Arrowstreet Whitepapers

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.

Small Cap Equities: Strategic and Tactical Considerations
December 2005: Peter Rathjens, Ph.D. and Tuomo Vuolteenaho, Ph.D.
As Arrowstreet began describing its small cap product, one common question received has been about the timing of investments into small cap names in general, quite apart from our investment approach. In particular, investors have expressed concern that, relative to large cap names, small cap names are overpriced, and therefore should be avoided, or under-weighted. In this paper, Peter Rathjens and Tuomo Vuolteenaho address these concerns by considering both the long-term (strategic) as well as the short-term (tactical) prospects for small cap stocks.

Alpha Signals in the Footnotes: Going Deeper into the Financial Statements
June 2005: Tuomo Vuolteenaho, Ph.D.
Aggressive accounting by firms requires aggressive countermeasures by stock market investors. In this abstract from Arrowstreet’s 2005 Client Conference, Tuomo Vuolteenaho explores some research undertaken at Arrowstreet on exploiting detailed information within financial statements, which seeks to create signals that act as such countermeasures within our quantitative process.

Growth vs. Capacity: Protecting Client Interests
June 2005: Bruce Clarke, CFA
Aligning the interests of the firm and its clients is critical for success in the asset management business. In this abstract from Arrowstreet’s 2005 Client Conference, Bruce Clarke highlights several examples of diverging interests and discusses how Arrowstreet’s structure and business practices ensure that clients’ interests remain protected at all times.

Country/Sector Baskets and Cross-Security Linkages
June 2005: Peter Rathjens, Ph.D.
Stock prices respond both to information about the stock in question (direct effects) as well as to information about other stocks (indirect effects, or effects based upon cross-security linkages). In this abstract from Arrowstreet’s 2005 Client Conference, Peter Rathjens describes some research undertaken at Arrowstreet to expand how we think about these increasingly important linkages across stocks.

Measuring Developed Markets Capacity
June 2005: Peter Rathjens, Ph.D. and Bruce Clarke, CFA
In this paper, which follows our recent paper on increasing emerging markets capacity, Peter Rathjens and Bruce Clarke review the changing environment for developed market equities and the growth of Arrowstreet’s business to include global mandates. They then describe enhancements to our investment approach, the impact they should have on our capacity limit, and the evolution of our trading costs since inception. Finally, they draw conclusions for our developed market capacity limit.

Investing in an Era of Low Returns
June 2005: John Y. Campbell, Ph.D.
Rates of return in traditional asset classes appear to be unusually low today. In this abstract from Arrowstreet’s 2005 Client Conference, John Campbell describes how investors require an intelligent combination of asset allocation and active management, “beta solutions” and “alpha solutions” to sustain portfolio rates of return in this environment.

Understanding Momentum
December 2004: John Y. Campbell, Ph.D.
“Momentum” refers to the tendency of stock prices to continue moving in the same direction for several months after an initial impulse. In this paper, John Campbell reviews the behavioral explanations of momentum and the pitfalls associated with momentum investing that one must consider in order to generate profits.

The Case For Increasing Emerging Markets Capacity
December 2004: Peter Rathjens, Ph.D. and Ezra Levine, CFA
In this paper, Peter Rathjens and Ezra Levine review the changing environment for emerging market equities. They then describe enhancements to our investment approach, the impact they should have on our capacity limit, and the evolution of our trading costs since inception. Finally, they draw conclusions that support increasing our emerging market capacity limit.

Refinements of Value and Momentum Terms
August 2004: Peter Rathjens, Ph.D.
Ongoing research, and the pursuit of alpha, is the lifeblood of any successful active management firm. Peter Rathjens provides an illustration of how we have adapted our models in recent years, using as specific examples some enhancements we made to how we measure momentum and value.

Inflation Illusion and Stock Prices
January 2004: John Y. Campbell, Ph.D. and Tuomo Vuolteenaho, Ph.D
Modigliani and Cohn’s hypothesis and the persistent use of the “Fed model” by Wall Street suggest that the stock market incorrectly extrapolates past nominal growth rates without taking into account the impact of time-varying inflation. Consistent with the Modigliani-Cohn hypothesis, John Campbell and Tuomo Vuolteenaho find that the level of inflation explains almost 80% of the time-series variation in stock-market mispricing.

A Practitioner's Guide to Cross-Border Trading
April 2004: James Thames, CFA
In today’s complex capital markets, there are a multitude of investment vehicles available to us as institutional investors for implementing our investment ideas. In this abstract from Arrowstreet’s 2004 Cambridge Research Seminar, Jim Thames describes a variety of vehicles available and how they can be used to help managers minimize transaction costs.

Emerging Markets:  The Great Diversifier?
February 2004
Emerging markets equities appear to be one of the most meaningful and consistent ways to diversify one’s portfolio. Taken from a panel discussion at Arrowstreet’s 2003 Client Conference, topics covered include: how diversification benefits may be changing in light of global integration around the world, alternative ways to gain exposure to the asset class, and long-term return opportunities.

Behavioral Finance: What Have We Learned?
February 2004: John Y. Campbell, Ph.D.
Twenty years ago, the efficient markets hypothesis enjoyed almost universal academic support. Behavioral finance has successfully undermined this orthodoxy, but a new paradigm has yet to emerge. In this abstract from Arrowstreet’s 2003 Client Conference, John Campbell considers the main issues raised by behavioral finance, including the determinants of irrational investor behavior and the factors that limit rational arbitrage.



Triumph of the Optimists
October 2003: Elroy Dimson, Ph.D., London Business School
In this abstract from Arrowstreet’s 2003 Client Conference, Elroy Dimson explores the returns on stocks, bonds, and bills in 14 countries since 1900. His findings include insights on the equity risk premium, as well as the probability of stocks achieving positive real returns in the future.

Value Opportunities After the Bubble
October 2003: John Capeci, Ph.D. and Marta Campillo, Ph.D.
A proposition of value investing is that when price multiples depart significantly from “normal” levels, the ratios revert toward the mean, and at least part of the reversion occurs through a price adjustment as opposed to an adjustment in fundamentals (earnings, book value, cash flow, dividends, etc.). In this abstract from Arrowstreet’s 2003 Client Conference, John Capeci and Marta Campillo explore the prospects for making cross-country value comparisons in the wake of the TMT bubble.

The Business of Asset Management:
Balancing Ownership Control, and Growth in Turbulent Times
August 2003: Bruce Clarke, CFA
Today’s market environment has created a new set of challenges for investors and asset management firms alike. Bruce Clarke provides a backdrop to the business of asset management and discusses the advantages and challenges of the “boutique” business model.

The Case for International Diversification Part 2:
Reducing Risk and the Cost of Diversification
May 2003: John Y. Campbell, Ph.D. and Peter Rathjens, Ph.D.
If all markets move together, why not keep your money safely at home? This argument, while superficially plausible, creates a paradox of globalization. It implies that investors should buck the trend of global integration, investing domestically even while the world economy is reorganized on a global basis. John Campbell and Peter Rathjens resolve this paradox by showing that the case for international diversification remains strong.

The Case for International Diversification Part 1:
Forming Return Expectations
May 2003: John Y. Campbell, Ph.D. and Peter Rathjens, Ph.D.
US investors have seen their returns reduced sharply as a result of their investments outside of the US. In this paper, John Campbell and Peter Rathjens evaluate more carefully the sources of under-performance for non-US stocks, and evaluate how investors might reasonably adjust their return expectations in light of the disappointment suffered over this ten year interval.



Growing Sector Momentum in Emerging Markets
April 2002: John Capeci, Ph.D. and Marta Campillo, Ph.D.
As markets have become increasingly integrated, investors have become more focused on investment opportunities that arise from mispricing among global sectors as opposed to mispricing among markets. John Capeci and Marta Campillo examine the importance of global sectors in emerging markets, focusing specifically on a strategy that has performed quite well in the developed markets, investing on the basis of global sector momentum.

Managing Active Tilts
January 2002: Peter Rathjens, Ph.D.
In this paper, Peter Rathjens evaluates what kind of decisions active managers make. Specifically, he draws the distinction between those tilts that are essentially permanent and those that are more transient in nature. He then presents some suggestions as to how investors can use this information.

Active Management in Periods of Structural Change
October 2001: John Y. Campbell, Ph.D. and Peter Rathjens, Ph.D.
Events such as September 11, 2001 can impact equity markets in such a way that the normal signals of opportunity and risk are temporarily obscured. John Campbell and Peter Rathjens argue that the appropriate response to structural change is to re-evaluate and override the inputs to an investment process rather than the outputs or portfolio decisions that result from the process.

Forecasting US Equity Returns in the 21st Century
July 2001: John Y. Campbell, Ph.D.
In this abstract from a presentation to the Social Security Administration, John Campbell discusses alternative methods for forecasting market returns and then, given current conditions, provides his own view of what we should expect the US equity market to return in the coming years.

The Promise of Emerging Markets
April 2001: Peter Rathjens, Ph.D. and Ezra Levine, CFA
After disappointing investors for much of the last ten years, emerging markets have fallen out of favor. Peter Rathjens and Ezra Levine view the high volatility as a buying opportunity and believe investors will be compensated for bearing the higher risk of emerging markets with returns that outperform those of developed markets.



Sources of Returns and Risk in Hedge Funds
April 2001: Peter Rathjens, Ph.D.
The name “Market Neutral Hedge Fund” implies a fund that is attempting to identify and exploit pure return opportunities without introducing risk into the portfolio. Absent risk-free arbitrage opportunities, however, every hedge fund necessarily introduces portfolio risks as it attempts to exploit return opportunities. Peter Rathjens outlines some of the common approaches to thinking about risk in the hedge fund context, and suggests a more generalized way of thinking about the problem.

Merger Mania
January 2001: Bruce Clarke, CFA and Kevin Taube, CFA
Despite the blaze of publicity surrounding acquisitions, the merger (and especially takeover) route is not the best way to align the interests of investment managers and their clients. Bruce Clarke and Kevin Taube argue that firms that retain management ownership are more likely to have a stable, less cumbersome organizational structure that results in more effective decision-making and greater performance consistency.

Systematic Tilts In International Investing
September 2000: John Y. Campbell, Ph.D., Peter Rathjens, Ph.D., and John Capeci, Ph.D.
Plan sponsors evaluating active managers typically rely heavily on two measures of performance: value added and residual risk. While these measures are undoubtedly useful, by themselves they do not adequately describe the performance of an active manager. John Campbell, Peter Rathjens, and John Capeci illustrate how the source of the manager’s value added is also relevant.

International Investing In A Changing World
June 2000: John Y. Campbell, Ph.D. and Peter Rathjens, Ph.D.
In this paper, John Campbell and Peter Rathjens outline four major sources of change in global markets: mean-reversion, momentum, volatility spikes, and structural change. These sources have far-reaching implications for the strategic benchmark portfolios of plan sponsors, for the role of active managers, and for the signals of value added and risk models that should be employed by active global investors.

Debunking the Growth/Value Myth
April 2000: Peter Rathjens, Ph.D.
Style investing, and in particular growth/value investing, has been an increasingly popular way to manage international equities. In an attempt to understand and evaluate this trend, Peter Rathjens identifies the likely benefits and costs of managing using this approach relative to the alternatives.

Non-Investment Alpha: The Essence of Strategic Partnering
April 2000: Bruce Clarke, CFA
As investment markets have grown in size and complexity, and as plan sponsor budgets have grown tighter, the job of the plan sponsor has become increasingly complex. Bruce Clarke defines the concept of non-investment alpha and how it can be used to help plan sponsors do their jobs.



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