The investment value of the value premium

Value investment strategies are premised on research that value stocks outperform growth stocks. However, the research findings are dependent on the portfolio classification method that is used to sort stocks using the attributes of size and book-to-market ratios. Different stock markets contain different distributions of stocks, and in many markets, illiquidity concerns combined with a lack of investment scale, effectively create barriers to practical portfolio formations that align with the research. This study conducts a case study on one such market (Australia) and demonstrates that different methods of portfolio formation lead to different conclusions. For example, previous studies in Australia find evidence of the value premium only being present in the largest stocks, in contrast to the results from the US market. However, we find a value premium that is systematic across all size categories and generally increases inversely with size. Further, we find the well-documented size premium largely disappears once portfolios are formed that better represent feasible investment sets and once ‘penny dreadfuls’ are removed. Finally, asset pricing tests support the existence of a value premium in Australian stock returns when a more appropriate portfolio formation method is employed.     

INTERNATIONAL DIVERSIFICATION OF EQUITIES AND FIXED-INCOME SECURITIES

Portfolio selection models have been applied principally to common stocks traded in the United States and in foreign stock markets. This study examines the efficient set of portfolios selected from a choice set that includes returns derived from domestic and international corporate bond and government bond indices as well as domestic and international stock indices. To assess the benefits of international multi-asset diversification, the authors examine the following issues: (1) the extent to which international and domestic fixed-income securities are included in efficient portfolios; (2) the effect on efficient set composition of using the Sharpe portfolio selection model as compared to the Markowitz portfolio selection model; (3) the sensitivity of efficient set characteristics produced from a single-index based portfolio selection model to alternative world market indices; and (4) the correspondence between expected and realized portfolio risk and return for the different portfolio selection models.     

Responsible investment in the Chinese stock market

This paper provides insights into the current development of responsible investment in the Chinese stock market. We find that responsible investment can bring portfolio benefits to investors, and institutional investors have a holding preference for stocks in responsible investment indexes. By using a national air pollution proxy, we find that investors’ pessimistic mood on days with heavy air pollution has a negative influence on the stock return of A-shares, while stocks in responsible investment indexes display improved performance over the same time period. We use aggregated trading data to study the trading preference of Chinese retail investors on days when they are influenced by air pollution, and find that their total trading ratio shows a negative influence for both A-shares and responsible investment indexes. Moreover, there is more seller-initiated trading of the whole sample but more buyer-initiated trading of stocks in responsible investment indexes on air pollution days. This finding is consistent with the different stock return performances of these two samples. Our finding extends the studies of responsible investment to emerging markets and presents new evidence about the influence of environmental factors on trading behavior and return performance.     

Are paper winners gamblers? Evidence from Australian retail investors

This study examines stock market gambling using a comprehensive set of investor characteristics and past portfolio performance measures. We find that retail investors overinvest in ‘lottery stocks’, stocks with gambling‐like properties. Significant portfolio underperformance is the result of gambling through lottery stocks. Investors are more likely to gamble following recent portfolio paper gains, regardless of realised performance, providing new evidence that paper gains trigger a house money effect. Investors trading greater values or holding more stocks, and older and female investors, are less likely to invest in lottery stocks.     

Portfolio strategies and performance

The relative performance of several portfolio selection strategies is assessed empirically. These strategies vary in sophistication from a ‘naive’ strategy of maintaining equal dollar investments in each stock available to a strategy that periodically uses updated parameter estimates to calculate new optimal proportions of portfolio value to be invested in the stocks available. Although it is to be expected a priori that relatively sophisticated strategies will perform at least as well as the more naive strategies, implementation costs will clearly differ across strategies and across investor-specific parameters such as total portfolio value. Thus estimation of the various strategies' performance gross of these costs is a necessary consideration in rational strategy selection by any given investor.     

Risk Reduction and Mean-Variance Analysis: An Empirical Investigation

Abstract:  I examine the performance of global minimum variance (GMV) and minimum tracking error variance (TEV) portfolios in UK stock returns using different models of the covariance matrix. I find that both GMV and TEV portfolios deliver portfolio risk reduction benefits in terms of significantly lower volatility and tracking error volatility relative to passive benchmarks for every model of the covariance matrix used. However, the GMV (TEV) portfolios do not provide significantly superior Sharpe (1966) (adjusted Sharpe) performance relative to passive benchmarks except for the restricted GMV portfolios. I find that a number of alternative covariance matrix models can improve the performance of the restricted TEV portfolio formed using the sample covariance matrix but not the restricted GMV portfolio. I also find that simpler covariance matrix models perform as well as the more sophisticated models.     

The Effects of Stock Characteristics on the Direction and Extent of Herding by Foreign Institutional Investors in the Taiwan Stock Exchange

We use a dynamic herding measure to explore the causes of foreign institutional investor (FII) herding in the Taiwan stock market and examine the effects of stock characteristics on the direction and extent of such herding. We find that FII herding primarily results from cascades rather than habit investing or momentum trading. The result of a panel smooth transition regression shows that FIIs' negative cascades focus on their largest net purchases of stocks, but FIIs' positive cascades focus on winner and small-sized stocks. To increase portfolio returns, investors can use FIIs' cascades to inform their stock purchases.     

Do Socially Responsible Index Investors Incur an Opportunity Cost?

We construct index‐tracking portfolios using integer programming and then compare the tracking errors and performances of portfolios formed from an unrestricted and socially screened stock universe. We find that one can construct a portfolio of socially responsible stocks that deliver market performance. Thus, the exclusion of a set of stocks from consideration does not exhaust the existence of efficient index‐tracking portfolios, especially when the exclusionary screen is for nonfinancial reasons. Our results are robust to various specifications in constructing the portfolio, for example, number of stocks included in the portfolio and weighting schemes, and robust to alternative tracking error measurement; we show that the difference induced from conducting socially responsible screen is never statistically significant.     

Gold and US sectoral stocks during COVID-19 pandemic

In this study, we examine the hedging relationship between gold and US sectoral stocks during the COVID-19 pandemic. We employ a multivariate volatility framework, which accounts for salient features of the series in the computation of optimal weights and optimal hedging ratios. We find evidence of hedging effectiveness between gold and sectoral stocks, albeit with lower performance, during the pandemic. Overall, including gold in a stock portfolio could provide a valuable asset class that can improve the risk-adjusted performance of stocks during the COVID-19 pandemic. In addition, we find that the estimated portfolio weights and hedge ratios are sensitive to structural breaks, and ignoring the breaks can lead to overestimation of the hedging effectiveness of gold for US sectoral stocks. Since the analysis involves sectoral stock data, we believe that any investor in the US stock market that seeks to maximize risk-adjusted returns is likely to find the results useful when making investment decisions during the pandemic.     

Large returns,conditional correlation and portfolio diversification: a value-at-risk approach

This paper, using daily returns on 30 Dow Jones Industrial stocks for the period 1991-1999, investigates the possibility of portfolio diversification when there are negative large movements in the stock returns (i.e. when the market is bearish). We estimate the quantiles of stock return distributions using non-parametric and parametric methods that are widely being used in measuring value-at-risk (VaR). We find that the average conditional correlation of 30 stocks is much higher when the large movements are negative than that when the market is 'usual'. Further, we find that, contrary to the results of previous studies, there is no notable difference between the average conditional correlations when the large movements are positive and when the market is 'usual'. Moreover, it is evident from the results of the conditional CAPM that the portfolio's diversifiable and non-diversifiable risks, as measured by the error variance of the CAPM and beta respectively, are highly unstable when the market is bearish than that when it is 'usual' or bullish. The overall results suggest that the possibility of portfolio diversification would be eroded when the stock market is bearish. These findings have implications for portfolio diversification and risk management in particular and for finance in general. The ideas presented in this paper can be utilized for testing contagion in the international financial markets, a much-researched topic in international finance.     

Investor Inattention and the Underreaction to Stock Recommendations

Investors’ reaction to stock recommendations is often incomplete so that there is a predictable postrecommendation drift. I investigate investor inattention as a plausible explanation for this drift by using prior turnover as a proxy for attention. I find that low-attention stocks react less to stock recommendations than high-attention stocks around the three-day event window. Subsequently, the recommendation drift of firms with low attention is more than double in magnitude when compared to firms with high attention. Similar conclusions are reached with alternative proxies for attention. The evidence supports investor inattention as a source of the stock recommendation drift.     

Optimal Number of Stock Holdings in Mutual Fund Portfolios Based on Market Performance

Among the decisions that most mutual fund portfolio managers make is the number of stocks to hold. We posit that there is an optimal number of stocks for each mutual fund, reflecting the trade‐off between diversification benefits versus transactions and monitoring costs. We find a significant quadratic relation between number of stock holdings and risk‐adjusted returns for U.S. equity mutual fund portfolios during 1992–2000. Moreover, we find that changes in the number of stocks held over time are more highly correlated with mutual fund flows than with funds' investment returns.     

The relationship between asset growth and the cross-section of stock returns

There is a large body of literature examining the association between stock characteristics and the cross-section of stock returns in international markets. Recently, Cooper et al. (2008) reported a strong association between total asset growth and stock returns in the US. In this paper, we show that an asset-growth effect also exists in the Australian equity market. Of particular interest, it is present amongst the largest Australian stocks. Over the 1983-2007 period, an equally-weighted portfolio of low-growth Big stocks outperforms a portfolio of high-growth Big stocks by an average 1% per month, equating to nearly 13% per annum. At an individual stock level of analysis, the asset-growth effect remains even after controlling for other variables whose association with the cross-section of returns is well known. Finally, we explicitly test whether asset growth is a priced risk factor using the common two-stage cross-sectional regression methodology. We find no evidence to support a risk-based explanation, thereby lending credence to Cooper et al.’s (2008) suggestion that the asset-growth effect is attributable to mispricing.     

International portfolio diversification benefits: Cross-country evidence from a local perspective

We investigate how the benefits of international portfolio diversification differ across countries from the perspective of a local investor. We find that the benefits of investing abroad are largest for investors in developing countries, including when controlling for currency effects. Most of the benefits are obtained from investing outside the region of the home country. These global diversification benefits remain large when controlling for short-sales constraints in developing stock markets. The gains from international portfolio diversification appear to be largest for countries with high country risk. In addition to this cross-sectional evidence, we also provide evidence that diversification benefits vary over time as country risk changes. We find that diversification benefits have decreased for most countries in our sample over the past two decades.     

Measuring Mutual Fund Performance with Characteristic-Based Benchmarks

This article develops and applies new measures of portfolio performance which use benchmarks based on the characteristics of stocks held by the portfolios that are evaluated. Specifically, the benchmarks are constructed from the returns of 125 passive portfolios that are matched with stocks held in the evaluated portfolio on the basis of the market capitalization, book-to-market, and prior-year return characteristics of those stocks. Based on these benchmarks, “Characteristic Timing” and “Characteristic Selectivity” measures are developed that detect, respectively, whether portfolio managers successfully time their portfolio weightings on these characteristics and whether managers can select stocks that outperform the average stock having the same characteristics. We apply these measures to a new database of mutual fund holdings covering over 2500 equity funds from 1975 to 1994. Our results show that mutual funds, particularly aggressive-growth funds, exhibit some selectivity ability, but that funds exhibit no characteristic timing ability.     

Are investors consistent in their trading strategies? An examination of individual investor-level data

While it has been demonstrated that momentum or contrarian trading strategies can be profitable in a range of institutional settings, less evidence is available concerning the actual trading strategies investors adopt. Standard definitions of momentum or contrarian trading strategies imply that a given investor applies the same strategy to both their buy and sell trades, which need not be the case. Using investor-level, transaction-based data from China, where tax effects are neutral, we examine investors' buy-sell decisions separately to investigate how past returns impact differentially on the trading strategies investors adopt when buying and selling stock. After controlling for a wide range of stock characteristics, extreme price changes and portfolio value, a clear asymmetry in trading is observed; with investors displaying momentum behavior when buying stocks, but contrarian behavior when selling stocks. This asymmetry in behavior is not driven purely by reactions to stock characteristics or extreme stocks. We discuss behavioral and cultural explanations for our findings.     

Conditional portfolio allocation: Does aggregate market liquidity matter?

This paper investigates how aggregate liquidity influences optimal portfolio allocations across various US characteristic portfolios. We consider short-term allocation problems, with single and multiple risky assets, and use the nonparametric approach of Brandt (1999) to directly express optimal portfolio weights as functions of aggregate liquidity shocks. We find, first, that the effect of aggregate liquidity is positive and decreasing with the investment horizon. Second, at daily and weekly horizons, this effect is weaker on allocations in large stocks and gets stronger as we move toward small stocks, regardless of the other stock characteristics, suggesting that liquidity is the main concern of very short-term investors. Third, conditional allocations in risky assets decrease and exhibit shifts toward more liquid assets as aggregate liquidity worsens. Overall, conditioning on aggregate liquidity yields empirical results that are consistent with the so-called flight-to-safety and flight-to-liquidity episodes. Finally, we propose a simple tactical investment strategy and show how aggregate liquidity information can be exploited to enhance the out-of-sample performance of long-term strategies.     

Is the Value Spread a Good Predictor of Stock Returns? UK Evidence

Abstract:  This paper explores the predictive ability of the value spread in the UK. I replicate the US analysis of Liu and Zhang (2007) using UK data. In addition, I extend their work by exploring the predictive ability of the book-to-market, market-to-book and value spread on other size and value investment strategies, namely: large-caps only; small-caps minus large-caps (SML); value stocks only; growth stocks only; value stocks minus growth stocks (VMG) and a market portfolio that includes all stocks. The results are consistent with Liu and Zhang (2007) on the value spread. The value spread shows no predictive power for portfolio returns. Therefore, I show that the predictive power of book-to-market and market-to-book spreads depend on the portfolio formation strategies and the relative proportion of small-cap, large-cap, value and growth stocks in the portfolio.     

A semiparametric graphical modelling approach for large-scale equity selection

We propose a new stock selection strategy that exploits rebalancing returns and improves portfolio performance. To effectively harvest rebalancing gains, we apply ideas from elliptical-copula graphical modelling and stability inference to select stocks that are as independent as possible. The proposed elliptical-copula graphical model has a latent Gaussian representation; its structure can be effectively inferred using the regularized rank-based estimators. The resulting algorithm is computationally efficient and scales to large data-sets. To show the efficacy of the proposed method, we apply it to conduct equity selection based on a 16-year health care stock data-set and a large 34-year stock data-set. Empirical tests show that the proposed method is superior to alternative strategies including a principal component analysis-based approach and the classical Markowitz strategy based on the traditional buy-and-hold assumption.     

Social media effect,investor recognition and the cross-section of stock returns

Investor recognition affects cross-sectional stock returns. In informationally incomplete markets, investors have limited recognition of all securities, and their holding of stocks with low recognition requires compensation for being imperfectly diversified. Using the number of posts on the Chinese social media platform Guba to measure investor recognition of stocks, this paper provides a direct test of Merton's investor recognition hypothesis. We find a significant social media premium in the Chinese stock market. We further find that including a social media factor based on this premium significantly improves the explanatory power of Fama-French factor models of cross-sectional stock returns, and these results are robust when we control for the mass media effect and liquidity effect. Finally, we find that investment strategies based on the social media factor earn sizable risk-adjusted returns, which signifies the importance of the social media premium in portfolio management.