Discussion of the hypotheses

Discussion

Page 101 of 118

Discussion

Page 102 of 118 Hypothesis 2: Liberalization of the capital markets, and reduced barriers to entry, have

improved the efficiency of the market, lowering the profitability of value investments.

When dividing the performance of our portfolio into time baskets, we found that all the portfolios returned a lower premium and Sharpe ratio after the breakpoint set at 1985, than compared to the years before. Contrary, the US market index increased its yearly premium from 4,69% before 1985 to 7,79% after, and its Sharpe ratio increased from 0,32 to 0,52. Even though the market has returned the highest premium after 1985, the Sharpe ratio still lacks the value-momentum and value-quality ratios before adjusting for costs. When taking costs into account, a passive investment in the US market index outperforms the value portfolios after 1985, measured on Sharpe ratios. When dividing the portfolios into six time baskets based on shorter periods, we find that the premiums have been rather volatile over the different time-baskets. However, the US market index have been superior to the value portfolios since 2010, based on both the premium and Sharpe ratio.

As the market has become more liberalized over the years, and barriers to entry have been reduced due to easier access to online trading and lower costs, our findings imply that the profitability of value investing strategies have diminished. However, the diversification obtained in the combined portfolios provides a less risky investment opportunity than the US market index measured on standard deviation. Contrary to the pure value portfolio and market index, none of the combined portfolios returned a negative premium in any of the six time baskets. The portfolios were also less affected than the market in the 2000-2009 time basket, which contains both the collapse of the dot-com bubble and the financial crisis. Even though our findings back the hypothesis that the value premiums have been lowered as markets has become more liberalized, they still proved less volatile than a passive market index investment. Based on our findings, we accept the hypothesis, as the premium from all the value strategies have decreased, contrary to the market which have improved.

Discussion

Page 103 of 118 Hypothesis 3: The quantitative constructed value portfolios are superior to the discretionary

approach used by Warren Buffett, as it minimizes behavioral biases and errors in human judgement.

Buffett manages to outperform all of the strategies analyzed in this thesis, as well as the US market index. From 1958-2016 he has six years with negative excess returns, compared to the value-momentum portfolio with four years of negative excess returns. However, Buffett significantly outperform the value-momentum portfolio, before transaction cost, with a staggering average of 9,6%

on yearly basis. Even though he uses a discretionary approach, which should be more vulnerable to human error, he has been superior to the quantitative factor value strategies we have analyzed. We therefore reject the hypothesis. However, for the average investor, a quantitative investing strategy could still be useful in order to minimize human judgement errors.

Hypothesis 4: Observing key macroeconomic indicators, and forecasting their future development, can help investors decide on how to allocate capital most efficiently, based on the economic development.

In chapter 5 we tested the performance of the portfolios during four different states of the economy.

We found that combining value with either momentum or quality resulted in portfolios less impacted by changes in the economy. Contrary to the pure value portfolio and US market index, neither of the combined value portfolios returned a negative premium during each of the economic states. We found that value-quality is favorable in challenged economic times, as the portfolio returns the highest premiums and Sharpe ratios during economic contraction and recessions. The US market index was favorable in a recovering economy, but due to the diversification between the investment factors, value-momentum yielded the highest Sharpe ratio during an expanding and recovering economy. As quality perform best during contractions and recessions measured on Sharpe ratios, and value-momentum performs best during expansions and recoveries, investors can profit by allocating capital between these investment options at different economic times. To make investors able to effectively allocate capital to counter economic fluctuations, we compared the indicators CCI, PMI and a macro composite index, to assess their ability to predict the economic development. Our analysis showed that the macro composite index, composed of ten leading and lagging indicators, predicted correctly 44,33% of the times. However, the leading indicator, PMI, was most effective with least deviation

Discussion

Page 104 of 118 when comparing the squared forecasting errors. We therefore conclude that investors, to some extent, can use the development of the PMI to estimate the economic development, and use this measure to base macroeconomic capital allocation decisions. As noted in chapter 5, we use actual recessions and estimate economic expansions, contractions and recoveries from this. As our method estimates three out of the four economic state, some noise is introduced into the comparison of the indicators predicting ability. However, we argue the analysis is useful in estimating the economic development.

We therefore accept the hypothesis to some extent, and recommend that investors follow the macroeconomic development closely. We can’t conclude that investors can base their capital allocation decisions from predicting the economic development precisely, as previous results have shown that timing strategies are of poor performance. Therefore, the hypothesis cannot be fully accepted.