Does it pay to be ethical? Evidence from the FTSE4Good

The empirical mean–variance evidence comparing the performance of Socially Responsible Investments (SRI) and conventional investments suggests that there is no significant difference between the two. This paper re-examines the problem in the context of Marginal Conditional Stochastic Dominance (MCSD), which can accommodate any return distribution or concave utility function. Our results provide strong evidence that there is a financial price to be paid for socially responsible investing. Indices composed of socially responsible firms are MCSD dominated by trademarked indices composed of conventional firms as well as by indices carefully matched by size and industry with the firms in the SRI indices. Zero cost portfolios created by shorting the SRI index and using the proceeds to invest in the conventional index generate higher average returns, lower variance and higher skewness than either of the two indices standing alone. They also MCSD dominate the SRI and conventional indices standing alone.     

A note on the returns from minimum variance investing

Disappointed with the performance of market weighted benchmark portfolios yet skeptical about the merits of active portfolio management, investors in recent years turned to alternative index definitions. Minimum variance investing is one of these popular concepts. I show in this paper that the portfolio construction process behind minimum variance investing implicitly picks up risk-based pricing anomalies. In other words the minimum variance tends to hold low beta and low residual risk stocks. Long/short portfolios based on these characteristics have been associated in the empirical literature with risk adjusted outperformance. This paper shows that 83% of the variation of the minimum variance portfolio excess returns (relative to a capitalization weighted alternative) can be attributed to the FAMA/FRENCH factors as well as to the returns on two characteristic anomaly portfolios. All regression coefficients (factor exposures) are highly significant, stable over the estimation period and correspond remarkably well with our economic intuition. The paper also shows that a direct combination of market weighted benchmark portfolio and risk based characteristic portfolios will provide a statistically significant improvement over the indirect pickup via the minimum variance portfolio.     

Abnormal Returns from Takeover Prediction Modelling: Challenges and Suggested Investment Strategies

While takeover targets earn significant abnormal returns, studies tend to find no abnormal returns from investing in predicted takeover targets. In this study, we show that the difficulty of correctly identifying targets ex ante does not fully explain the below‐expected returns to target portfolios. Target prediction models’ inability to optimally time impending takeovers, by taking account of pre‐bid target underperformance and the anticipation of potential targets by other market participants, diminishes but does not eliminate the potential profitability of investing in predicted targets. Importantly, we find that target portfolios are predisposed to underperform, as targets and distressed firms share common firm characteristics, resulting in the misclassification of a disproportionately high number of distressed firms as potential targets. We show that this problem can be mitigated, and significant risk‐adjusted returns can be earned, by screening firms in target portfolios for size, leverage and liquidity.     

Constructing inverse factor volatility portfolios: A risk-based asset allocation for factor investing

In this study, we investigate risk-based asset allocation approaches for factor investing strategies by constructing a multifactor portfolio based on the inverse weighting method. We propose the inverse factor volatility (IFV) strategy, which is the simplified variant of a factor risk parity, assuming constant factor correlation. In IFV portfolio construction, the portfolio's weights are determined by using scaled inverse factor volatility treated as a proxy for a targeted exposure in the optimization. Based on daily stock and index returns on global markets from 2002 to the end of 2017, we implemented the empirical analysis of IFV portfolios among three stock markets: Japan, Euro, and the US. The results obtained reveal that the IFV portfolios significantly outperformed market capitalization weighted portfolios by successfully acquiring factor risk premiums.     

Are investors really home-biased when investing at home?

Investors who only invest in their domestic market are typically referred to as being home-biased. We refer to firm-level internationalization and call into question whether investing in domestic stock indices actually leads to home bias. We use three measures of firm-level internationalization based on percentages of foreign sales, employees in foreign countries, and foreign tax payments. We aggregate firm-level results to determine the degree of internationalization of German, French, UK and US stock indices. French and UK stock indices exhibit the largest degree of internationalization. The German index provides slightly less internationalization, whereas internationalization of the US index is lowest but nonetheless considerable. This means that investors who invest in their domestic market do not necessarily suffer from home bias. Instead, investing in domestic stock indices more likely prevents investors from a home bias instead of entrapping them to insufficient portfolios.     

Lead–Lag Effects in Australian Industry Portfolios

This study finds that returns to stocks with relatively high market capitalizations lead returns to stocks with relatively low market capitalizations in Australian industry portfolios. These lead–lag patterns or positive cross-correlations are found in both daily and weekly returns and continue to hold even after the market factor is removed. The results for weekly returns are consistent with the findings of Hou (Rev Fin Stud 20:1113–1138, 2007) who found significant lead–lag effects in weekly returns to US industry portfolios. However while that study found stronger lead–lag effects for industries with relatively small average market capitalizations this study finds that industries with larger average market capitalizations have stronger lead–lag effects. This may be caused by industry momentum created by positive news to the leader stocks of an industry, and implies investors can gain significantly by investing in the smaller firms of prominent industries, following an earlier shock to the corresponding leader stocks.     

Style investing,comovement and return predictability

Barberis and Shleifer (2003) argue that style investing generates momentum and reversals in style and individual asset returns, as well as comovement between individual assets and their styles. Consistent with these predictions, in some specifications, past style returns help explain future stock returns after controlling for size, book-to-market and past stock returns. We also use comovement to identify style investing and assess its impact on momentum. High comovement momentum portfolios have significantly higher future returns than low comovement momentum portfolios. Overall, our results suggest that style investing plays a role in the predictability of asset returns.     

Nonlinear mean reversion in stock prices

This paper provides new evidence on the time-series predictability of stock market returns by introducing a test of nonlinear mean reversion. The performance of extreme daily returns is evaluated in terms of their power to predict short- and long-horizon returns on various stock market indices and size portfolios. The paper shows that the speed of mean reversion is significantly higher during the large falls of the market. The parameter estimates indicate a negative and significant relation between the monthly portfolio returns and the extreme daily returns observed over the past one to eight months. Specifically, in a quarter in which the minimum daily return is −2% the expected excess return is 37 basis points higher than in a month in which the minimum return is only −1%. This result holds for the value-weighted and equal-weighted stock market indices and for each of the size decile portfolios. The findings are also robust to different sample periods, different indices, and investment horizons.     

Options Trading and the CAPM

This article studies equilibrium asset pricing when agents facenonnegative wealth constraints. In the presence of these constraintsit is shown that options on the market portfolio are nonredundantsecurities and the economy's pricing kernel is a function ofboth the market portfolio and the nonredundant options. Thisimplies that the options should be useful for explaining riskyasset returns. To test the theory, a model is derived in whichthe expected excess return on any risky asset is linearly related(via a collection of betas) to the expected excess return onthe market portfolio and to the expected excess returns on thenonredundant options. The empirical results indicate that thereturns on traded index options are relevant for explainingthe returns on risky asset portfolios.     

Systematic Risk and Empirical Research

We show here that risky asset returns generating processes stated in terms of factors which include both accounting and non-accounting based measures of risk (e.g. book to market ratios) imply, under fairly standard regularity conditions, that the Sharpe-Lintner-Black asset pricing model beta is a 'sufficient' statistic in the sense that it captures all important attributes of the returns generating process in a single number. We then derive the parametric relationship between betas based on inefficient index portfolios and betas based on the market or tangency portfolio. We demonstrate that the relationship between risky asset expected returns and betas computed on the basis of inefficient index portfolios is both consistent with the predictions of the Capital Asset Pricing Model and the multi-factor asset pricing models of Fama and French (1992, 1993, 1995 and 1996). The 'trick' is to realise that inefficient index portfolios are composed of the market portfolio and a collection of inefficient but self financing 'kernel' or 'arbitrage' portfolios. It then follows that there is a perfect linear cross sectional relationship between risky asset expected returns, betas based on inefficient index portfolios and the arbitrage portfolios. Hence, if we happen to stumble across variables that span the same subspace as the vectors representing the arbitrage portfolios, it is easy to create the illusion that risky asset expected returns depend on variables other than 'beta'.     

Mispriced index option portfolios

In model-free out-of-sample tests, we find that the optimal portfolio of a utility maximizing investor trading in the S&P500 Index, cash, and index options bought at ask and written at bid prices stochastically dominates the optimal portfolio without options and yields returns with higher mean and lower volatility in most months from 1990 to 2013. Unlike earlier claims of overpriced puts, our portfolios include mostly short calls and are particularly profitable when maturity is short and volatility is high. Similar results are obtained with the CAC and DAX indices. Neither priced factors nor a nonmonotonic stochastic discount factor explains the excess returns.     

An analysis of the importance of S&;P 500 discretionary constituent changes

The main purpose of this paper is to investigate the impact of the S&P 500 index committee’s decisions to change the constituent firms in the index on benchmark risk measures. The index is managed and changed discretionally by the index committee to make it as representative of the market condition as possible. In addition, the index constantly changes due to important corporate events such as bankruptcies, mergers and acquisitions, and spin-offs. We reconstruct market portfolios by retaining all discretionally deleted firms in a 3 and 5 year periods. We estimate betas at every deletion date in terms of reconstructed market portfolios; we found that these estimate betas are significantly different from the betas obtained from the constantly updated S&P 500 portfolio. We also found that such portfolios are less representative of the business cycle than the actual S&P 500 portfolio. Finally, we found that the portfolio returns obtained by retaining all discretionally deleted firms deviate significantly from the returns of the actual S&P 500 index over the studied period, October 1989 to December 2007.     

Takeover Prediction and Portfolio Performance: A Note

This paper empirically tests whether it is possible to generate abnormal returns from investing in a portfolio of predicted successful takeover targets. Portfolios are formed on the basis of predictions from models similar to those estimated by Palepu (1986). However, unlike Palepu (1986), the portfolios in this paper are formed using a decision rule that results in smaller portfolios with higher average takeover probabilities. This provides a stronger test of whether share prices reflect future takeover probabilities. The results show that while the models have significant explanatory power, the portfolios fail to beat the return on the market over a 12-month holding-period.     

Do fear indices help predict stock returns?

This study investigates the forecasting power of implied volatility indices on forward looking returns. Prior studies document that negative innovations to returns are associated with increasing implied volatility of the underlying indices; thus, suggesting a possible relationship between extremely high levels of implied volatility and positive short term returns. We investigate this issue by examining the predictive power of three implied volatility indices, VIX, VXN and VDAX, on the underlying index returns. We extend previous research by also focusing on characterised selected stocks and examine the relationship between implied volatility indices and future returns across different sectors and classified portfolios. Our findings suggest that implied volatility indices are good predictors of 20-days and 60-days forward looking returns and illustrate insignificant predictive power for very short term (1-day and 5-days) returns.     

The role of exchange rates in intertemporal risk–return relations

This paper investigates the significance of an intertemporal relation between expected returns on countries’ stock market portfolios and their risk exposures to the world market portfolio. We find that the intertemporal risk–return relation differs significantly under different currency denominations. The slope coefficient is the largest at around seven when the returns are denominated in Japanese yen, moderate at about five when the returns are denominated in the Canadian or US dollars, and the smallest at around three when the returns are denominated in pound or euro and its predecessors. The ranking of the risk–return coefficients across different currency denominations remains the same when we replace country equity indices with global industry portfolios in estimating the intertemporal relations, when we change the return frequency from monthly to daily, and when we consider different specifications for the conditional covariance process.     

Do ETFs provide effective international diversification?

Global investments have been a hot issue for years. Investors can diversify risks and obtain benefits from foreign markets by investing directly in the foreign security market or indirectly in Exchange-Trade Funds (ETFs). Because direct investments are not always feasible, we investigate whether indirect investments can replace direct investments. We create different regional optimal portfolios containing ETFs and ensure optimal asset portfolio allocation. In addition to mean-variance approach, the Sharpe index, we also adopt the Campbell et al. (2001) method to have the efficient frontier under control risks, the Value at Risk. We apply both normal and non-normal distributions for comparisons and find that different assumptions of return distributions affect the results of efficient frontier. The results show that international diversification is a reasonable strategy. In addition, when comparing ETFs and target market index portfolios, ETFs have higher Sharpe measures than target market indices especially in the emerging markets. However, there are no significant performance differences between direct and indirect methods even if we use different performance measures. We also find that the diversification benefits are the same before and after the Subprime crisis. We conclude that it is effective for investors to use indirect methods to create internationally diversified portfolios.     

Fundamental indexation via smoothed cap weights

If prices of individual stocks are unbiased but noisy approximations to fundamental values, there will be a gap in returns between the standard cap-weighted market portfolio and the one based on fundamentals. The discrepancy occurs because, relative to fundamentals, cap-weights are too large (small) for stocks with positive (negative) deviations from fundamental values. It follows that the usual cap-weighted portfolio will underperform relative to the fundamental-based portfolio as long as prices revert to fundamental values. This has led Arnott et al. to propose new market indices based on a firm’s fundamental size as measured by its revenues, number of employees, and so on. In this paper we follow the same principle but propose to estimate fundamental weights using a smoothed average of standard cap-weights. Since the putative excess returns of a fundamentals-weighted portfolio requires reversion to fundamental values, and because fundamental values are likely to change slowly, we can estimate current fundamentals by smoothing the time series of a stock’s noisy prices. The determination of fundamental size in terms of accounting data is thereby replaced by a simple estimate based on price history. We derive expressions for expected returns of the market capitalization-based and fundamentals-based portfolios under various assumptions about (i) the random deviations from fundamental values and (ii) the change in fundamentals over time. We present empirical comparisons between portfolios and find the returns of the fundamentals-based portfolios exceed the standard indices by an amount comparable to the prior estimates that used accounting data to determine size.     

Hedge Fund Indices: Reconciling Investability and Representativity

Following a growing concern among investors about the quality of hedge fund index return data, this paper addresses the question of whether designing hedge fund indices that fulfil the usual requirements (in particular representative and investable) is or not a feasible task, given a variety of features that are specific to that industry. To test whether or not investability should necessarily come at the cost of representativity, we use a well‐known methodology in the asset pricing literature based on the concept of factor replicating portfolios. Our results suggest that it is actually possible to construct representative indices based on a limited number of funds that are open to new investments, except perhaps in the case of equity market neutral strategies, provided that: i) these funds are suitably selected and ii) a portfolio is constructed with the objective of replicating the common trend in hedge fund returns for a given strategy. A range of robustness tests are performed that show that high correlation of the factor replicating portfolios with the common factor of returns for each strategy is remarkably stable with respect to modifying the number of funds in the replicating portfolio or changing the frequency of rebalancing.     

On Indexing Commercial Real Estate Properties and Portfolios

Commercial real estate indices play an important role in performance evaluation and overall investment strategy. However, the issue of how representative they are of the returns on portfolios of commercial properties is an open issue. Our study addresses this topic by analyzing a sample of 12,427 repeat sales transactions between Q4 2000 and Q2 2011. We find that the aggregate real estate indices (Moody’s REAL CPPI) do a good job of tracking real returns when portfolios of more than 20 properties are considered. At this level, tracking is somewhat less effective than our benchmark of the S&P500 and its component stocks. Compared to the average root mean squared deviation (RMSD) from one asset, randomly selected portfolios with 20 assets reduce the RMSD by 75 % for the S&P500 compared to 66 % for the aggregate index. These results suggest that the aggregate indices can be effective in hedging and evaluating the performance of direct real estate investment. We further find that tracking at the property type level provides little benefit over using an aggregate index. However, indexing using a property type and location matched index provides lower tracking error for any level of diversification.     

The Piotroski F‐score: evidence from Australia

A market‐neutral strategy that is long [short] stocks with a high [low] Piotroski F‐score generates an index‐weighted 0.8 percent pm on S&P/ASX 200 stocks and 1.4 percent pm on smaller stocks. Equal‐weighted returns are higher and in all cases returns are statistically significant. However, the Carhart model alphas are not statistically significant except in the case of equal‐weighted small cap portfolios. For such portfolios, however, most of the alpha comes from the short side and most institutional investors would find them uninvestable due to capacity constraints. A range of tests indicate that analyst neglect does not explain the F‐score premium.