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Arrowstreet Whitepapers
Please contact us to request a copy of our full whitepapers.
A list of recent Arrowstreet Whitepapers follows:
The Equity Premium - A Long Term View
May 2009: John Y. Campbell, Ph.D
Through April 2009, the MSCI World Index of global equities declined just over 47% in dollar terms from its peak in October 2007. The decline in the MSCI US index was almost as severe at 43% over the same period. In this note we consider what these large price declines imply for the equity premium. We take a long-term view rather than a tactical view; our analysis gives us a reasonable estimate of average returns over the next five to ten years, but should not be used to forecast returns over shorter periods such as a year.
Can Managers Capture the "Value Premium," and Should They?
February 2009: Peter Rathjens, Ph.D.
In this note, Peter explains how Arrowstreet answers the question of whether it is possible to capture the value premium without disturbing the portfolio’s style tilt and seeks to communicate the following three points: 1) In order to measure a style tilt, one must calculate the exposure or beta of a portfolio’s return to a style return. This directly measures the risk that (we believe) investors are concerned about. Given an accurate measure of a portfolio’s style beta, no other information is needed to measure the portfolio’s style tilt; 2) Historical evidence shows that in the case of value, the style beta is only weakly related to the value premium; and 3) Arrowstreet therefore constructs portfolios to earn the value premium without establishing a systematic value tilt. Our long-term results demonstrate this success.
Inflation Bets or Deflation Hedges? The Changing Risks of Nomimal Bonds
May 2008: John Y. Campbell, Ph.D
Conventional US Treasury bonds make fixed nominal payments whose real value is negatively affected by inflation. Are these bonds risky assets, or do they hedge other risks that investors already bear? The answer depends on the time period, because the covariance between nominal Treasury bond returns and stock returns has moved considerably over time. While it has been slightly positive on average over the last fifty years, it was particularly high in the early 1980’s and turned negative in the early 2000’s. This behavior reflects changes in the behavior of inflation. When inflationary expectations and the supply side of the economy are stable, as was the case in the early 2000’s, inflation is procyclical and bonds move opposite stocks. In such an environment investors hold bonds as hedges against the risk of a deflationary downturn, and their strong demand leads to low risk premia and a typically flat yield curve. This talk will explore the behavior of bonds and bond investors in different inflationary environments including the possible return of “stagflation”.
Linkages Revisited: Information in the Value Signals of Related Stocks
May 2008: Tuomo Vuolteenaho, Ph.D.
From Arrowstreet's inception, one of the hallmarks of our investment approach has been to focus on indirect or spillover effects that operate accross stocks. In this paper, Tuomo highlights the ways in which indirect (related) stock information can be used in constructing spillover value signals.
Variation in Signal Effectiveness: Sources of Return, Sources of Risk
May 2008: Peter Rathjens, Ph.D.
In this paper, Peter Rathjens will examine how consistently effective valuation ratios are in forecasting excess returns, with special attention paid to the unusual and extreme events since the summer of 2007. He’ll also explore approaches that attempt to minimize this risk by identifying timing mechanisms to turn off or even reverse valuation ratios and other excess return signals. Finally, he’ll highlight the potential benefits and pitfalls of these approaches.
Consistency of the Value Premium across Asset Classes
May 2008: Yijie Zhang, Ph.D.
In this paper, Yijie Zhang investigates the consistency of the value premium across various asset classes. In particular, he explores whether there is a consistent value premium to be found in emerging markets and in small market capitalization stocks. He then examines whether these asset classes experience the same value/growth cycle and whether Arrowstreet’s forecast process is able to capture the highest value premium among these asset classes. Finally he investigates whether we can reduce the risk associated with the value premium further by controlling for the exposure to the global growth/value cycle.
Why Active Extension Strategies (e.g., 130/30)?
February 2008: Jim Thames, CFA
In recent years, active extension strategies have grown in usage among the institutional investment community. In this paper, Jim Thames first provides a precise definition of what we mean by an extension strategy. He then explores some of the sources of their growing popularity, as well as their costs and benefits relative to both long-only alternatives as well as more traditional long-short strategies. Finally, he presents some concluding comments.
The Quant Meltdown of July and August, 2007
September 2007: Peter Rathjens, Ph.D.
Many investors have been made aware of the sharp liquidity crisis that developed in the credit markets in the early part of the third quarter of 2007. In turn, this liquidity crisis migrated into a segment of the market for public equities: those that were attractive on the basis of well known and widely monitored quantitative signals. In this paper Peter Rathjens explores what happened in the early part of the third quarter of 2007.
Beta Arbitrage
September 2007: John Capeci, Ph.D.
The intent of beta arbitrage is to exploit the average underperformance of high beta stocks relative to the return predictions of standard asset pricing models. Exploiting this insight must be done carefully because the return advantage of holding long portfolios of low beta stocks comes with significant risk. In this paper John Capeci provides a background on how the beta arbitrage component of Arrowstreet’s long/short equity strategy has worked over time.
What Is The Equity Premium Today?
July 2007: John Y. Campbell, Ph.D.
The equity premium is the expected excess return on a broad stock index over a safe bond market investment. It is the reward that investors can expect to receive for taking on equity risk, and thus has an important influence on asset allocation decisions. In this paper, John Campbell compares four commonly used methods for estimating the equity premium.
Opportunities in Small Cap
November 2006: John Capeci, Ph.D.
Small cap stocks have gained increasing attention from institutional investors as their returns have outpaced large cap stocks in recent years. This paper addresses the question of whether small cap exposure is more appropriately exploited as a stand alone asset class or as part of an all cap mandate. To address this question, John Capeci focuses on two related issues. Are the factors which drive successful equity management for small cap stocks and large cap stocks distinct? Second, is there a role for tactical selection between small and large cap?
Adding Value Through Tactical Tilts
November 2006: Jim Thames, CFA
Arrowstreet's investment process is designed to avoid systematic biases, for example towards small or large stocks, or towards growth or value stocks. However, the process does generate tactical tilts as a result of the changing opportunities that we perceive in the market. Since our inception in 1999, we have witnessed several noteworthy shifts in our portfolios. This paper reviews the history of our tilts and the positioning of the portfolios today.
Country/Sector Baskets and Cross-Security Linkages
November 2006: Peter Rathjens, Ph.D.
At Arrowstreet's 2005 Client Conference, we described research measuring linkages across stocks beyond those contained in our original country-sector basket approach. We explore linkages based on three concepts: common country, sector, or basket inclusion; historical return correlations; and other measures of business relationships. In this abstract from Arrowstreet’s 2006 Client Conference, Peter Rathjens describes how we think about linkages, and how we derive value added from them.
Value Investing - Alpha Without the Risk
November 2006: Tuomo Vuolteenaho, Ph.D.
There is a broad consensus in academic literature that over the long run, value stocks earn a premium over growth stocks. There is significant disagreement about whether this premium is caused by market inefficiency or higher risk of value stocks. At Arrowstreet, we consider that alpha and risk are separate dimensions: A value stock can have high alpha and low risk, or low alpha and high risk. In this abstract from Arrowstreet’s 2006 Client Conference, Tuomo Vuolteenaho discusses why separating alpha and risk is important, how we separately measure them, and how our clients can understand the resulting strategy in the context of their larger portfolios.
Global Currency Hedging
November 2006: John Y. Campbell, Ph.D.
How can global equity investors adjust their foreign currency exposures to hedge their portfolio risk? Many currencies are positively correlated with stock returns, implying that the minimum-risk strategy is to over-hedge these currencies. However, major reserve currencies such as the dollar and euro are uncorrelated or even negatively correlated with equity markets, suggesting that these currencies should not be fully hedged.
Modeling Developed and Emerging Markets in an Integrating World
November 2006: Tuomo Vuolteenaho, Ph.D.
As a part of the ongoing research effort at Arrowstreet, we have combined the emerging markets and developed markets basket models into a single basket model. Although the benefits from combining the models are mostly operational, the combined model is also expected to improve our forecasting performance in the following ways: (1) The combined, larger universe yields higher statistical precision; (2) Instead of a binary dichotomy, a market’s level of development is now considered a continuous variable making the forecasting process for large and relatively developed emerging markets (e.g., South Korea) quite similar to that for small and relatively inefficient developed markets (e.g., Portugal); and (3) The combined model allows us to form an opinion on the future returns of emerging markets relative to developed markets.
Volatility: It's Baaaaack?
June 2006: John Y. Campbell, Ph.D.
Recent market movements have reminded investors that equities are risky assets. The S&P 500 index, for example, has fallen by 6.5% since its peak in May, and declines in international equity markets, particularly emerging markets, have been considerably larger. The volatility of daily market movements has also increased. A monthly moving average of daily changes in the S&P 500 was around 8% in April, but increased in May above 11%. The VIX, the implied volatility of the S&P 500 calculated from the prices of index options, was 11-12% in April and peaked at 23% earlier in June before falling back to 16% at this date. Many investors are asking themselves whether these movements presage the end of the relatively benign market conditions of the last couple of years, and a return to a more volatile environment.
Global Tilts: Opportunities and Source of Risk on Global Portfolios
May 2006: Peter Rathjens, Ph.D.
All active portfolios are characterized by one or more of a series of active tilts or themes. International portfolios, because of their breadth, may reflect multiple tilts at any point in time, including not only growth/value tilts and small cap/large cap tilts, but also tilts involving sector/industry decisions and country/regional decisions. In this paper, Peter Rathjens describes several tilts, addresses both the long-term average expected return attached to those tilts and how one might forecast the cyclical variation in the returns of those tilts, and shows how these forecasts can evolve over time.
Active Currency Management
April 5 2006: Sam Thompson , Ph.D.
Since our inception, Arrowstreet Capital has focused narrowly on managing active equities. Thus, when our equity decisions result in incidental currency decisions, we neutralize those currency decisions by using offsetting forward currency contracts. When an investment is made in a (developed) foreign country, the active position is hedged with an off-setting forward transaction. As the active weights drift, the currency hedge is rebalanced.
Beta Arbitrage as an Alpha Opportunity
January 2006: Tuomo Vuolteenaho, Ph.D.
Market-neutral strategies that seek to exploit the mispricing of high-beta stocks and low-beta stocks relative to the overall stock and bond markets can be referred to as “beta arbitrage.” In contrast to strategic beta arbitrage, which takes a permanent tilt towards low-beta stocks and away from high-beta stocks, tactical beta arbitrage adjusts these positions with market conditions. In this paper, Tuomo Vuolteenaho demonstrates how Arrowstreet’s ability to forecast the overall market’s equity premium and the and the returns of high-beta and low-beta stocks allows us to exploit tactical beta arbitrage and add more value than strategic beta arbitrage alone.
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