IDEAS home Printed from https://ideas.repec.org/
MyIDEAS: Login to save this article or follow this journal

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

  • Boguth, Oliver
  • Carlson, Murray
  • Fisher, Adlai
  • Simutin, Mikhail
Registered author(s):

    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.

    If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.

    File URL: http://www.sciencedirect.com/science/article/pii/S0304405X11001413
    Download Restriction: Full text for ScienceDirect subscribers only

    As the access to this document is restricted, you may want to look for a different version under "Related research" (further below) or search for a different version of it.

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

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

    as
    in new window

    Handle: RePEc:eee:jfinec:v:102:y:2011:i:2:p:363-389
    Contact details of provider: Web page: http://www.elsevier.com/locate/inca/505576

    References listed on IDEAS
    Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:

    as in new window
    1. Jacquier, Eric & Polson, Nicholas G & Rossi, Peter E, 2002. "Bayesian Analysis of Stochastic Volatility Models," Journal of Business & Economic Statistics, American Statistical Association, vol. 20(1), pages 69-87, January.
    2. Chen, Yong & Ferson, Wayne & Peters, Helen, 2010. "Measuring the timing ability and performance of bond mutual funds," Journal of Financial Economics, Elsevier, vol. 98(1), pages 72-89, October.
    3. Jonathan Berk & Richard C. Green & Vasant Naik, 1998. "Optimal Investment, Growth Options, and Security Returns," NBER Working Papers 6627, National Bureau of Economic Research, Inc.
    4. Bawa, Vijay S. & Lindenberg, Eric B., 1977. "Capital market equilibrium in a mean-lower partial moment framework," Journal of Financial Economics, Elsevier, vol. 5(2), pages 189-200, November.
    5. Fama, Eugene F. & French, Kenneth R., 1993. "Common risk factors in the returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 33(1), pages 3-56, February.
    6. Brandt, Michael W. & Kang, Qiang, 2004. "On the relationship between the conditional mean and volatility of stock returns: A latent VAR approach," Journal of Financial Economics, Elsevier, vol. 72(2), pages 217-257, May.
    7. Chen, Nai-Fu & Roll, Richard & Ross, Stephen A, 1986. "Economic Forces and the Stock Market," The Journal of Business, University of Chicago Press, vol. 59(3), pages 383-403, July.
    8. Fowler, David J. & Rorke, C. Harvey, 1983. "Risk measurement when shares are subject to infrequent trading : Comment," Journal of Financial Economics, Elsevier, vol. 12(2), pages 279-283, August.
    9. Eric Ghysels & Pedro Santa-Clara & Rossen Valkanov, 2004. "There is a Risk-Return Tradeoff After All," CIRANO Working Papers 2004s-24, CIRANO.
    10. Lawrence R. Glosten & Ravi Jagannathan & David E. Runkle, 1993. "On the relation between the expected value and the volatility of the nominal excess return on stocks," Staff Report 157, Federal Reserve Bank of Minneapolis.
    11. Lewellen, Jonathan & Nagel, Stefan, 2006. "The conditional CAPM does not explain asset-pricing anomalies," Journal of Financial Economics, Elsevier, vol. 82(2), pages 289-314, November.
    12. Martin Lettau, 2001. "Consumption, Aggregate Wealth, and Expected Stock Returns," Journal of Finance, American Finance Association, vol. 56(3), pages 815-849, 06.
    13. McDonald, Robert & Siegel, Daniel, 1986. "The Value of Waiting to Invest," The Quarterly Journal of Economics, MIT Press, vol. 101(4), pages 707-27, November.
    14. Murray Carlson & Adlai Fisher & Ron Giammarino, 2004. "Corporate Investment and Asset Price Dynamics: Implications for the Cross-section of Returns," Journal of Finance, American Finance Association, vol. 59(6), pages 2577-2603, December.
    15. Dennis Kristensen & Andrew Ang, 2009. "Testing Conditional Factor Models," CREATES Research Papers 2009-09, School of Economics and Management, University of Aarhus.
    16. Mark Grinblatt & Bing Han, 2001. "Prospect Theory, Mental Accounting, and Momentum," Yale School of Management Working Papers amz2533, Yale School of Management, revised 01 May 2007.
    17. Shanken, Jay, 1990. "Intertemporal asset pricing : An Empirical Investigation," Journal of Econometrics, Elsevier, vol. 45(1-2), pages 99-120.
    18. Hentschel, Ludger & Campbell, John, 1992. "No News is Good News: An Asymmetric Model of Changing Volatility in Stock Returns," Scholarly Articles 3220232, Harvard University Department of Economics.
    19. Ball, Ray & Kothari, S. P. & Shanken, Jay, 1995. "Problems in measuring portfolio performance An application to contrarian investment strategies," Journal of Financial Economics, Elsevier, vol. 38(1), pages 79-107, May.
    20. Foster, Dean P & Nelson, Daniel B, 1996. "Continuous Record Asymptotics for Rolling Sample Variance Estimators," Econometrica, Econometric Society, vol. 64(1), pages 139-74, January.
    21. Doron Avramov & Tarun Chordia, 2006. "Asset Pricing Models and Financial Market Anomalies," Review of Financial Studies, Society for Financial Studies, vol. 19(3), pages 1001-1040.
    22. Sangjoon Kim, Neil Shephard & Siddhartha Chib, . "Stochastic volatility: likelihood inference and comparison with ARCH models," Economics Papers W26, revised version of W, Economics Group, Nuffield College, University of Oxford.
    23. Dimson, Elroy, 1979. "Risk measurement when shares are subject to infrequent trading," Journal of Financial Economics, Elsevier, vol. 7(2), pages 197-226, June.
    24. Fama, Eugene F. & French, Kenneth R., 1988. "Dividend yields and expected stock returns," Journal of Financial Economics, Elsevier, vol. 22(1), pages 3-25, October.
    25. Chan, K C, 1988. "On the Contrarian Investment Strategy," The Journal of Business, University of Chicago Press, vol. 61(2), pages 147-63, April.
    26. Cochrane, John H, 1996. "A Cross-Sectional Test of an Investment-Based Asset Pricing Model," Journal of Political Economy, University of Chicago Press, vol. 104(3), pages 572-621, June.
    27. Fama, Eugene F. & French, Kenneth R., 1989. "Business conditions and expected returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 25(1), pages 23-49, November.
    28. Jagannathan, Ravi & Wang, Zhenyu, 1996. " The Conditional CAPM and the Cross-Section of Expected Returns," Journal of Finance, American Finance Association, vol. 51(1), pages 3-53, March.
    29. Wayne E. Ferson & Campbell R. Harvey, 1999. "Conditioning Variables and the Cross Section of Stock Returns," Journal of Finance, American Finance Association, vol. 54(4), pages 1325-1360, 08.
    30. K. Rouwenhorst, 1996. "International Momentum Strategies," Yale School of Management Working Papers ysm36, Yale School of Management, revised 01 Feb 2008.
    31. Campbell, John, 1987. "Stock Returns and the Term Structure," Scholarly Articles 3207699, Harvard University Department of Economics.
    32. Andrew Ang & Joseph Chen & Yuhang Xing, 2005. "Downside risk," Proceedings, Board of Governors of the Federal Reserve System (U.S.).
    33. Lawrence R. Glosten & Ravi Jagannathan, 1993. "A contingent claim approach to performance evaluation," Staff Report 159, Federal Reserve Bank of Minneapolis.
    34. Ross, Stephen A., 1976. "The arbitrage theory of capital asset pricing," Journal of Economic Theory, Elsevier, vol. 13(3), pages 341-360, December.
    35. Bollerslev, Tim & Engle, Robert F & Wooldridge, Jeffrey M, 1988. "A Capital Asset Pricing Model with Time-Varying Covariances," Journal of Political Economy, University of Chicago Press, vol. 96(1), pages 116-31, February.
    36. Fama, Eugene F & MacBeth, James D, 1973. "Risk, Return, and Equilibrium: Empirical Tests," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 607-36, May-June.
    37. Wayne Ferson & Tyler R. Henry & Darren J. Kisgen, 2006. "Evaluating Government Bond Fund Performance with Stochastic Discount Factors," Review of Financial Studies, Society for Financial Studies, vol. 19(2), pages 423-455.
    38. William Goetzmann & Jonathan Ingersoll & Matthew Spiegel & Ivo Welch, 2002. "Portfolio Performance Manipulation and Manipulation-Proof Performance Measures," Yale School of Management Working Papers amz2471, Yale School of Management, revised 01 Apr 2006.
    39. Ang, Andrew & Chen, Joseph, 2002. "Asymmetric correlations of equity portfolios," Journal of Financial Economics, Elsevier, vol. 63(3), pages 443-494, March.
    40. Dybvig, Philip H & Ross, Stephen A, 1985. " Differential Information and Performance Measurement Using a Security Market Line," Journal of Finance, American Finance Association, vol. 40(2), pages 383-99, June.
    41. Petkova, Ralitsa & Zhang, Lu, 2005. "Is value riskier than growth?," Journal of Financial Economics, Elsevier, vol. 78(1), pages 187-202, October.
    42. Busse, Jeffrey A, 1999. "Volatility Timing in Mutual Funds: Evidence from Daily Returns," Review of Financial Studies, Society for Financial Studies, vol. 12(5), pages 1009-41.
    43. Kothari, S. P. & Shanken, Jay, 1992. "Stock return variation and expected dividends : A time-series and cross-sectional analysis," Journal of Financial Economics, Elsevier, vol. 31(2), pages 177-210, April.
    44. Ferson, Wayne E & Schadt, Rudi W, 1996. " Measuring Fund Strategy and Performance in Changing Economic Conditions," Journal of Finance, American Finance Association, vol. 51(2), pages 425-61, June.
    45. Kevin Q. Wang, 2003. "Asset Pricing with Conditioning Information: A New Test," Journal of Finance, American Finance Association, vol. 58(1), pages 161-196, 02.
    46. Tano Santos & Pietro Veronesi, 2006. "Labor Income and Predictable Stock Returns," Review of Financial Studies, Society for Financial Studies, vol. 19(1), pages 1-44.
    47. Kent Daniel & David Hirshleifer & Avanidhar Subrahmanyam, 1998. "Investor Psychology and Security Market Under- and Overreactions," Journal of Finance, American Finance Association, vol. 53(6), pages 1839-1885, December.
    48. French, Kenneth R. & Schwert, G. William & Stambaugh, Robert F., 1987. "Expected stock returns and volatility," Journal of Financial Economics, Elsevier, vol. 19(1), pages 3-29, September.
    49. Lakonishok, Josef & Lev, Baruch, 1987. " Stock Splits and Stock Dividends: Why, Who, and When," Journal of Finance, American Finance Association, vol. 42(4), pages 913-32, September.
    50. Harvey, Campbell R., 1989. "Time-varying conditional covariances in tests of asset pricing models," Journal of Financial Economics, Elsevier, vol. 24(2), pages 289-317.
    51. Timothy C. Johnson, 2002. "Rational Momentum Effects," Journal of Finance, American Finance Association, vol. 57(2), pages 585-608, 04.
    52. Hamada, Robert S, 1972. "The Effect of the Firm's Capital Structure on the Systematic Risk of Common Stocks," Journal of Finance, American Finance Association, vol. 27(2), pages 435-52, May.
    53. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
    54. Jacquier, Eric & Polson, Nicholas G & Rossi, Peter E, 1994. "Bayesian Analysis of Stochastic Volatility Models: Comments: Reply," Journal of Business & Economic Statistics, American Statistical Association, vol. 12(4), pages 413-17, October.
    55. Ferson, Wayne E & Harvey, Campbell R, 1993. "The Risk and Predictability of International Equity Returns," Review of Financial Studies, Society for Financial Studies, vol. 6(3), pages 527-66.
    56. Sagi, Jacob S. & Seasholes, Mark S., 2007. "Firm-specific attributes and the cross-section of momentum," Journal of Financial Economics, Elsevier, vol. 84(2), pages 389-434, May.
    57. Wiggins, James B., 1987. "Option values under stochastic volatility: Theory and empirical estimates," Journal of Financial Economics, Elsevier, vol. 19(2), pages 351-372, December.
    58. Jeff Fleming, 2001. "The Economic Value of Volatility Timing," Journal of Finance, American Finance Association, vol. 56(1), pages 329-352, 02.
    59. Fama, Eugene F & French, Kenneth R, 1996. " Multifactor Explanations of Asset Pricing Anomalies," Journal of Finance, American Finance Association, vol. 51(1), pages 55-84, March.
    60. Andersen, Torben G. & Bollerslev, Tim & Diebold, Francis X. & Ebens, Heiko, 2001. "The distribution of realized stock return volatility," Journal of Financial Economics, Elsevier, vol. 61(1), pages 43-76, July.
    61. Henriksson, Roy D & Merton, Robert C, 1981. "On Market Timing and Investment Performance. II. Statistical Procedures for Evaluating Forecasting Skills," The Journal of Business, University of Chicago Press, vol. 54(4), pages 513-33, October.
    62. Bawa, Vijay S. & Lindenberg, Eric B., 1977. "Abstract: Capital Market Equilibrium in a Mean-Lower Partial Moment Framework," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 12(04), pages 635-635, November.
    63. Martin Lettau & Sydney Ludvigson, 1999. "Resurrecting the (C)CAPM: a cross-sectional test when risk premia are time-varying," Staff Reports 93, Federal Reserve Bank of New York.
    64. Ferson, Wayne E & Harvey, Campbell R, 1991. "The Variation of Economic Risk Premiums," Journal of Political Economy, University of Chicago Press, vol. 99(2), pages 385-415, April.
    65. Gregory R. Duffee, 2005. "Time Variation in the Covariance between Stock Returns and Consumption Growth," Journal of Finance, American Finance Association, vol. 60(4), pages 1673-1712, 08.
    66. Korajczyk, Robert A & Lucas, Deborah J & McDonald, Robert L, 1991. "The Effect of Information Releases on the Pricing and Timing of Equity Issues," Review of Financial Studies, Society for Financial Studies, vol. 4(4), pages 685-708.
    67. Campbell R. Harvey & Akhtar Siddique, 2000. "Conditional Skewness in Asset Pricing Tests," Journal of Finance, American Finance Association, vol. 55(3), pages 1263-1295, 06.
    68. Shanken, Jay & Weinstein, Mark I., 2006. "Economic forces and the stock market revisited," Journal of Empirical Finance, Elsevier, vol. 13(2), pages 129-144, March.
    69. Grinblatt, Mark & Titman, Sheridan, 1985. " Approximate Factor Structures: Interpretations and Implications for Empirical Tests," Journal of Finance, American Finance Association, vol. 40(5), pages 1367-73, December.
    70. Jagannathan, Ravi & Korajczyk, Robert A, 1986. "Assessing the Market Timing Performance of Managed Portfolios," The Journal of Business, University of Chicago Press, vol. 59(2), pages 217-35, April.
    71. Lamoureux, Christopher G & Zhou, Guofu, 1996. "Temporary Components of Stock Returns: What Do the Data Tell Us?," Review of Financial Studies, Society for Financial Studies, vol. 9(4), pages 1033-59.
    72. Breen, William & Glosten, Lawrence R & Jagannathan, Ravi, 1989. " Economic Significance of Predictable Variations in Stock Index Returns," Journal of Finance, American Finance Association, vol. 44(5), pages 1177-89, December.
    73. McDonald, Robert L & Siegel, Daniel R, 1985. "Investment and the Valuation of Firms When There Is an Option to Shut Down," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 26(2), pages 331-49, June.
    74. Murray Carlson & Adlai Fisher & Ron Giammarino, 2010. "SEO Risk Dynamics," Review of Financial Studies, Society for Financial Studies, vol. 23(11), pages 4026-4077, November.
    Full references (including those not matched with items on IDEAS)

    This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

    When requesting a correction, please mention this item's handle: RePEc:eee:jfinec:v:102:y:2011:i:2:p:363-389. See general information about how to correct material in RePEc.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Zhang, Lei)

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If references are entirely missing, you can add them using this form.

    If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    This information is provided to you by IDEAS at the Research Division of the Federal Reserve Bank of St. Louis using RePEc data.