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Conditional risk and performance evaluation: Volatility timing, overconditioning, and new estimates of momentum alphas

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  • Boguth, Oliver
  • Carlson, Murray
  • Fisher, Adlai
  • Simutin, Mikhail
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    Abstract

    Unconditional alphas are biased when conditional beta covaries with the market risk premium (market timing) or volatility (volatility timing). We demonstrate an additional bias (overconditioning) that can occur any time an empiricist estimates risk using information, such as a realized beta, that is not available to investors ex ante. Calibrating to U.S. equity returns, volatility timing and overconditioning can plausibly impact alphas more than market timing, which has been the focus of prior literature. To correct market- and volatility-timing biases without overconditioning, we show that incorporating realized betas into instrumental variables estimators is effective. Empirically, instrumentation reduces momentum alphas by 20–40%. Overconditioned alphas overstate performance by up to 2.5 times. We explain the sources of both the volatility-timing and overconditioning biases in momentum portfolios.

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    Bibliographic Info

    Article provided by Elsevier in its journal Journal of Financial Economics.

    Volume (Year): 102 (2011)
    Issue (Month): 2 ()
    Pages: 363-389

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    Handle: RePEc:eee:jfinec:v:102:y:2011:i:2:p:363-389

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    Web page: http://www.elsevier.com/locate/inca/505576

    Related research

    Keywords: Performance evaluation; Conditional CAPM; Volatility timing; Momentum;

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    Cited by:
    1. Kent Daniel & Ravi Jagannathan & Soohun Kim, 2012. "Tail Risk in Momentum Strategy Returns," NBER Working Papers 18169, National Bureau of Economic Research, Inc.
    2. Andrew Ang & Dennis Kristensen, 2011. "Testing Conditional Factor Models," NBER Working Papers 17561, National Bureau of Economic Research, Inc.
    3. Galvani, Valentina & Gubellini, Stefano, 2013. "Mean–variance dominant trading strategies," Finance Research Letters, Elsevier, vol. 10(3), pages 142-150.

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