Domestic Equity Research Articles

Equity Home‐Bias: A Suboptimal Choice for UK investors?

Abstract In spite of the popularity of international portfolio diversification theory, extant empirical literature shows that investors prefer domestic assets and as a result, many studies argue that investors' portfolios are largely suboptimal. This paper examines whether British investors need to diversify their portfolios internationally to gain performance benefits from international markets or can they obtain these benefits by mimicking the portfolios with domestically traded assets. The results confirm that it is possible to mimic the performance of foreign equity with domestic equity. Indeed, the pay‐offs from homemade portfolios outperform those from international portfolios regardless of the periodic variation in the overall performance of the UK market vis‐à‐vis foreign markets. The superiority of homemade portfolio is more prominent in recent years and is enhanced by the increased internationalisation of developed capital markets. Therefore, investors' home bias is not suboptimal.

Alternative Overlay for a Traditional Managed Equity Portfolio

The impetus of this paper is to present an investment strategy that is both easy to implement and has a value-added performance component. The core of the investment approach is based on the concept of “alternative” asset classes, and their historical lack of correlation to more traditional asset classes such as domestic and foreign equities, sector funds, domestic and foreign bonds, and cash equivalent instruments. Several trading systems are explored, and are shown to not necessarily accomplish their goal of reducing risk or enhancing return. These approaches are often labeled as being a type of “active” investing, but since most stay fully invested, they often do not achieve the result they are designed for: reducing market risk. It is demonstrated that using actively managed systems, which have the ability to move out of the market at critical points, can indeed add value. The discussion turns to the importance of choosing which investments are used when the system signals a move to the “sidelines”. Traditionally, riskless investments (or as close to riskless as can be expected) are used, such as short-term bonds and cash and cash-like investments. Recently, with the introduction of numerous ETFs and mutual funds in the “alternative” investment space, practitioners have turned to using a portfolio of these assets in lieu of moving to bonds or cash. It is believed that the historically low correlation of these assets to stocks and bonds will result in value-added performance above that of using bonds or cash when moving out of the market. Since the “sideline” investments in this case are not riskless, the success of the method is largely dependent on the stability of the correlation between them and traditional equities. This paper will show that this reliance is a significant flaw, especially during market shocks and increased volatility. As a way of overcoming this flaw, it is shown that the use of “active alternative investments has the ability to insulate a portfolio against market shocks, and at the same time, deliver enhanced risk-adjusted performance.

Standard & Poor’s Indices Versus Active Funds (SPIVA) Scorecard, Year-End 2009

Survivor-Bias-Free U.S. Mutual Fund Database provides the underlying data. To accommodate CRSP release schedules, SPIVA is now published semi-annually with a 6 to 8 week lag.Over the last five years, the SP the SP and the S&P SmallCap 600 has outperformed 66.6% of small-cap funds.The five-year data results are similar for actively managed fixed income funds. Across all categories, with the exception of emerging market debt, more than 70% of active managers have failed to beat benchmarks.The conclusions are less unequivocal when looking at asset-weighted averages, which measure the performance of the average invested dollar in active funds. In several equity and fixed income categories, there is a more level playing field with index returns.Short-term outcomes (such as periods of 12 months or less) of the index versus active debate are less consistent than longer-term outcomes. This notion is demonstrated by the active versus index match up for each of the last 10 years.The turmoil of the past five years saw 29% of domestic equity funds, 21% of international equity funds, and 10% of fixed income funds merge or liquidate.

Performance and Persistence in Institutional Investment Management

ABSTRACTUsing new, survivorship bias‐free data, we examine the performance and persistence in performance of 4,617 active domestic equity institutional products managed by 1,448 investment management firms between 1991 and 2008. Controlling for the Fama–French (1993) three factors and momentum, aggregate and average estimates of alphas are statistically indistinguishable from zero. Even though there is considerable heterogeneity in performance, there is only modest evidence of persistence in three‐factor models and little to none in four‐factor models.

The impact of cross‐listings on the UK and the German stock markets

PurposeThe purpose of this paper is to examine volatility transmissions between portfolios of cross‐listed equities and exchange rate differences and also the volatility persistence for home, foreign equities, and exchange rate differences in the UK and German markets.Design/methodology/approachA primary focus of this paper is to see if there is an impact first on the volatility persistence for foreign equities that are listed in the UK and German markets, second on the respective home portfolios of cross‐listed equities, and third on the exchange rate differences. In addition, whether there are any bilateral spillovers between the following equity portfolios: foreign cross‐listed equities, home cross‐listed equities, and also local or global exchange rate differences are investigated.FindingsThe paper finds that the volatility persistence is more prominent than error persistence from cross‐listed equities, foreign or home, and the exchange rate differences. Furthermore, the transmission mechanism indicates a bilateral integration process in some of the cases that were examined. Based on these results, it is concluded that in the UK market the foreign cross‐listings affect less the domestic equities compared to the German market.Originality/valueThis paper examines the interdependence of portfolios of home and foreign equities for cross‐listings that belong to the same stock exchange with two exchange rates, a local and a global one in order to provide more evidence in this area of literature.

An Examination of International Portfolio Diversification Benefits for Korean Investors

We employ mean‐variance spanning and intersection tests in the stochastic discount factor approach to examine the potential diversification benefits of international investments from the perspective of Korean investors. Our results show that the addition of international regional indices to the set of domestic equities provides significant diversification benefits. However, the source and economic magnitude of diversification benefits differ across international markets. Furthermore, we find that when investors manage their portfolio based on instrument variables, they can not only expand their investment opportunities by investing in international assets, but also increase the efficiency gain of diversification benefits.

Competition and International Equity Returns: Some Empirical Tests of “Turbulent Arbitrage”

The idea that capital flows accelerate and decelerate in response to differential rates of return on real investment is common to virtually all of economic theory. This paper examines the nature of this process, especially the relationship between returns in the stock market and returns on real investment. Shaikh (1998) makes the case that the rate of return on new physical (real) investment is the “required” rate of return for the stock market and that competitive forces produce a rough equalization between these two rates of return, what he terms “turbulent arbitrage.” In contrast to neoclassical theories of perfect competition, with its notions of perfect information and convergence to a uniform rate of return, the notion of “turbulent arbitrage” is a dynamic process that requires a tendency toward convergence as well as the constant differentiation of profit rates (Botwinick 1993). Data on rates of return at the country, industry, and firm level for Japan, Germany, the United Kingdom, and the United States are analyzed and correlated with Shaikh’s “incremental rate of return on real investment” which, it is argued, is the target of the equalization process. Statistical and econometric tests based on time series methods and pooling techniques support the hypothesis that the rate of return on equity prices is linked to the incremental return on real investment. In addition, this association is examined for two industries—steel and retail trade—across these same four countries. Global and domestic equity markets are found to be significantly correlated with the incremental returns for the steel industry but not for the retail trade sector. JEL classification: G15, F02, C33

Fund Flow Volatility and Performance

AbstractThis paper provides a detailed analysis of the impact of daily mutual fund flow volatility on fund performance. I document a significant negative relationship between the volatility of daily fund flows and cross-sectional differences in risk-adjusted performance. This relationship is driven by domestic equity funds, as well as small funds, well-performing funds, and funds that experience inflows over the sample period. My results are consistent with performance differences arising from the transaction costs of nondiscretionary trading driven by daily fund flows, but not with performance differences arising from the suboptimal cash holdings that arise from fund flows.

When Indexing Works and When It Doesn’t in U.S. Equities: The Purity Hypothesis

Conventional wisdom says that domestic equity indexing is more likely to outperform active managers in efficient markets like large stocks and is more apt to underperform active managers in less efficient areas like small stocks. But data from 1998–2007 does not support this idea. Instead, 1998–2007 data show that domestic equity indexing tends to outperform active management in the highest-returning asset classes and tends to underperform active management in the lowest-returning asset categories. This concept is called the Purity Hypothesis. The Purity Hypothesis held true for the 10-year period ended 2007 for the S&P, MSCI, Russell, and Morningstar domestic equity indexes. But its effectiveness on a single-year basis during this time varied by index provider.

Standard & Poor's Indices Versus Active Funds Scorecard, Midyear 2009

The S&P Indices Versus Active Funds (SPIVA) Scorecard reports performance comparisons corrected for survivorship bias, shows equal- and assetweighted peer averages, and provides measures of style consistency for actively managed U.S. equity, international equity, and fixed income mutual funds. The CRSP Survivor-Bias-Free U.S. Mutual Fund Database provides the underlying data. To accommodate CRSP release schedules, SPIVA is now published semi-annually with a 6 to 8 week lag. As a result of the market volatility over the past year, domestic and international equity funds have performed in line or marginally ahead of benchmarks. However, both taxable and tax exempt fixed income funds’ assetweighted returns trail benchmarks by large margins. The latest five-year SPIVA data for equity funds can be interpreted favorably by proponents of both active and passive management. Passive management believers can point out that indices have outperformed a majority of active managers across all major domestic and international equity categories, with real estate being the lone exception. Proponents of active management can point to asset-weighted averages suggesting a more level playing field, with active managers level or ahead of benchmarks in most categories, with the exception of midcaps and emerging markets. The five-year data is unequivocal for fixed income funds. Across all categories except emerging market debt, more than three-fourths of active managers have failed to beat fixed income benchmarks. Similarly, five-year assetweighted average returns are lower for active funds in all but two categories. The turmoil of the past year saw 9% of domestic equity funds, 5% of international equity funds and 6% of fixed income funds merge or liquidate.

How Active Is Your Fund Manager? A New Measure That Predicts Performance

We introduce a new measure of active portfolio management, Active Share, which represents the share of portfolio holdings that differ from the benchmark index holdings. We compute Active Share for domestic equity mutual funds from 1980 to 2003. We relate Active Share to fund characteristics such as size, expenses, and turnover in the cross-section, and we also examine its evolution over time. Active Share predicts fund performance: funds with the highest Active Share significantly outperform their benchmarks, both before and after expenses, and they exhibit strong performance persistence. Nonindex funds with the lowest Active Share underperform their benchmarks.

Decisions of domestic equity fund investors: determinants and search costs

In the present study, we confirm the asymmetry of the performance-flow relationship documented in the literature, but with the particularities of the sample of Spanish funds. Thus, we conclude that mid-performers show no significant influence on investor decisions. The panel data analysis also allows us to conclude that custodial and management fees and the size of the fund have a negative impact on the flows into funds. Empirical evidence is provided on the differential response of investors to the decision factors depending on the market states.

Standard & Poor's Indices Versus Active Funds Scorecard, Year End 2008

The S&P Indices Versus Active Funds (SPIVA) Scorecard report performance comparisons corrected for survivorship bias, shows equal- and asset-weighted peer averages, and provides measures of style consistency covering actively managed U.S. equity, international equity and fixed income mutual funds. Underlying data is from the CRSP Survivor-Bias-Free U.S. Mutual Fund Database. To accommodate CRSP release schedules, SPIVA is published semi-annually with a fourteen week lag. Over the five year market cycle from 2004 to 2008, S&P 500 outperformed 71.9% of actively managed large cap funds, S&P MidCap 400 outperformed 79.1% of mid cap funds and S&P SmallCap 600 outperformed 85.5% of small cap funds. These results are similar to that of the previous five year cycle from 1999 to 2003. The belief that bear markets favor active management is a myth. A majority of active funds in eight of the nine domestic equity style boxes were outperformed by indices in the negative markets of 2008. The bear market of 2000 to 2002 showed similar outcomes. Benchmark indices outperformed a majority of actively managed fixed income funds in all categories over a five-year horizon. Five year benchmark shortfall ranges from 2-3% per annum for municipal bond funds to 1-5% per annum for investment grade bond funds. The script was similar for non-U.S. equity funds, with indices outperforming a majority of actively managed non-U.S. equity funds over the past five years.

AN EMPIRICAL ANALYSIS OF STOCK MARKET INTEGRATION: COMPARISON STUDY OF SINGAPORE AND MALAYSIA

Using a GARCH (1,1) model, this paper compares the extent to which financial sector liberalization in Singapore and Malaysia each has led to integration of its domestic equity market with external markets. The results show that the level of integration of the domestic markets with the external markets is higher when MSCI regional and global data are used, as compared to when individual country data are used to proxy regional and global markets. Inferences are made about the preferred pace of liberalization in Singapore, as well as, the impact of the Asian financial crisis and capital control measures imposed in Malaysia on financial integration, in the respective countries under study.

The Investment Strategies of Sovereign Wealth Funds

This paper examines the direct private equity investment strategies across sovereign wealth funds and their relationship to the funds' organizational structures. SWFs seem to engage in a form of trend chasing, since they are more likely to invest at home when domestic equity prices are higher, and invest abroad when foreign prices are higher. Funds see the industry P/E ratios of their home investments drop in the year after the investment, while they have a positive change in the year after their investments abroad. SWFs where politicians are involved have a much greater likelihood of investing at home than those where external managers are involved. At the same time, SWFs with external managers tend to invest in lower P/E industries, which see an increase in the P/E ratios in the year after the investment. By way of contrast, funds with politicians involved invest in higher P/E industries, which have a negative valuation change in the year after the investment.

To Liberalize or Not to Liberalize: Political and Economic Factors Affecting the Government’s Decision to Liberalize the Domestic Equity Markets

The paper investigates the political and economic factors which affect the government’s decision to allow foreign investors to purchase domestic equity securities. The levels of industrialization and financial development, the quality of investor protection, and the level of the government’s involvement in the economy are closely associated with the stock market liberalization decision. Additionally, the amount of foreign financial aid received by the governments in the emerging market countries is significantly and positively related to the probability of a stock market liberalization. The latter result contributes to the debate about the effectiveness of foreign aid by illustrating that foreign financial aid may indirectly affect economic growth through its influence on the government’s decision to liberalize the national equity markets.

Investors' Misperception: A Hidden Source of High Markups in the Mutual Fund Industry

We develop a principal-agent model based on a sequential game played by a representative investor and a fund manager in an asymmetric information framework. The model shows that investors' perceptions of the fund market play the key role in the fund's fee-setting mechanism. The managers' true ability to deliver performance is not relevant. Along with a simple relation between fees and funds' performance, empirical evidence suggests that most U.S. domestic equity mutual funds have added high markups in recent years. We show that, for these fees to be justified, investors would have expected the fund managers to be able to deliver an overall annual excess-return of around 3% over the S&P 500, net of fees, irrespective of the investment style and of the risk level of the funds. Therefore, we interpret these high markups as resulting from the investors' optimism bias whose root can be found in their lack of financial literacy as well as in funds' marketing effort.

What is the Wind Behind this Sail? Can Fund Managers Successfully Time Their Investment Styles?

There is a considerable body of literature that examines the behaviour of institutional investors as a potential source of market price movement. Most existing studies focus on the market timing abilities of active fund managers and find mixed evidence for their fund timing skills. However, few studies have investigated fund manager timing abilities within segments of the market, such as factor timing and sector timing. This study investigates the style timing behaviour of US domestic equity funds existing at any time during the period 1992-2002. Specifically, I examine the timing activities of actively managed mutual funds within different market segments based on such established systematic risk factors as size, book-to-market, momentum, and across different fund styles such as aggressive growth, growth and income, and small company funds, etc. Mutual fund timing strategy can be viewed as the fund manager's response to his/her private information regarding future factor premiums. Instead of directly observing how fund managers make their timing decisions, an alternative approach is to look at the direct outcomes of their decisions, which are related to the factor timing loadings derived from a factor timing model. I significantly expand on the work of Bollen and Busse (2001) and Volkman (1999) by combining systematic risk factors unique to equity markets with timing factors unique to actively managed portfolios. Within this empirical timing-activity evaluation framework, I additionally investigate fund timing behaviour in the context of Morningstar star rating performance record, investment objectives, fund age, turnover, and load expense, etc. This paper is an original contribution to the literature of fund timing activities, which seeks to contribute to our understanding in terms of investigating mutual fund managers' timing strategies with respect to specific systematic risk factors and their evolution over time. This research has important implications both for extant asset pricing theories and for practitioners especially in the evaluation of portfolio performance and investigation of fund managers' timing activities.

International Portfolio Allocation under Model Uncertainty

This paper revisits an old argument, hedging real exchange rate risk, as an explanation of the international home bias in equity. In a dynamic model, the relevant risk to be hedged is the long-run risk as opposed to the short-run risk. Domestic equity is indeed a good hedge with respect to long-run real-exchange-rate risk. Two new frameworks are able to explain a large share of the observed US home bias: a model with Hansen-Sargent preferences in which agents fear model misspecification and a model with Epstein-Zin preferences. These two models are also immune to the risk-free rate puzzle. (JEL C58, F31, G11, G15)

Liberalism and Home Equity Bias

Countries whose citizens have liberal ideals are less biased toward domestic equity. Data from 30 countries suggests that economic as well as social liberalism is associated with proportionally higher foreign equity holdings. A one standard deviation increase in the level of economic (social) liberalism relative to time-series and cross-sectional averages, is associated with a 5% (2%) relative decrease of home equity bias. These results hold after controlling for standard rational and behavioral explanations of the home equity bias as well as country and time fixed effects.