The accruals effect is a central concept in quantitative trading. This investment strategy based on accruals information has been studied in depth since Sloan's pioneering work in 1996.

👉 Percent Accruals by Nader Hafzalla is an example of an accruals effect algo trading strategy.

The accrual effect refers to a stock selection strategy based on accrual information. An accrual is an accounting entry relating to the recording of a revenue or expense paid without any exchange of cash. To illustrate, let's take the example of a utility company that supplies electricity in December, but only invoices its customers in January after the meters have been read. For the financial statements to reflect the appropriate amounts, an adjusting entry is required to increase the revenue earned in December.

The phenomenon was first documented by Sloan in 1996, who demonstrated a negative association between accounting accruals (the non-cash component of earnings) and subsequent stock market returns. This discovery prompted a great deal of research, confirming the implications of accruals for returns in subsequent periods.

Sloan (1996) suggests that the accruals effect is due to investors' misunderstanding of the different persistence of accruals versus cash flows for future earnings. However, some research questions a persistence-based explanation for the effect of accruals.

Moreover, the effect of accruals has been observed internationally. Pincus et al (2005) found evidence of mispricing of accruals in Australia, Canada, the UK and the USA. They argue that the inter-country variation in the existence of accruals anomaly is due to differences in institutional characteristics between countries.

An accrual-based strategy generally consists of buying low-accretion stocks and shorting high-accretion stocks. However, it is essential to note that the accrual anomaly is concentrated in small-cap, illiquid stocks with volatile market returns.

For algorithmic traders, the accruals effect can be exploited by developing predictive models based on company accounting data. These models can help identify which stocks are likely to outperform or underperform the market based on their accruals. Moreover, by combining this strategy with rigorous fundamental analysis, it is possible to achieve excess returns.

The accrual effect is a well-established phenomenon in the literature on finance and quantitative trading. By understanding this phenomenon and exploiting it appropriately, traders can develop robust strategies for navigating the financial markets. However, as with any trading strategy, it is essential to be aware of the associated risks and to always carry out thorough due diligence before making any investment decisions.

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