Returning to Quality: An Empirical Investigation of Short Sale Constraints Effect on a Quality Investment Strategy

Abstract: This paper examines an investment strategy relying on underlying characteristics of stocks and how market efficiency drives its returns. By using the recently published quality-minus-junk factor this paper attempts to explain the abnormal performance of portfolios sorted on their quality score by using a natural experiment which interferes with market efficiency. Using data from the U.S. and the SEC SHO pilot program it is shown that the returns associated with quality investing is significantly affected by varying degrees of short sale constraint. This effect is negative in size indicating that a quality investment strategy fares better in times of low market efficiency.