PORTFOLIO CHOICES,CONSUMPTION, AND PRICES IN A MARKET WITH DURABLE ASSETS

Recent research in investments has focused almost exclusively on financial assets such as corporate stocks. Although durable assets constitute an important part of investors' holdings, little effort has been made to explore their role in individuals' investments decisions and on assets pricing. This paper establishes results concerning the role of durable assets in the determination of optimum portfolio choices. The paper explores the effect of consumption considerations related to the service flows generated by durable assets on optimum portfolio considerations and asset prices. The main result is tied to the existence, or lack thereof, of efficient rental markets. In the absence of rental markets (or with restrictions on renting), investors' portfolio choices are not independent of consumption considerations as they are assumed to be in the standard CAPM. Individuals may thus hold different portfolios, and prices reflect the owner's inability to trade consumption flows. Under perfect market assumptions with unrestricted rental markets, optimum portfolio choices are undistinguishable from those implied by the standard CAPM in the sense that they are mean-variance efficient and identical for all individuals. Consumption is adjusted by trading service flows in the rental market. Prices, and the price of risk, however, reflect the existence of durable assets service flows as well as the risks involved in trading these flows in the rental market. In the model, risky rental income is introduced by uncertain rental costs. Equilibrium rental rates, an important part of the return expected from holding durable assets, are determined in the context of the mean-variance framework as a function of return and undiversifiable risk.     

On the Exclusion of Assets from Tests of the Mean Variance Efficiency of the Market Portfolio: An Extension

This paper extends Kandel's [3] analysis of the testability of the mean-variance efficiency of a market index when the return on some component of the index is not perfectly observable. In addition to information about the mean and variance of the missing asset, considered by Kandel, we explore the usefulness of information about the beta of the missing asset on the observed sub-portfolio in an economy with a riskless asset. The results are somewhat more supportive of the notion that mean-variance efficiency is testable on a subset of the assets.     

Using Generalized Method of Moments to Test Mean-Variance Efficiency

This paper develops tests of unconditional mean-variance efflciency under weak distributional assumptions using a Generalized Method of Moments framework. These tests are potentially more robust than commonly employed tests which rely on the assumption that asset returns are normally distributed and temporarily i.i.d. Using returns for size-based portfolios from 1926 to 1988 we show that the conclusion concerning the mean-variance effilciency of market indexes can be sensitive to the test considered.     

Characteristic-based mean-variance portfolio choice

We study empirical mean-variance optimization when the portfolio weights are restricted to be direct functions of underlying stock characteristics such as value and momentum. The closed-form solution to the portfolio weights estimator shows that the portfolio problem in this case reduces to a mean-variance analysis of assets with returns given by single-characteristic strategies (e.g., momentum or value). In an empirical application to international stock return indexes, we show that the direct approach to estimating portfolio weights clearly beats a naive regression-based approach that models the conditional mean. However, a portfolio based on equal weights of the single-characteristic strategies performs about as well, and sometimes better, than the direct estimation approach, highlighting again the difficulties in beating the equal-weighted case in mean-variance analysis. The empirical results also highlight the potential for ‘stock-picking’ in international indexes using characteristics such as value and momentum with the characteristic-based portfolios obtaining Sharpe ratios approximately three times larger than the world market.     

Is socially responsible investment useful in Mexico? A multi-factor and ex-ante review

The present paper continues the firsts reviews made to socially responsible investment in Mexico. We extended these reviews by using a non-parametric multivariate equality test, along with a multi-factor market cap model, and a Monte Carlo simulation. Our results show that the IPCS index, the IPCcomp and the IPC have a statistically equal mean-variance performance, suggesting that this sort of investment style (SRI) is a good substitute of the broad market investment style in the long term. Among the causes of this finding is the fact that the IPCS and the IPCcomp indexes have almost the same large and small cap stock concentration and the IPC index (a large-cap one) is not as diversified and mean-variance efficient as the former.     

Term Structures in the Office Rental Market in Stockholm

This paper contains an empirical study of the rental term structure in a property market that included a dramatic boom and bust cycle. The study is applied to office leases in commercial properties located in Stockholm CBD, Sweden. The time period under study is 1977–1991. The number of observations (lease contracts) that we were able to make full use of in the regression analyses is n=861. For seven out of fifteen years studied, a significant term structure was observed. The estimated hedonic rent equation was also used to construct an office rental index.     

A critique of the asset pricing theory's tests Part I: On past and potential testability of the theory

Testing the two-parameter asset pricing theory is difficult (and currently infeasible). Due to a mathematical equivalence between the individual return/‘beta’ linearity relation and the market portfolio's mean-variance efficiency, any valid test presupposes complete knowledge of the true market portfolio's composition. This implies, inter alia, that every individual asset must be included in a correct test. Errors of inference inducible by incomplete tests are discussed and some ambiguities in published tests are explained.     

Conditions Ensuring the Decomposition of Asset Demand for All Risk-Averse Investors

Abstract

The paper explores how the demand for a risky asset can be decomposed into an investment effect and a hedging effect by all risk-averse investors. This question has been shown to be complex when considered outside of the mean-variance framework. Dependence among returns on the risky assets is restricted to quadrant dependence and it is found that the demand for one risky asset can be decomposed into an investment component based on the risk premium offered by the asset and a hedging component used against the fluctuations in the return on the other risky asset. The paper also discusses how the class of quadrant-dependent distributions is related to that of two-fund separating distributions. This contribution opens up the search for broader distributional hypotheses suitable to asset demand models. Examples are discussed.     

Exact distribution-free tests of mean-variance efficiency

This paper develops exact distribution-free tests of unconditional mean-variance efficiency. These new tests allow for unknown forms of non-normalities, conditional heteroskedasticity, and other non-linear temporal dependencies among the absolute values of the error terms in the asset pricing model. Exactness here rests on the assumption that the joint temporal error density is symmetric around zero. This still leaves open the possibility of return distribution asymmetry via coskewness with the benchmark portfolio. A simulation study shows that the new tests have very good power relative to that of many commonly used tests. The inference procedures developed are further illustrated by tests of the mean-variance efficiency of a market index using a 42-year sample of monthly returns on ten U.S. equity portfolios.     

Further Ambiguity When Performance Is Measured by the Security Market Line

This paper employs the optimality conditions for expected utility and mean-variance portfolio problems to examine the ambiguities associated with the security market line criterion both at a point in time and through time. At a point in time, we show that the security market line criterion can be irrelevant, even in meanvariance economies. In a multiperiod setting, we show that the analysis of performance based on portfolio choice is inconsistent with the analysis based on return generating models. Empirical work suggests that the inconsistency can lead to dramatically different estimates of a security's required return.     

Testing for mean-variance spanning: a survey

In this paper, we present a survey on the various approaches that can be used to test whether the mean-variance frontier of a set of assets spans or intersects the frontier of a larger set of assets. We analyze the restrictions on the return distribution that are needed to have mean-variance spanning or intersection. The paper explores the duality between mean-variance frontiers and volatility bounds, analyzes regression-based test procedures for spanning and intersection, and shows how these regression-based tests are related to tests for mean-variance efficiency, performance measurement, optimal portfolio choice and specification error bounds.     

Mean-Gini,Portfolio Theory,and the Pricing of Risky Assets

This paper presents the mean-Gini (MG) approach to analyze risky prospects and construct optimum portfolios. The proposed method has the simplicity of a mean-variance model and the main features of stochastic dominance efficiency. Since mean-Gini is consistent with investor behavior under uncertainty for a wide class of probability distributions, Gini's mean difference is shown to be more adequate than the variance for evaluating the variability of a prospect. The MG approach is then applied to capital markets and the security valuation theorem is derived as a general relationship between average return and risk. This is further extended to include a degree of risk aversion that can be estimated from capital market data. The analysis is concluded with the concentration ratio to allow for the classification of different securities with respect to their relative riskiness.     

The likelihood ratio test statistic of mean-variance efficiency without a riskless asset

The question whether a given porfolio is mean-variance efficient is a basic problem of investment analysis. Mean-variance efficiency is also the basis of the Capital Asset Pricing Model. This paper presents the explicit form of the likelihood ratio test of the hypothesis that a given portfolio, or a particular market index, is ex-ante mean-variance efficient in the case where there is no riskless asset. Geometric relations are illustrated to provide intuition about the constrained maximum likelihood estimators and the test statistic, and two simple economic interpretations of the test are given.     

The use of domestic and world market indexes in the estimation of time-varying betas

This paper generates time-varying estimates of Australian industry betas relative to an Australian market index and a world market index using the Kalman filter approach. As a means of comparison, these conditional estimated betas are used to forecast each industry’s return in-sample. The forecast error metrics suggest that the estimates of conditional risk relative to the domestic market index are preferred to estimates generated using the world market index, irrespective of the industry concerned. While not to suggest time-varying betas estimated relative to a domestic index are universally superior, these results suggest that they are preferable in certain circumstances.     

On the Cross-sectional Relation between Expected Returns and Betas

There is an exact linear relation between expected returns and true “betas” when the market portfolio is on the ex ante mean-variance efficient frontier, but empirical research has found little relation between sample mean returns and estimated betas. A possible explanation is that market portfolio proxies are mean-variance inefficient. We categorize proxies that produce particular relations between expected returns and true betas. For the special case of a zero relation, a market portfolio proxy must lie inside the efficient frontier, but it may be close to the frontier.     

Testing for Mean-Variance Spanning with Short Sales Constraints and Transaction Costs: The Case of Emerging Markets

We propose regression-based tests for mean-variance spanning in the case where investors face market frictions such as short sales constraints and transaction costs. We test whether U.S. investors can extend their efficient set by investing in emerging markets when accounting for such frictions. For the period after the major liberalizations in the emerging markets, we find strong evidence for diversification benefits when market frictions are excluded, but this evidence disappears when investors face short sales constraints or small transaction costs. Although simulations suggest that there is a possible small-sample bias, this bias appears to be too small to affect our conclusions.     

Cross-sectional determinants of New Zealand share market returns

We present evidence of the cross-sectional relation between security returns, beta, firm size and book-to-market ratio over the period 1971 to 1993 on the New Zealand sharemarket. Our results suggest that the NZSE-40 market index is not a mean-variance efficient market proxy—the betas calculated with respect to it being of little use for explaining expected returns cross-sectionally. Also, there is a significant positive relation between book-to-market ratio and average return.     

Mean-variance optimization using forward-looking return estimates

Despite its theoretical appeal, Markowitz mean-variance portfolio optimization is plagued by practical issues. It is especially difficult to obtain reliable estimates of a stock’s expected return. Recent research has therefore focused on minimum volatility portfolio optimization, which implicitly assumes that expected returns for all assets are equal. We argue that investors are better off using the implied cost of capital based on analysts’ earnings forecasts as a forward-looking return estimate. Correcting for predictable analyst forecast errors, we demonstrate that mean-variance optimized portfolios based on these estimates outperform on both an absolute and a risk-adjusted basis the minimum volatility portfolio as well as naive benchmarks, such as the value-weighted and equally-weighted market portfolio. The results continue to hold when extending the sample to international markets, using different methods for estimating the forward-looking return, including transaction costs, and using different optimization constraints.

     

Testing asset pricing models with changing expectations and an unobservable market portfolio

When the assumption of constant risk premiums is relaxed, financial valuation models may be tested, and risk measures estimated without specifying a market index or state variables. This is accomplished by examining the behavior of conditional expected returns. The approach is developed using a single risk premium asset pricing model as an example and then extended to models with multiple risk premiums. The methodology is illustrated using daily return data on the common stocks of the Dow Jones 30. The tests indicate that these returns are consistent with a single, time-varying risk premium.     

Investor attention,index performance,and return predictability

We investigate a link between the performance of several security indexes in broad investment categories and investor attention as measured by Google search probability. We find that there is a significant short-term change in index returns following an increase in attention. Conversely, a shock to returns leads to a long-term change in attention. Given this evidence, we hypothesize that a change in index return or the sign of its return in the past can indicate the nature of the information that investors are paying attention to. Therefore, past returns should determine the impact of attention on the future returns and volatility. Indeed, we find significant interaction effects between lagged returns and attention. This result suggests that attention can alter predictability of index returns. Specifically, we demonstrate that increased investor attention diminishes return predictability and, therefore, improves market efficiency.