suisse 130/30 have been launched to constitute passive exposure ○ The general problem with both indices is that there is no broad consensus on underlying quantitative investment strategies (e.g. accounting factors, technical analysis, market factor or macroeconomic factors) The median or average returns of the peer group of funds 

● 
is also not very useful for 130/30 strategy ○ The survivorship bias is a serious concern for the use average peer return as a benchmark in general ○ Most of the 130/30 funds are fairly young and there is no long enough time series history The paper claims that traditional indices are better benchmarks for 130/30 strategies ○ The short portion of the portfolio shouldn’t change the risk characteristics ○ The goal of 130/30 managers is to deliver a portfolio beta of close to 1, which is the market beta ○ 130/30 managers themselves report that they take the index as the benchmark (S&P survey results) 

Paper Type: 
Working Papers 
Date: 
20080813 
Category: 
alternative index, fundamental indexing 
Title: 
The Value of Fundamental Indexation 
Authors: 
David Blitz and Laurens Swinkels 
Source: 
SSRN working paper series 
Link: 

Summary: 
This paper suggests that fundamental indexation (FI) is inferior to other more sophisticated multifactor quantitative strategies. 
● 
Definition of FI 

● 
○ An index in which stocks are weighted by economic fundamentals, such as book value, sales and/or earnings, instead of market capitalization ○ Rationale: capitalization weighted indices are inferior because they necessarily invests more in overvalued stocks and less in undervalued stocks FI outperforms market index 

● 
○ FI (using RAFI 1000 index) generates the alpha amounts to 0.19% per month in case of the FamaFrench market factor (beta) (19622005), and 0.26% per month in case of the Russell 1000 index (19792005). FI has high exposure to value factor ○ In the 3factor Fama and French model, FI shows a large and highly significant (tstatistic over 30) exposure of 0.36 towards the value factor. 

○ 
It shows a beta of 0.38 with regard to the Russell 1000 Value/Growth return difference, associated with a highly significant tstatistic of over 30 

● 
Little exposure to size 

○ 
The loading on the size factor is small and 

● 
negative, just 0.07 FI vs. Capitalizationweighted indices ○ The market capitalization is unique in the sense that it is the only portfolio which every investor can hold with minimum turnover ○ FI cannot be held in equilibrium by every investor, and contrary to a market capitalizationweighted index, a fundamental index does not represent passive, buyandhold strategy ○ Several subjective choices needed to define a FI. Most notably, which particular fundamental factor to use (e.g. book value, sales, earnings, cashflow, 
●
dividends, etc.) and how exactly should it be defined ○ Fundamental indices more resemble active strategies FI may be inferior to multifactor quantitative Strategies ○ FI benefit only from the value premium where as Multifactor Quantitative Investment Strategies benefit from numerous anomalies
○
Comments: 
1. Discussions FI has been successfully marketed to investors. In our humble view, it is more like wrapping an old idea (ie, value) with new packaging. This paper provides a detailed analysis why the FI strategies might not be bearing superior results as suggested by proponents of fundamental indices. At a time when many smart people have intensively studied equity quant strategies, we tend to think it’s more likely for new alpha to come from new data source. 
Though this paper provides theoretical argument against the fundamental indices, extensive empirical analysis is need for supporting the conclusions. 

2. Data RAFI 1000 index (the Research Affiliates Fundamental Index for the top 1000 US equities) and Russell 1000 index are used for the period of 1962 2005. 

Paper Type: 
Working Papers 
Date: 
20080520 
Category: 
130/30, alternative index 
Title: 
130/30 Investing: Just Another Hype or Here to Stay? 
Authors: 
David Blitz 
Source: 

Link: 
Summary: 
● 
In terms of alpha potential and beta exposure, 130/30 funds behave more like traditional mutual funds than hedge funds, mainly because of their market exposure. 
● 
Some 130/30 indices, e.g., “130/30: The New LongOnly” 

● 
Expenses for 130/30 funds are likely higher than 

longonly funds due to cost related to shorting stocks and managing a more complex portfolio 

● 
A piecewise implemented 130/30 funds (eg, a 100% long portfolio on top of a 30% market neutral portfolio) is suboptimal since its portfolio construction is not integrated 

Paper Type: 
Working Papers 

Date: 
20080501 

Category: 
130/30 index, alternative index 

Title: 
Benchmarking 130/30 Strategies 

Authors: 
Srikant Dash, Philip Murphy 

Source: 
S&P white paper 

Link: 

Summary: 
This white paper proposes that a better benchmark for 130/30 funds is actually an appropriate longonly index. Any dedicated 130/30 index may be inappropriate. Their reasons: 
No set of factors in 130/30 indices can capture a broad consensus in identifying stock mispricing. 130/30 managers can use both quantitative and qualitatively methodology The 130/30 proposed by Lo and Patel (which emphasizes the impact of leverage) is problematic since:
●
●
● the effects of leverage are no different than effects of big factor bets such as style, industry or size. the goal of 130/30 managers is to deliver a portfolio beta of close to 1
●
●
generally managers try to outperform in a risk controlled fashion
Interestingly, this paper does not agree with a 130/30 index by S&P
which we covered before
rategy_Index_Methodology_Web.pdf), where a short extension is added to S&P’s proprietary stockselection model.
Paper Type: 
Working Papers 
Date: 
20080409 
Category: 
Optimal indexing scheme, MSCI World Index, alternative index 
Title: 
Alternative Indexing with the MSCI World Index 
Authors: 
Thomas Neukirch 
Source: 
SSRN working paper 
Link: 

Summary: 
This paper finds that “equalrisk weighting” performs better than the capweight scheme used by the MSCI World Developed Index during 2001/01 through 2008/01. 
Weighting 
Description 
Performance 
scheme 

Original index 
• Uses floatadjusted 
• Yields 2.86% 
weighting 
market capitalization 
during 2001/01  
as weights 
2008/01 

Equal weighting 
• All constituents get same weight 
• Equalweighted both components and countries generates 8.19%. 
Equal risk 
• Each constituents 
• Equalrisk 
weighting 
get a weight of 
weighting index 
1/(constituents’ 
components: 

volatility) i.e., each 
6.27%, 

constituents contributes the same amount of risk (volatility) to the resulting portfolio 
• Equal risk weighting with equal country weighting generates 8.27%, with low volatility 
Other findings:
● All alternative weighting schemes perform better than the original index, though such outperformance is more obvious when market is rising The costs of implementing an equal weighting strategy:
●
○ Before expenses, the equal weighting strategy returns 1.45% annually, the original index returns
3.17%
○ After expenses, the equalweighted index returns 0.70%, and the authors did not give the number for the original index
Comments: 
1. Discussions Our major concern is that the finding here has a lookahead bias. What happened during 2001/012008/01 may not repeat in the future. The author has the benefit of perfect hindsight: he first found that during the past 7 years, higher cap weighted countries yield lower returns (figure 2), and then proposes the “equalrisk weighting” and “equalweighting”. He argues that “? riskiness is quite stable over time and hence a risk weighting component may lead to more stable results”, this may not always be true. Using an example in US, energy sector was a lowbeta, low volatility sector before 2006, but it is no longer the case. 
Paper Type: 
Working Papers 
Date: 
20071226 
Category: 
130/30 index, alternative index 
Title: 
130/30: The New LongOnly 
Authors: 
Andrew Lo, Pankaj Patel 
Source: 
SSRN working paper 
Link: 

Summary: 
This paper proposes two indices for the increasingly popular 

130% long/30% short (130/30) funds. The two indices are: 

● 
An investable index: which uses only prior information 

● 
and is dynamically rebalanced based on a mechanic trading rule A"lookahead" index: which uses lookahead information 

(such as realized excess return) and can be used as a performance upper bound. 

The proposed indices are based on a stock ranking strategy and a standard portfolio construction method.Specifically, stocks are ranked based on 10 commonly used factors: 



















10. Small Size. 

Key insights: 

● An optimal benchmark index should be: transparent (systematic rules, clear), investable (liquid components), passive (mechanical implementation, no human discretion) 

● 
Compared with the S&P 50 index, the new 130/30 index 

● 
has similar volatility (about 15% annual volatility for both) Compared with the S&P 500 index, the new 130/30 index has slightly higher Sharpe ratio (0.4 for the 130/30 index, 

● 
vs 0.37 for the S&P 500 index). The authors claim that this comparison is fair since although 130/30 has 1.6 times leverage, the volatility and beta of the 130/30 index is at similar level to S&P 500) It has high correlation with com on equity indices eg, Russell 2000 

Comments: 
1. Discussions In our view, the proposed indices sound more like a quant index and less a 130/30 index.130/30 funds are different from 
(arguably, better than) the traditional longonly for two reasons:
it can exploit the short side of stocks, which many believe there still exist inefficiencies since managers do not have a way to express their negative view of some stocks. An ideal index should reflect opportunity set in this new territory. it has a 1.6 leverage (130% + 30%). In reality few 130/30 managers would keep their volatility and beta at the same level of S&P 500. A more desirable index (in our humble view) is an index with higher volatility. This said, the proposed 130/30 index has better performance than S&P500 due to its quant stock selection (likely value tilt).
●
●
2. Data 1996/01  2007/09 US stock data are used. The authors uses the MSCI Barra Aegis Portfolio Manager with the Barra U.S. Equity LongTerm Risk Model to construct the 130/30 portfolios
Paper Type: 
Working Papers 
Date: 
20071226 
Category: 
130/30 funds, alternative index 
Title: 
An Empirical Analysis of 130/30 Strategies 
Authors: 
Gordon Johnson, Shannon Ericson, Vikram Srimurthy 
Source: 
Lee Munder research paper 
Link: 

Summary: 
This is a nice summary of the key features of the 130/30 strategies. Key points: 
● 
less than 10% of stocks can be underweight 25bps or 
● 
more relative to large cap benchmark stocks with highest weights do not necessarily have the 
● 
lowest alphas so a 130/30 funds can potentially increase alpha 
● 
In backtesting 130/30 outperform longonly by about 1.5 
● 
times, with a tracking error that is about 1.15 times higher. The authors also proposed a simple performance contribution analysis. 
Paper Type: 
Working Papers 

Date: 
20090201 

Category: 
130/30, alternative index 

Title: 
Benchmarking 130/30 strategies 

Authors: 
Srikant Dash and Philip Murphy 

Source: 
SSRN Working Paper 

Link: 

Summary: 
The paper claims that traditional market indices are the most appropriate benchmarks for 130/30 managers. 

● 
With the growth of the 130/30 strategy the need for an 

● 
appropriate benchmark has arisen ○ S&P 500 130/30 and Credit Suisse 130/30 have been launched to constitute passive exposure ○ The general problem with both indices is that there is no broad consensus on underlying quantitative investment strategies (e.g. accounting factors, technical analysis, market factor or macroeconomic factors) The median or average returns of the peer group of funds 

● 
is also not very useful for 130/30 strategy ○ The survivorship bias is a serious concern for the use average peer return as a benchmark in general ○ Most of the 130/30 funds are fairly young and there is no long enough time series history The paper claims that traditional indices are better benchmarks for 130/30 strategies ○ The short portion of the portfolio shouldn’t change the risk characteristics ○ The goal of 130/30 managers is to deliver a portfolio beta of close to 1, which is the market beta ○ 130/30 managers themselves report that they take the index as the benchmark (S&P survey results) 

Paper Type: 
Working Papers 
Date: 
20080813 
Category: 
alternative index, fundamental indexing 
Title: 
The Value of Fundamental Indexation 
Authors: 
David Blitz and Laurens Swinkels 
Source: 
SSRN working paper series 
Link: 

Summary: 
This paper suggests that fundamental indexation (FI) is inferior to other more sophisticated multifactor quantitative strategies. 
● 
Definition of FI 

● 
○ An index in which stocks are weighted by economic fundamentals, such as book value, sales and/or earnings, instead of market capitalization ○ Rationale: capitalization weighted indices are inferior because they necessarily invests more in overvalued stocks and less in undervalued stocks FI outperforms market index 

● 
○ FI (using RAFI 1000 index) generates the alpha amounts to 0.19% per month in case of the FamaFrench market factor (beta) (19622005), and 0.26% per month in case of the Russell 1000 index (19792005). FI has high exposure to value factor ○ In the 3factor Fama and French model, FI shows a large and highly significant (tstatistic over 30) exposure of 0.36 towards the value factor. 

○ 
It shows a beta of 0.38 with regard to the Russell 1000 Value/Growth return difference, associated with a highly significant tstatistic of over 30 

● 
Little exposure to size 

○ 
The loading on the size factor is small and 

● 
negative, just 0.07 FI vs. Capitalizationweighted indices ○ The market capitalization is unique in the sense that it is the only portfolio which every investor can hold with minimum turnover ○ FI cannot be held in equilibrium by every investor, and contrary to a market capitalizationweighted index, a fundamental index does not represent passive, buyandhold strategy ○ Several subjective choices needed to define a FI. Most notably, which particular fundamental factor to use (e.g. book value, sales, earnings, cashflow, 
●
dividends, etc.) and how exactly should it be defined ○ Fundamental indices more resemble active strategies FI may be inferior to multifactor quantitative Strategies ○ FI benefit only from the value premium where as Multifactor Quantitative Investment Strategies benefit from numerous anomalies
○
Comments: 
1. Discussions FI has been successfully marketed to investors. In our humble view, it is more like wrapping an old idea (ie, value) with new packaging. This paper provides a detailed analysis why the FI strategies might not be bearing superior results as suggested by proponents of fundamental indices. At a time when many smart people have intensively studied equity quant strategies, we tend to think it’s more likely for new alpha to come from new data source. 
Though this paper provides theoretical argument against the fundamental indices, extensive empirical analysis is need for supporting the conclusions. 

2. Data RAFI 1000 index (the Research Affiliates Fundamental Index for the top 1000 US equities) and Russell 1000 index are used for the period of 1962 2005. 

Paper Type: 
Working Papers 
Date: 
20080520 
Category: 
130/30, alternative index 
Title: 
130/30 Investing: Just Another Hype or Here to Stay? 
Authors: 
David Blitz 
Source: 

Link: 
Summary: 
● 
In terms of alpha potential and beta exposure, 130/30 funds behave more like traditional mutual funds than hedge funds, mainly because of their market exposure. 
● 
Some 130/30 indices, e.g., “130/30: The New LongOnly” 

● 
Expenses for 130/30 funds are likely higher than 

longonly funds due to cost related to shorting stocks and managing a more complex portfolio 

● 
A piecewise implemented 130/30 funds (eg, a 100% long portfolio on top of a 30% market neutral portfolio) is suboptimal since its portfolio construction is not integrated 

Paper Type: 
Working Papers 

Date: 
20080501 

Category: 
130/30 index, alternative index 

Title: 
Benchmarking 130/30 Strategies 

Authors: 
Srikant Dash, Philip Murphy 

Source: 
S&P white paper 

Link: 

Summary: 
This white paper proposes that a better benchmark for 130/30 funds is actually an appropriate longonly index. Any dedicated 130/30 index may be inappropriate. Their reasons: 
No set of factors in 130/30 indices can capture a broad consensus in identifying stock mispricing. 130/30 managers can use both quantitative and qualitatively methodology The 130/30 proposed by Lo and Patel (which emphasizes the impact of leverage) is problematic since:
●
●
● the effects of leverage are no different than effects of big factor bets such as style, industry or size. the goal of 130/30 managers is to deliver a portfolio beta of close to 1
●
●
generally managers try to outperform in a risk controlled fashion
Interestingly, this paper does not agree with a 130/30 index by S&P
which we covered before
rategy_Index_Methodology_Web.pdf), where a short extension is added to S&P’s proprietary stockselection model.
Paper Type: 
Working Papers 
Date: 
20080409 
Category: 
Optimal indexing scheme, MSCI World Index, alternative index 
Title: 
Alternative Indexing with the MSCI World Index 
Authors: 
Thomas Neukirch 
Source: 
SSRN working paper 
Link: 

Summary: 
This paper finds that “equalrisk weighting” performs better than the capweight scheme used by the MSCI World Developed Index during 2001/01 through 2008/01. 
Weighting 
Description 
Performance 
scheme 

Original index 
• Uses floatadjusted 
• Yields 2.86% 
weighting 
market capitalization 
during 2001/01  
as weights 
2008/01 

Equal weighting 
• All constituents get same weight 
• Equalweighted both components and countries generates 8.19%. 
Equal risk 
• Each constituents 
• Equalrisk 
weighting 
get a weight of 
weighting index 
1/(constituents’ 
components: 

volatility) i.e., each 
6.27%, 

constituents contributes the same amount of risk (volatility) to the resulting portfolio 
• Equal risk weighting with equal country weighting generates 8.27%, with low volatility 
Other findings:
● All alternative weighting schemes perform better than the original index, though such outperformance is more obvious when market is rising The costs of implementing an equal weighting strategy:
●
○ Before expenses, the equal weighting strategy returns 1.45% annually, the original index returns
3.17%
○ After expenses, the equalweighted index returns 0.70%, and the authors did not give the number for the original index
Comments: 
1. Discussions Our major concern is that the finding here has a lookahead bias. What happened during 2001/012008/01 may not repeat in the future. The author has the benefit of perfect hindsight: he first found that during the past 7 years, higher cap weighted countries yield lower returns (figure 2), and then proposes the “equalrisk weighting” and “equalweighting”. He argues that “? riskiness is quite stable over time and hence a risk weighting component may lead to more stable results”, this may not always be true. Using an example in US, energy sector was a lowbeta, low volatility sector before 2006, but it is no longer the case. 
Paper Type: 
Working Papers 
Date: 
20071226 
Category: 
130/30 index, alternative index 
Title: 
130/30: The New LongOnly 
Authors: 
Andrew Lo, Pankaj Patel 
Source: 
SSRN working paper 
Link: 

Summary: 
This paper proposes two indices for the increasingly popular 

130% long/30% short (130/30) funds. The two indices are: 

● 
An investable index: which uses only prior information 

● 
and is dynamically rebalanced based on a mechanic trading rule A"lookahead" index: which uses lookahead information 

(such as realized excess return) and can be used as a performance upper bound. 

The proposed indices are based on a stock ranking strategy and a standard portfolio construction method.Specifically, stocks are ranked based on 10 commonly used factors: 



















10. Small Size. 

Key insights: 

● An optimal benchmark index should be: transparent (systematic rules, clear), investable (liquid components), passive (mechanical implementation, no human discretion) 

● 
Compared with the S&P 50 index, the new 130/30 index 

● 
has similar volatility (about 15% annual volatility for both) Compared with the S&P 500 index, the new 130/30 index has slightly higher Sharpe ratio (0.4 for the 130/30 index, 

● 
vs 0.37 for the S&P 500 index). The authors claim that this comparison is fair since although 130/30 has 1.6 times leverage, the volatility and beta of the 130/30 index is at similar level to S&P 500) It has high correlation with com on equity indices eg, Russell 2000 

Comments: 
1. Discussions In our view, the proposed indices sound more like a quant index and less a 130/30 index.130/30 funds are different from 
(arguably, better than) the traditional longonly for two reasons:
it can exploit the short side of stocks, which many believe there still exist inefficiencies since managers do not have a way to express their negative view of some stocks. An ideal index should reflect opportunity set in this new territory. it has a 1.6 leverage (130% + 30%). In reality few 130/30 managers would keep their volatility and beta at the same level of S&P 500. A more desirable index (in our humble view) is an index with higher volatility. This said, the proposed 130/30 index has better performance than S&P500 due to its quant stock selection (likely value tilt).
●
●
2. Data 1996/01  2007/09 US stock data are used. The authors uses the MSCI Barra Aegis Portfolio Manager with the Barra U.S. Equity LongTerm Risk Model to construct the 130/30 portfolios
Paper Type: 
Working Papers 
Date: 
20071226 
Category: 
130/30 funds, alternative index 
Title: 
An Empirical Analysis of 130/30 Strategies 
Authors: 
Gordon Johnson, Shannon Ericson, Vikram Srimurthy 
Source: 
Lee Munder research paper 
Link: 

Summary: 
This is a nice summary of the key features of the 130/30 strategies. Key points: 
● 
less than 10% of stocks can be underweight 25bps or 
● 
more relative to large cap benchmark stocks with highest weights do not necessarily have the 
● 
lowest alphas so a 130/30 funds can potentially increase alpha 
● 
In backtesting 130/30 outperform longonly by about 1.5 
● 
times, with a tracking error that is about 1.15 times higher. The authors also proposed a simple performance contribution analysis. 
Paper Type: 
Working Papers 
Date: 
20140410 
Category: 
Preannouncements, Management forecasts, Analyst forecasts 
Title: 
Stock Market Overreaction to Management Earnings Forecasts 
Authors: 
JeanSébastien Michel 
Source: 
CIRPÉE 
Link: 

Summary: 
Stock prices overreacts to management earnings forecasts, and revert 
around the earnings announcement. Negative forecast surprises lead to a 5.9% abnormal return around the forecast and a 1.9% correction in the 2month after earnings announcements. Positive surprises lead to a 1.9% abnormal return and a 1.7% correction
Variables definitions ● Reaction to management earnings forecasts: the returns over the first 3days following the forecast Reaction to earnings announcement: the returns over the first 61 days following the announcement Overreaction to management earnings forecasts, particularly negative forecasts ● The 3day CAR is 5.86% for negative surprises, 1.93%/0.65% for positive (no) surprises (Table 1) Results are robust to controlling for firm characteristics and analyst forecasts (Table 2) Following the RegFD, the 3day stock returns after
●
●
●
management forecasts is lower yet still significant (~2% after RegFD vs ~6% before RegFD) (Table 3) Correction after earnings announcements
●
Significant CAR reversal following earnings announcement:
negative surprises predicts 1.88% CAR over next two months, positive(no) surprise predicts 1.72(1.61%) (Table 1) ○ Robust to firm characteristics and analyst forecasts (Table 2)
Source: The Paper ● In regressions, more reliable results after RegFD when controlling for firm characteristics and analyst forecasts (Table
4)
● 
A management forecast cumulative abnormal return increase 
● 
of 1% is associated with a subsequent correction of 0.41% (Table 4) Robust to size, value/growth, and analyst coverage: a 
● 
management earnings forecast CAR increase of 1% is associated with a subsequent correction of 0.38% to 0.44% (Tables 6, 7, 8) Overreaction is present mainly when analyst forecasts 
Data 
corroborate management forecasts (Table 9) 
● 
U.S. firms accounting data from the Compustat database 
● 
U.S. stock data from CRSP database 
● 
Data on companies’ EPS guidance from First Call 
● 
Data on analyst EPS forecasts from the I/B/E/S database 
● 
Data range: 1994  2011 
Paper 
Working Papers 
Type: 

Date: 
20130703 
Category: 
Novel strategy, company guidance range, analyst estimate 
Title: 
Investor Overreaction to Analyst Reference Points 
Authors: 
JeanSebastien Michel 
Source:
SSRN working paper
Summary 
Analysts tend to keep their estimates within the company guidance range. 
: 
Those estimates that are exactly equal to endpoints of guidance range may suggest analysts’ conservatism. Investors overreact to such forecasts, but not other types of forecasts 
Intuitions and definitions ● Most companies tend to give a range of their expected earnings Analysts tend to keep their estimates within the company issued guidance (CIG) range. Any estimates outside of the range signals analysts unusual confidence, and may risk their reputation Investors seem to be overconfident that endpoints estimates are conservative, and overreact to such estimates Define Low RP (reference point): equals 1 when at least one analyst forecast equals the low point of CIG, and 0 otherwise Define High RP: equals 1 when at least one analyst forecast equals the high point of CIG, and 0 otherwise Define “No RP (low)”: equals 1 when all analyst forecasts are less than the low point of CIG , and 0 otherwise Define “No RP (High)”: equals 1 when all analyst forecasts are greater than the high point of CIG, and 0 otherwise Define forecast error: the percentage difference between the analyst quarterly EPS forecast and realized quarterly EPS 1/3 of estimates are on the endpoints, with comparable forecast error ● The percentage of forecasts exactly equal to the CIG Low (High) are around 15% (20%) (Table 1) The percentage of forecasts between the CIG Low and High hovers around 50%. (Table 1) When Analyst Forecast < CIG Low, the error is much higher at 19%,
●
●
●
●
●
●
●
●
●
compared with other cases where the error is 2% to 4% (Table 1, 2) Strong reversal on announcement days for low RP stocks
● 
For the Low RP stocks, days before the earnings announcements see 
● 
large negative abnormal return ○ Tstat is significant (Table 4) ○ Suggesting that investors react more strongly to analyst forecasts in this case Similar pattern for No RP (Low) and No RP (High) stocks (Table 4, 
Figure2)
Source: the paper
The overreaction theory is further supported by higher turnover ● Low (high) RP stocks have share turnover of 2.67% (2.64%) 30% higher than the turnover of No RP stocks whose turnover is 2.09%. (Table 8 panel A) Not driven by the magnitude of the forecast ○ When comparing the forecasts equal to CIG endpoints to those that exceed CIG endpoints, the overreaction is even more pronounced
●
●
Data 

● 
January 2000 to June 2011 EPS guidance are from First Call 
● 
○ Only retain range estimates Data on analyst EPS forecasts are from the I/B/E/S 
● 
Stock returns, prices and shares outstanding are from CRSP/Compustat 
Paper Type: 
Working Papers 
Date: 
20130228 
Category: 
Novel strategy, insider trading, analyst revi 
Title: 
Insider Trading and Analyst Forecast Revisions: Global Evidence 
Authors: 
Wen Jin, Joshua Livnat, and Yuan Zhang 
Source: 
SSRN Working Paper 
Link: 

Summary: 
Stocks with analysts revision confirming prior insider trading yields significant return spreads, with a return spread of 8.6% in the threeday period surrounding the revision. Such interaction works best for insider sales in US, and for insider purchases in international markets 
Definitions INSIDER: set to 1 if there is any insider trading activity in the designated window, and 0 otherwise Insider PURCHASE (SALE): set to 1 if the aggregate timeweighted trading is a net purchase (sale), and 0 otherwise In US, there are 833 purchases and 1439 sells on average each month In international market, there are 1478 net purchase position and 904 net sale position each month(Table 5) ○ Suggesting a weaker emphasis on stockbased compensation outside of the US Insider trading predicts stock returns
●
●
●
●
● 
From January 1996 to October 2011, long(short) insider buy(sell) earns 0.22% in the 30day window after the 
● 
calendar month end (Table 1) Most of the hedge return coming from long portfolio: 
suggesting that insider purchases are more informative In international market, the returns spread is 0.77%, with more return comes from short portfolio Market reacts immediately to analyst revisions
●
●
Sort the analyst forecast revisions into 10 deciles
In US, the threeday hedged return is 7.6% (Table 2, Panel A) In international markets, the hedged return is much lower at 2.5% (Table 6 Panel A ) Insiders trading and analyst revisions are supplement to each other
●
●
● 
In the US market, when analysts confirm the insider 
● 
trading signal, the hedged return around the threeday period surrounding the revision is 8.6%, with the lowest (highest) decile of revisions earns 5.2% (3.4%) When analysts conflict with prior insider trading, the 
● 
hedged return is 7.1% (20% lower than confirming scenario) Similar findings in international markets 
Data 
○ When analysts agree with insiders, the market responds more strongly (coefficient 25% higher) to their forecast revisions (Panel B, Table 7) 
● 
19962012 US data are from the Thomson Reuters insider 
● 
trading database Analyst forecast data are from IBES 
● 
20062012 international insider trading data are from 2iQ Research, which covers European and AsiaPacific countries 
Paper Type: 
Working Papers 
Date: 
20120729 
Category: 
Novel strategy, analyst revisions, analyst optimism 
Title: 
Are Analysts Really Too Optimistic? 
Authors: 
JeanSébastien Michel and J. Ari Pandes 
Source: 
AAA Conference Paper 
Link: 

Summary: 
A new measure of analyst ability, firmlevel relative analyst earnings forecasts (ARAF), can predict future stock returns. A strategy based 
on ARAF earns riskadjusted return of 11% per year. This effect is more pronounced among smaller, more illiquid and more uncertain stocks
Background ● Stocks with high analysts revisions (adjusted for average estimate error) may signal analysts’ ability and confidence in the stock Note that such confidence is not analysts’ (unfounded) optimism, and it should be based on analysts’ private information and effective analysis Constructing average relative analyst forecast (ARAF) ● Step1: for each analyst, each stock, and each month, define relative analyst forecast (RAF) as
●
Where Fi,j,t is analyst j’s forecast for firm i and for the forecast date t; μ() is the average forecast of all analysts for the period t to tk for the same firm, and σ() is the standard deviation of these forecasts In other words, RAF is the (“analysts forecast” – “prior 3months average forecast of all analysts”) / (“standard deviation of these forecasts” ) Step2: for each stock, get the aggregate RAF (ARAF) by averaging RAF across all analysts ○ So ARAF controls for any company or timespecific factors that affect forecasts and therefore eliminates the general biases attributed to consensus forecasts or recommendations ● Average ARAF varies substantially by quintile (Table 3) Constructing the ARAF portfolio
●
●
Each month, sort stocks into quintiles by ARAF Rebalance monthly and calculate equalweighted return for each portfolio ○ The (unreported) valueweighted returns is qualitatively similar, though with lower economic significance Higher ARAF, higher returns
●
●
● 
HighARAF firms significantly outperform lowARAF firms by 
● 
0.92% (1.45% vs. 0.53%) per month (annualized spread 11.04%) (Table 5) The riskadjusted hedged portfolio monthly return is 0.97% 
and highly statistically significant at the 1% level (annualized spread 11.64%) (Table 5) ● Returns monotonically increase with ARAF measure Robust to risk factors and RegFD
● 
Double sort stocks by ARAF and size (P/B, momentum, 
● 
liquidity) into 5x5 portfolios ARAF works better in smaller, riskier (measured by 
● 
booktomarket) and less liquid segments But still demonstrate strong abilities among firms that are larger, less risky and more liquid (Table 6, 7) 
Sort by size
Sort by illiquidity
Sort by volatility
In small cap quintile, 22.68% annually
In illiquid quintile, 18.36% annually
In high volatility quintile, 24.00% annually
In large cap quintile, 2.76% annually
In most liquid quintile, 3.00% annually
In low volatility quintile, 4.44%) annually
● 
Regression confirms the findings (Table 8) 
● 
○ Control variables include size, booktomarket, momentum, analyst EPS forecast dispersion, priormonth return to capture the reversal, S&P longterm debt rating, and forecast error Weaker but still effective postReg FD (Table 9) ○ Divide the sample into preReg FD (19842000) and postReg FD (20012010) ○ On a factoradjusted basis, the annualized hedged 
return is 14.40% preReg FD and 7.56% postReg FD Higher ARAF, better accounting performance and higher forecast accuracy
●
Better operating performance in terms of ROA, CROA (cash flow on assets), and ROE
● 
○ Strong and positive relationship: high ARAF portfolios significantly outperform low ARAF portfolios operationally by $0.95 to $1.32 per $100 of assets and $3.53 per $100 of equity in mean (Table 4) Forecast error (FCE) decreases with ARAF (Table 4) ○ More pronounced for high uncertainty firms: they see a fivetimes larger mean difference in FCE between high and low ARAF firms (0.88 versus 0.17), comparing to low uncertainty firms (Table 4) 
Data 

● 
January 1984 to December 2011 stock data is from CRSP 
● 
Analyst EPS forecasts data (for the oneyear fiscal period) is 
● 
from Thomson Reuters’ I/B/E/S unadjusted detail history file Actual EPS is from the I/B/E/S unadjusted detail actuals file, while other accounting data from Compustat 
Paper Type: 
Working papers 
Date: 
20101220 
Category: 
Novel strategy, analyst estimates, warranted forecasts 
Title: 
A New Approach to Predicting Analyst Forecast Errors: 
Implications for Investment Decisions 

Authors: 
Eric C. So 
Source: 
SSRN Working paper 
Link: 

Summary: 
A new earnings forecasting metric, Warranted Optimism (WO), yields longshort average portfolio returns of 16% per year. Such WO is better than analyst forecast since it forecasts future earnings directly from lagged firm characteristics, and is not related to analysts’ private information or incentive 
Definitions and intuition ● Warranted Forecast (WF) are forecasts of future earnings estimated directly from lagged firm characteristics ○ The regressors are the lagged values of the following firm characteristics: enterprise value (Vj), total assets (Aj), dividend levels (Dj), a binary variable indicating zero dividends (DDj), net income before extraordinary items (Ej), and a
●
binary variable indicating negative earnings (NEGE) (Equation 9, Page 11) Warranted optimism (WO) = (Warranted Forecast (WF)  Analyst Forecast (AF)) / (Total Assets)
The WF approach is less biased since it is directly based on firm characteristics ○ It is wellknown that Analyst Forecasts (AF) are systematically biased ○ WF directly estimates future earnings based on firm characteristics, instead of regressing realized forecast errors on firm characteristics ○ So WF results in unbiased estimates of future earnings, and WF forecast errors are unbiased estimates of the realized analyst forecast error Traditional approach to projecting analyst forecast errors are biased
●
● 
In this approach, analyst forecasts (Fj,t) are a linear 
● 
function of observable firm characteristics and analysts’ private information and incentives Traditional approach regresses FEj,t (Realized analyst 
forecast errors, defined as FEj,t = Ej,t −Fj,t ) on a set of firm characteristics ○ The regression parameters obtained from this step are then used with current firm characteristics to estimate the analysts’ forecast error for the next year But the analysts’ private information or incentives are correlated with firm characteristics, so this traditional approach is biased (Equations 1, 2, and 3 on Page 5) Constructing portfolios based on WO
●
● 
Sort stocks into quintiles by WO Returns adjusted for FamaFrench factors show 
● 
Portfolios are formed at the end of June each year, and 
● 
hold for 13 years Stock raw and riskadjusted returns increase with WO 
● 
(Table 4) ○ Over the next year, the longshort portfolio raw return spread is 16.4% (statistically significant) ○ The longshort portfolio returns are statistically significantly positive for up to 3 years ○ Risk adjusted return returns increase with WO: significant alphas increasing in WO (Table 5) Robust to earnings drift and accruals (Table 6) 
● 
Robust to size, booktomarket, momentum, accruals, turnover, and longterm growth forecasts (Table 7), as WO effects still exist in a twoway sorting 
Robust to extreme outliers: beginning in the third month following portfolio formation, average returns monotonically increase with WO, so the finding is not driven by a extreme performers (Figure 4) Good (maybe too good?) yearbyyear performance (Table 9) ● The performance number look extraordinarily consistent:
●
● 
only 1 year during 19762008 see negative return spread of WO Quintiles WO longshort portfolio returns have been positive almost every year during the 1976  2008 period. Over the 20032008 period, the sizeadjusted longshort portfolio return is between 5.19% and 19.71% 
Data 

● 
19762008 60,010 firmyears stock data are from CRSP, Compustat and IBES 
Paper Type: 
Working papers 
Date: 

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