The effect of sector quality in quality minus junk : the quality puzzle deepens

Abstract

In this thesis we test whether sector quality effects drive the abnormal returns of the Quality Minus Junk (QMJ) strategy. We find that the strategy makes involuntarily sector bets, as it invests in outperforming sectors rather than individual quality stocks. This implies that sector quality effects partially drive the QMJ abnormal returns. A consequence of the sector quality effects is lack of diversification in the QMJ strategy. Having established that sector quality effects partially drive QMJ abnormal returns, we create a sector neutral QMJ that is restricted to how aggressively it can invest in sectors. This strategy is more diversified than the unrestricted QMJ but does not match its performance in terms of abnormal returns and Sharpe ratio. We volatility-manage the sector neutral strategy and find that it yields significant abnormal returns and Sharpe ratio of the same magnitude as the unrestricted QMJ strategy. In other words, the volatility-managed strategy does not bet on outperforming sectors, and still performs well in return tests. Therefore, the QMJ abnormal returns cannot be explained by sector quality effects, and the quality puzzle deepens.