Priced risk and asymmetric volatility in the cross section of skewness

We investigate the sources of skewness in aggregate risk factors and the cross section of stock returns. In an ICAPM setting with conditional volatility, we find theoretical time series predictions on the relationships among volatility, returns, and skewness for priced risk factors. Market returns resemble these predictions; however, size, book-to-market, and momentum factor returns are not always consistent with our predictions. We find evidence that size and book-to-market may be priced post-crisis but not in the decade before. Momentum does not appear priced by our test. We link aggregate risk and skewness to individual stocks and find empirically that the risk aversion effect manifests in individual stock skewness. Additionally, we find several firm characteristics that explain stock skewness. Smaller firms, value firms, highly levered firms, and firms with poor credit ratings have more positive skewness.     

The long-run performance of initial public offerings: Stochastic dominance criteria

We examine the long-run performance of initial public offerings (IPOs) using the idea of stochastic dominance. The analysis is a first attempt using a non-event study methodology to evaluate long-horizon performance. We find that there is no first-order stochastic dominance relation between the IPO portfolio and the benchmark of a broad index or a portfolio including either small size or low book-to-market stocks. However, those benchmarks second-order stochastically dominate the IPO portfolio. When using a portfolio including both small size and low book-to-market stocks as benchmark, there is a clear dominance of the IPO portfolio over the benchmark for both orders. Our findings generally imply that the question of assessing portfolio performance between IPO firms and benchmark portfolios depends critically on the specific construction or the cumulative distribution function of the benchmark portfolios. The empirical results also potentially explain the extent of sample dependent results in the literature.     

Firm size,economic risks,and the cross-section of international stock returns

Recent empirical evidence from developed markets indicates a negative relation between value premium and firm size. We find that the value premium in small stocks is consistently priced in the cross-section of international returns, whereas the value premium in big stocks is not. Based on US data, we show that the small-stock value premium is associated with business cycle news and reflects changes in macroeconomic, especially credit market related risks. Our results hold true for regional and global equity markets and remain valid after controlling for firm characteristics and prominent profitability and investment factors.     

The determinants of momentum in the United Kingdom

This study examines the effects of size, analyst coverage, and book-to-market in explaining momentum profits in UK stocks. We document a pattern of momentum in UK stocks and find that momentum profits are negatively related to firm size, analyst coverage, and book-to-market. We find that book-to-market is more important than coverage and coverage is more important than size in explaining momentum profits. We examine the book-to-market effect closely and find that a value premium exists for past stock losers, but a growth discount exists for past stock winners. Finally, the results of this study provide mixed support for the information diffusion hypothesis of Hong and Stein (1999).     

Is there a diversification “cost” of Shari’ah compliance? Empirical evidence from Malaysian equities

Islamic equity portfolios work with a smaller investment universe given the filtering of non-Shari’ah compliant stocks. It has been theoretically argued that this culminates in suboptimal portfolio diversification, which in turn adversely affects risk-adjusted returns. We offer empirical evidence that such a conceived portfolio diversification “penalty” is far from a foregone conclusion, at least empirically. Our results tend to indicate that Islamic portfolios are not invariably handicapped in terms of portfolio diversification. We also explored dimensions that may account for differences in the relative investment performance between Islamic and conventional portfolios, such as portfolio constraints, short selling and market conditions. We believe this paper is among the first to apply substantial empirical analysis specifically with respect to the portfolio diversification perspective on Islamic equity investments.     

How Do Alphas and Betas Move? Uncertainty,Learning and Time Variation in Risk Loadings*

I employ a parsimonious model with learning, but without conditioning information, to extract time‐varying measures of market‐risk sensitivities, pricing errors and pricing uncertainty. The evolution of these quantities has interesting implications for macroeconomic dynamics. Parameters estimated for US equity portfolios display significant low‐frequency fluctuations, along patterns that change across size and book‐to‐market stocks. Time‐varying betas display superior predictive accuracy for returns against constant and rolling‐window OLS estimates. As to the relationship of betas with business‐cycle variables, value stocks’ betas move pro‐cyclically, unlike those of growth stocks. Investment growth, rather than consumption, predicts the betas of value and small‐firm portfolios.     

Pricing the hedging factor in the cross-section of stock returns

We investigate the role of investors’ net hedging strategy (factor) in predicting stock returns and pricing the cross-section of individual stocks and equity portfolios. We estimate stock exposure to changes in the hedging factor and show that the hedging premium is driven by outperformance of stocks with large positive net hedging betas, which explains their higher average returns. We find the positive hedging premium indicates risk-averse investors demand extra compensation to hold stocks with higher equity risk premiums, and they are themselves willing to pay higher prices for stocks with positive hedging betas.     

Mutual funds relationships and performance analysis

The present paper aims at exploring the equity exposure of Italian equity mutual funds as they emerge from their portfolio holdings at the date of December 31st, 2010. The technique adopted in the analysis considers the construction of a bipartite network and the detection of the overlap of portfolios held by mutual funds. The relationship among stocks due to their presence in the same portfolios is analyzed, too. Methods typical of complex networks are then applied. The comparison with several performance measures allows to discuss features of active/passive style management for institutional portfolios.     

Size and value effects in high-tech industries: The role of R&D investment

We use monthly US stock data over 55 years from 1962 to 2017 to show that the R&D intensity at firms adds another important dimension to the size and value effects in describing stock returns, especially for small high-tech firms. A trading strategy that double sorts on R&D intensity and size or book-to-market ratio outperforms a simple small-minus-big (SMB) or high-minus-low (HML) strategy in producing higher and more significant portfolio returns. The most profitable schemes involve triple sorts by size, BM, and R&D intensity: the payoffs of buying high-BM/R&D-Active portfolio and selling low-BM/R&D-Inactive portfolio in the small-size/high-tech group and that of buying high-tech/high-BM and selling low-tech/low-BM in the small-size/R&D-active group generate a return of more than 2% on a monthly basis. Our results are robust to alternative classification method of assigning stocks in portfolios.     

Market portfolio efficiency and value stocks

In this journal, Best, Best, and Yoder (2000) recently demonstrated that portfolios of U.S. value stocks dominate portfolios of U.S. growth stocks in terms of second-order stochastic dominance (SSD). We cannot conclude from this finding that the market is SSD inefficient, however, because market portfolio efficiency generally does not require growth portfolios to be efficient. Furthermore, stochastic dominance results are very sensitive to sampling error. In fact, the value-weighted market portfolio is not significantly inefficient, and no significant value effects exist in the sample of Best, Best, and Yoder. This study forms part of a research program on stochastic dominance. Details on the program are available at http://www.few.eur.nl/few/people/gtpost/stochastic_dominance.htm. We appreciate the comments of an anonymous referee. The financial support of Tinbergen Institute, Erasmus Research Institute of Management, and Erasmus Center of Financial Research is gratefully acknowledged. Any remaining errors are the authors' responsibility.     

Is there valuable private information in credit ratings?

Credit rating agencies (CRAs) contend their ratings contain a quantitative assessment based on hard information, and a qualitative adjustment based on private information. We study if the qualitative portion of ratings, generated with the companies’ own private information, contains valuable information for equity investors. We generate predicted ratings based on hard information alone and form portfolios of stocks based on the difference between observed and predicted ratings. Over a sample from 1998 to 2018, we find that stock portfolios formed on the basis of private information generate 2% to 4% in annual risk-adjusted returns. We also find that companies with positive private information have better future accounting performance. Our results suggest that CRAs bring valuable information to the market and investors could benefit from it.     

Spanning tests in return and stochastic discount factor mean–variance frontiers: A unifying approach

We propose new spanning tests that assess if the initial and additional assets share the economically meaningful cost and mean representing portfolios. We prove their asymptotic equivalence to existing tests under local alternatives. We also show that unlike two-step or iterated procedures, single-step methods such as continuously updated GMM yield numerically identical overidentifying restrictions test, so there is arguably a single spanning test. To prove these results, we extend optimal GMM inference to deal with singularities in the long run second moment matrix of the influence functions. Finally, we test for spanning using size and book-to-market sorted US stock portfolios.     

Size and book-to-market factors in the relationship between average stock returns and average book returns: some evidence from an emerging market

The present paper examines the association between average stock returns and average book returns and addresses the question as to whether there are common size and book-to-market factors in earnings and returns. The results of the empirical research, conducted in the Athens Stock Exchange, suggest that when the sample firms are grouped into size, book-to-market portfolios stock returns properly reflect differences in the evolution of accounting profitability. Moreover, it is found that the return on investment (ROI) measure contains size and book-to-market factors analogous to the mimic risk factors inherent in stock returns, in the sense that they capture information missed by ROI.     

The Fama-French model for estimating the cost of equity capital: The impact of real options of investment projects

We use the classic and modified Fama-French models to estimate the cost of capital of stock portfolios listed on selected markets. We compare four highly developed markets (US, EU, Japanese and global) and the Polish market as an alternative investment opportunity and a CEE emerging market. The performance of the applied procedures for estimating the cost of capital for company projects is examined and cost of capital is assessed with and without real option adjustment. We adjust the portfolios’ returns using the firms’ book-to-market ratios and idiosyncratic volatility as option proxies. The variability of cost of capital is evaluated using bootstrap methods. Our study shows a clear difference between bootstrapped distributions of cost of capital for the tested developed market and the Polish market portfolios. Wider confidence intervals of the estimated cost of capital of the studied Polish portfolios may result from political motivations in managing state-controlled companies. Our findings also indicate a clear difference between the cost of capital for tested portfolios with and without option adjustment. The widths of the estimated confidence intervals increase after option adjustment. The highest/lowest values of the cost of capital both with and without option adjustment are found for the US/Japanese market portfolios.     

The economic benefits of market timing the style allocation of characteristic-based portfolios

Many exchange traded funds track simple characteristic-based equity portfolios such as the market capitalization, the fundamental value or the inverse volatility portfolio. This paper provides theoretical and empirical evidence for the economic benefits in exploiting the timing-gains that result from the time-varying relative performance of these characteristic-based portfolios. Under a factor model for expected returns, we show that this dynamic portfolio allocation can be efficient across the low-dimensional set of characteristic-based portfolios. We assess the out-of-sample performance on the S&P 100 universe over the period 1990–2013 and show gains in stability and significant positive risk-adjusted returns for the dynamic style portfolio. We conduct several robustness tests and extensions confirming the benefits of dynamic style allocation across characteristic-based portfolios.     

Assessing and valuing the nonlinear structure of hedge fund returns

Several studies have put forward that hedge fund returns exhibit a nonlinear relationship with equity market returns, captured either through constructed portfolios of traded options or piece‐wise linear regressions. This paper provides a statistical methodology to unveil such nonlinear features with respect to returns on benchmark risk portfolios. We estimate a portfolio of options that best approximates the returns of a given hedge fund, account for this search in the statistical testing of the nonlinearity, and provide a reliable test for a positive valuation of the fund. We find that not all fund categories exhibit significant nonlinearities, and that only a few strategies provide significant value to investors. Our methodology helps identify individual funds that provide value in an otherwise poorly performing category. Copyright © 2010 John Wiley & Sons, Ltd.     

Estimating Cost of Equity: Do You Need to Adjust for Foreign Exchange Risk?

Empirical reports of priced foreign exchange (FX) risk raise the question of whether managers should adjust their cost of equity estimates for FX risk. To study this question, we empirically compare the cost of equity estimates of several risk–return models, including some that have explicit FX risk premia and others that do not. We find that adjusting for FX risk makes little difference, on average, in the cost of equity estimates, even for small firms and firms with extreme FX exposure estimates.     

A spatial dominance approach to evaluate the performance of stocks and bonds: Does the investment horizon matter?

The common advice by practitioners is to allocate a greater proportion of stocks for long-term investors than for short-term investors. However, part of the academic literature disagrees with this advice. We use a spatial dominance test which is suited for comparing alternative investments for a given time horizon. Using daily data for the US from 1962 to 2012, we test for dominance of cumulative returns series for stocks versus bonds at different investment horizons from 1 to 15 years. We find evidence that bonds second order spatially dominate stocks for horizons from 1 to 4 years. In contrast, for horizons of 6 years and longer, we find evidence that stocks dominate bonds. The conclusion that bonds dominate stocks at short horizons, while stocks dominate bonds at long horizons is consistent across different periods and international markets. When different portfolios of stocks and bonds are compared, we find that for long investment horizons only those portfolios with a sufficiently high proportion of stocks are efficient in the sense of spatial dominance.     

Low and high frequency macroeconomic forces in asset pricing

We use a frequency decomposition method to examine the differential pricing of low and high frequency movements in macroeconomic state variables that characterize systematic factor risks in the economy. We further examine whether the sensitivities to low and high frequency systematic risks differs by firm size. Results indicate that beta risk in low frequency cyclical periods of two years or more is priced with more significance than aggregate systematic risk, and that low frequency factor risks are relatively greater for small capitalization stocks while high frequency systematic factor risks are relatively greater for large capitalization stocks.