International channels of the Fed's unconventional monetary policy

Previous research has established that the Federal Reserve's large scale asset purchases (LSAPs) significantly influenced international bond yields. We use dynamic term structure models to uncover to what extent signaling and portfolio balance channels caused these declines. For the U.S. and Canada, the evidence supports the view that LSAPs had substantial signaling effects. For Australian and German yields, signaling effects were present but likely more moderate, and portfolio balance effects appear to have played a relatively larger role than in the U.S. and Canada. Portfolio balance effects were small for Japanese yields and signaling effects basically nonexistent. These findings about LSAP channels are consistent with predictions based on interest rate dynamics during normal times: Signaling effects tend to be large for countries with strong yield responses to conventional U.S. monetary policy surprises, and portfolio balance effects are consistent with the degree of substitutability across international bonds, as measured by the covariance between foreign and U.S. bond returns.     

Financial Globalization,Governance, and the Evolution of the Home Bias

We merge portfolio theories of home bias with corporate finance theories of insider ownership to create the optimal corporate ownership theory of the home bias. The theory has two components: (1) foreign portfolio investors exhibit a large home bias against countries with poor governance because their investment is limited by high optimal ownership by insiders (the “direct effect” of poor governance) and domestic monitoring shareholders (the “indirect effect”) in response to the governance and (2) foreign direct investors from “good governance” countries have a comparative advantage as insider monitors in “poor governance” countries, so that the relative importance of foreign direct investment is negatively related to the quality of governance. Using both country‐level data on U.S. investors' foreign investment allocations and Korean firm‐level data, we find empirical evidence supporting our optimal corporate ownership theory of the home bias.     

Measuring bond mutual fund performance with portfolio characteristics

This paper studies the performance of U.S. bond mutual funds using measures constructed from a novel data set of portfolio weights. Active fund managers exhibit outperformance before costs and fees generating, on average, gross returns of 1% per annum over the benchmark portfolio constructed using past holdings (approximately the same magnitude as expenses and transaction costs combined). This suggests that fund managers are able to earn back their fees and costs. There is evidence of neutral ability to time different portfolio allocations (sector, credit quality, and portfolio maturity allocations) and only a subgroup of bond funds exhibit successful timing ability. One performance measure based on portfolio holdings predicts future fund performance and provides information not contained in the standard measures. These results provide the first evidence of the value of active management in bond mutual funds.     

An alternate method of estimating the Cagan money demand function in hyperinflation under rational expectations

An alternate method of estimating the Cagan money demand function under rational expectations is presented. The technique utilizes the side assumptions that (1) accurate contemporaneous information on the price level and money stock is available to individuals and (2) unobservable noise in the portfolio balance schedule is neglible. The procedure has three main virtues. First, it is implemented without imposing restrictions on the money supply process. Second, the procedure is extremely simple and economical. Third, it admits a simple test of a restriction implied by the Cagan money demand function. Results are related to issues in recent hyperinflation studies.     

Monthly Pattern and Portfolio Effect on Higher Moments of Stock Returns: Empirical Evidence from Hong Kong

Using a direct test, this paper studies the month-of-the-year effect on the higher moments of six industrial stock indices of the Hong Kong market. We also examine the portfolio effect on skewness and kurtosis across month of the year to see if such an anomaly exists. The empirical results support a weak month-of-the-year effect in higher moments of stock returns. Using a complete sample of all possible combinations for each portfolio size, we show that portfolio effect varies across month of the year for both skewness and kurtosis. In particular, our results show that diversification does not necessarily provide benefits to rational investors when the stock return distribution is non-normal, even though portfolio formation can reduce standard deviation. In June, August and October, diversification across industrial sectors results in a more negatively skewed and leptokurtic return distribution, which is not preferred by investors with risk-aversion. Two (one) possible explanations for the portfolio effect on skewness (kurtosis) are also provided. Our empirical results add new evidence to the existence of anomalies in the Hong Kong stock market. This revised version was published online in August 2006 with corrections to the Cover Date.     

Current account balance and dollar standard: Exploring the linkages

This paper examines whether the international role of the dollar as main global reserve currency has contributed to persistent current account imbalances. To this end, we analyse how central banks' accumulation of reserve assets affects the current account balance of both reserve-accumulating and reserve-providing countries.Based on a simple portfolio balance model we show theoretically that the global demand for reserve assets by central banks may lower the current account balance of the reserve-issuing country. Our panel data analysis over the period 1970–2009 confirms this hypothesis: Any dollar of provided reserve assets decreases the US current account by more than one dollar. On average, the demand for dollar reserves has lowered the US current account by 1–2 percentage points relative to GDP. The flip side of this effect is a higher current account balance in reserve-accumulating countries. These novel findings show that the worldwide demand for international reserves has contributed to the buildup of global imbalances.     

A nineties perspective on international diversification

Investors often look to international diversification as a means to reduce the risk of a stock portfolio while maintaining a given level of return. In this study we look at ten years of historical data from the stock markets in the G-7 countries. We see how diversification from an S & P 500 portfolio into a two-market (two-country) portfolio would have impacted the risk and return. Across this ten-year period, we find that a portfolio consisting solely of the S & P 500 dominates any portfolio that can be constructed from the S & P 500 and the major market index of the G-7 countries.     

Institutional Investors and the QE Portfolio Balance Channel

The operation of the portfolio balance channel has been emphasized by monetary policymakers as a key channel through which quantitative easing (QE) policies work. We assess whether the investment behavior of insurance companies and pension funds in the United Kingdom during the global financial crisis was consistent with such an effect by analyzing both sectoral and institution‐level data. Our results suggest QE led to institutional investors shifting their portfolios away from government bonds toward corporate bonds but did not lead to a shift into equities.     

Household response to a money rain: Real and portfolio balance effects reconsidered

In order for changes in the stock of money to lead to changes in economic activity, production and spending units such as households and firms must respond to changes in the money supply. With respect to wealth effects on households, the real balance effect on consumption is thought to be empirically small. This puts the burden on portfolio balance and labor supply effects. Labor supply is shown to decrease in response to an increase in the money supply, and depending on the extent of markets, portfolio balance effects may be nonexistent.     

Markowitz efficiency and size effect: evidence from the UK stock market

Academics and practitioners have frequently debated the relationship between market capitalization and expected return. We apply the Markowitz efficient frontier approach to develop a portfolio performance measure that compares the return of a portfolio to its optimal return, using data from the UK stock market over the period 1985–2012. Our results show that there is a negative relationship between portfolio size and portfolio return during the period under study. When comparing actual portfolio return with achievable return for the same level of risk, we find that as the portfolio size expands, underperformance of the portfolio increases, i.e. the larger the portfolio size, the greater the underperformance. This indicates that Markowitz efficiency is difficult to achieve, particularly in large portfolios. Changing model parameters leads to alternative efficient frontiers that impact upon the measurement of performance. However, the use of alternative efficient frontiers does not affect our result of the size effect on the relative performance of portfolios. Our study shows that the size effect is present over the full period. Our findings also suggest that the excess returns found in small portfolios are likely to be associated with higher levels of diversifiable risk in comparison with larger portfolios. Furthermore, in contrast to other studies, we find no evidence to support the size reversal effect in the data.     

The Role of Learning in Dynamic Portfolio Decisions

This paper analyzes the effect of uncertainty about the mean return on the risky asset on the portfolio decisions of an investor who has a long investment horizon. Building on the earlier work of Detemple (1986), Dothan and Feldman (1986), and Gennotte (1986), it is shown that the possibility of future learning about the mean return on the risky asset induces the investor to take a larger or smaller position in the risky asset than she would if there were no learning, the direction of the effect depending on whether the investor is more or less risk tolerant than the logarithmic investor whose portfolio decisions are unaffected by the possibility of future learning. Numerical calculations show that uncertainty about the mean return on the market portfolio has a significant effect on the portfolio decision of an investor with a 20 year horizon if her assessment of the market risk premium is based solely on the Ibbotson and Sinquefield (1995) data.     

A dynamic model of active portfolio management with benchmark orientation

This paper studies optimal dynamic portfolios for investors concerned with the performance of their portfolios relative to a benchmark. Assuming that asset returns follow a multi-linear factor model similar to the structure of Ross (1976) [Ross, S., 1976. The arbitrage theory of the capital asset pricing model. Journal of Economic Theory, 13, 342–360] and that portfolio managers adopt a mean tracking error analysis similar to that of Roll (1992) [Roll, R., 1992. A mean/variance analysis of tracking error. Journal of Portfolio Management, 18, 13–22], we develop a dynamic model of active portfolio management maximizing risk adjusted excess return over a selected benchmark. Unlike the case of constant proportional portfolios for standard utility maximization, our optimal portfolio policy is state dependent, being a function of time to investment horizon, the return on the benchmark portfolio, and the return on the investment portfolio. We define a dynamic performance measure which relates portfolio’s return to its risk sensitivity. Abnormal returns at each point in time are quantified as the difference between the realized and the model-fitted returns. Risk sensitivity is estimated through a dynamic matching that minimizes the total fitted error of portfolio returns. For illustration, we analyze eight representative mutual funds in the U.S. market and show how this model can be used in practice.     

Price behavior of small-cap stocks and momentum: A study using principal component momentum

This study analyzes why the negative momentum effect appears in Asian (China, Japan, Korea) stock markets, contrary to the U.S. market. We use principal component momentum (PMOM), a newly devised momentum measure. The PMOM is constructed by extracting commonalities from traditional momentum measures using principal component analysis. The results show evidence of positive and negative momentum profits in the U.S. and Asian markets, respectively. Negative momentum profits in Asian markets are attributable to the strong performance reversal of small stocks in the loser portfolio. Conversely, the positive momentum profits of the U.S. market are driven by the performance continuity of small stocks in the winner portfolio. The PMOM strategy is significantly more advantageous than traditional momentum strategies, based on the economic and statistical perspectives of momentum profits. These results are robust to changes in empirical designs.     

The 4% strategy revisited: a pre-commitment mean-variance optimal approach to wealth management

In contrast to single-period mean-variance (MV) portfolio allocation, multi-period MV optimal portfolio allocation can be modified slightly to be effectively a down-side risk measure. With this in mind, we consider multi-period MV optimal portfolio allocation in the presence of periodic withdrawals. The investment portfolio can be allocated between a risk-free investment and a risky asset, the price of which is assumed to follow a jump diffusion process. We consider two wealth management applications: optimal de-accumulation rates for a defined contribution pension plan and sustainable withdrawal rates for an endowment. Several numerical illustrations are provided, with some interesting implications. In the pension de-accumulation context, Bengen (1994)’s [J. Financial Planning, 1994, 7, 171–180], historical analysis indicated that a retiree could safely withdraw 4% of her initial retirement savings annually (in real terms), provided that her portfolio maintained an even balance between diversified equities and U.S. Treasury bonds. Our analysis does support 4% as a sustainable withdrawal rate in the pension de-accumulation context (and a somewhat lower rate for an endowment), but only if the investor follows an MV optimal portfolio allocation, not a fixed proportion strategy. Compared with a constant proportion strategy, the MV optimal policy achieves the same expected wealth at the end of the investment horizon, while significantly reducing the standard deviation of wealth and the probability of shortfall. We also explore the effects of suppressing jumps so as to have a pure diffusion process, but assuming a correspondingly larger volatility for the latter process. Surprisingly, it turns out that the MV optimal strategy is more effective when there are large downward jumps compared to having a high volatility diffusion process. Finally, tests based on historical data demonstrate that the MV optimal policy is quite robust to uncertainty about parameter estimates.     

Risk Overhang and Loan Portfolio Decisions: Small Business Loan Supply before and during the Financial Crisis

We estimate a structural model of bank portfolio lending and find that the typical U.S. community bank reduced its business lending during the global financial crisis. The decline in business credit was driven by increased risk overhang effects (consistent with a reduction in the liquidity of assets held on bank balance sheets) and by reduced loan supply elasticities suggestive of credit rationing (consistent with an increase in lender risk aversion). Nevertheless, we identify a group of strategically focused relationship banks that made and maintained higher levels of business loans during the crisis.     

Robust portfolio selection under downside risk measures

We investigate a robust version of the portfolio selection problem under a risk measure based on the lower-partial moment (LPM), where uncertainty exists in the underlying distribution. We demonstrate that the problem formulations for robust portfolio selection based on the worst-case LPMs of degree 0, 1 and 2 under various structures of uncertainty can be cast as mathematically tractable optimization problems, such as linear programs, second-order cone programs or semidefinite programs. We perform extensive numerical studies using real market data to reveal important properties of several aspects of robust portfolio selection. We can conclude from our results that robustness does not necessarily imply a conservative policy and is indeed indispensable and valuable in portfolio selection.     

Do funds selected by managers’ skills perform better?

We construct a simple intuitive rating mechanism to evaluate stock picking and market timing skills of equity and hybrid equity fund managers in China. We find that both our skill-rated 5-star (SR-5S) fund and the Morningstar 5-star (MS-5S) fund portfolios outperform the market. The SR-5S fund portfolio outperforms its counterpart MS-5S portfolio in most situations, depending on whether portfolio performance is measured by the abnormal returns of the CAPM model, the Fama-French three-factor (FF3) model, the Carhart four-factor (CH4) model and the Fama-French five-factor (FF5) model. Both market timing skill and stock picking skill affect the performance difference between the SR-5S fund and MS-5S fund portfolios. Additionally, the departure of a SR-5S or MS-5S fund manager is associated with fund performance declines, and the declines in performance for SR-5S funds are generally larger than the declines for the MS-5S funds.     

Why Do Markets Move Together? An Investigation of U.S.-Japan Stock Return Comovements

This article explores the fundamental factors that affect cross-country stock return correlations. Using transactions data from 1988 to 1992, we construct overnight and intraday returns for a portfolio of Japanese stocks using their NYSE-traded American Depository Receipts (ADRs) and a matched-sample portfolio of U. S. stocks. We find that U. S. macroeconomic announcements, shocks to the Yen/Dollar foreign exchange rate and Treasury bill returns, and industry effects have no measurable influence on U.S. and Japanese return correlations. However, large shocks to broad-based market indices (Nikkei Stock Average and Standard and Poor's 500 Stock Index) positively impact both the magnitude and persistence of the return correlations.     

Taking the Long Way Home: U.S. Tax Evasion and Offshore Investments in U.S. Equity and Debt Markets

We empirically investigate one form of illegal investor‐level tax evasion and its effect on foreign portfolio investment. In particular, we examine a form of round‐tripping tax evasion in which U.S. individuals hide funds in entities located in offshore tax havens and then invest those funds in U.S. securities markets. Employing Becker's ( 1968 ) economic theory of crime, we identify the tax evasion component by examining how foreign portfolio investment varies with changes in the incentives to evade and the risks of detection. To our knowledge, this is the first empirical evidence of investor‐level tax evasion affecting cross‐border equity and debt investment.     

Are specialist funds “special”?

In this paper, I explore the relation between portfolio overlap and performance diversity. Using data on actively managed U.S. equity mutual funds, I find that the pairwise portfolio overlap between individual funds has increased over time and is significant compared to various randomized benchmarks. These findings motivate the main question of this paper, namely whether specialist funds (those with low levels of portfolio overlap with other funds) differ significantly from funds with high levels of overlap. Here, I find that these specialists differ with regard to certain portfolio‐ and fund‐specific characteristics, but they do not appear to outperform other funds.