The purpose of this thesis was to address how the value, momentum and quality factors could be utilized to create profitable value investment portfolios, and analyze the performance of these portfolios in the US.
To address the research question, we assessed the performance of a value portfolio based on the HML-devil factor. We further constructed dynamic value-momentum and value-quality tangency portfolios with semi-annually rebalancing.
Our findings suggest that the value, momentum and quality factors can be combined into profitable portfolios. We further find that it is preferable to combine value with either momentum or quality, as their negative correlation provides an effective diversification effect, which yields a large risk-adjusted return. Over the analyzed holding period, we found that all the portfolios returned a robust premium, but none returned a higher premium than the US market index. However, as the value, momentum and quality factors were negatively correlated, the combined portfolios outperformed both the market index and pure value portfolio measured on risk-adjusted return, as the diversification benefit amongst the factors largely reduced the risk. The best performing portfolio was the value-momentum combination, which yielded an excess return premium of 0,51% and Sharpe ratio of 0,32 monthly. However, the momentum factor was largely affected when adjusting the performance for costs, due to its short-term nature. After taking transaction cost into account, the value-quality portfolio returned both a higher premium and Sharpe ratio, than both the value and value-momentum portfolio. A passive investment in the US market index proved to yield the highest premium after costs, but lagged both value-momentum and value-quality on a risk-adjusted return basis.
Our portfolios are constructed from market anomalies discovered by academics, and adds to the discussion regarding EMH and behavioral finance. We tested our findings against CAPM and Fama and French’s (1993) three-factor model. According to EMH, returns are explained from risk exposures, contrary to the behavioral school who argues that the market is irrational in its pricing. All the portfolios yield an alpha when regressed against CAPM, indicating that the performance cannot be explained by exposure to systematic market risk alone. As the value portfolio is constructed from B/M-ratios, slightly modified from those used by Fama-French in their three-factor model, the value portfolio was fully explained when regressing the returns against their model. However, the
value-Conclusion
Page 113 of 118 momentum and value-quality portfolios still had unexplained returns after regressing the returns from these portfolios against the three-factor model. As the value part are fully explained, the performance of the momentum and quality part are due to other factors not captured by CAPM and the three-factor model, or behavioral biases leading to pricing errors in the market.
To summarize, we find that a value premium have existed in the US historically, but that a combination of value with either momentum or quality improves the premium and risk-adjusted returns.
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Page 114 of 118
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