Equity Portfolios Research Articles

Nonlinear spillover and portfolio allocation characteristics of energy equity sectors: Evidence from the United States and Canada

AbstractWe investigate the nonlinear spillover and portfolio allocation characteristics of the US and Canadian energy equity portfolios. Our empirical study based on directional spillover index and non‐convex portfolio optimization show that the spillover effects in the aggregate are smaller for the US portfolio across time. However, when only the largest spillover transmitters and receivers are considered, the total spillover effects are lower for the Canadian portfolio relative to the US portfolio. These portfolio optimization results indicate lower portfolio allocation risk for the Canadian energy equities during the global financial crisis of 2008 and for the full sample period.

Practical Applications of Using Active Share to Evaluate Single- and Multi-Manager Portfolios

In <b>Using Active Share to Evaluate Single- and Multi-Manager Portfolios</b>, in the <b><i>April 2020 Fund Manager Selection</i></b> special edition of <b><i>The Journal of Portfolio Management</i>, Mark Higgins, Matthew Sturdivan, Janelle Booth,</b> and <b>Claire Illo,</b> all of <b>RVK, Inc.,</b> consider the use of active share to evaluate investment strategies and to select and monitor individual equity managers. Active share statistically measures the difference between a fund manager’s portfolio holdings and the weightings of the fund’s benchmark index. The authors analyze how investors can apply active share when assessing their strategies and managers’ performance and thereby improve their manager selection and portfolio building. Using a simulation approach to evaluate multi-manager US large-cap equity portfolios, the authors show how active share can help quantify the impact of managerial diversification on the quality and efficiency of multi-manager portfolios. They also demonstrate how investors can establish a conditional ideal number of managers for a portfolio. They note, however, that active share has several limitations and should be coupled with other quantitative and qualitative analytical measures to build multi-manager portfolios. <b>TOPICS:</b>Manager selection, performance measurement

Inequality, autocracy, and sovereign funds as determinants of foreign portfolio equity flows

AbstractWe identify new country characteristics that influence cross‐border equity flows: income inequality, autocracy, and sovereign wealth funds. Using 149 source countries and 34 Organisation for Economic Co‐operation and Development (OECD) host countries for 2002–2013, we find that OECD host countries receive higher foreign portfolio investment (FPI) inflows from source countries with high income inequality and source countries with a sovereign wealth fund, but lower inflows from autocratic source countries. We argue that concentrated wealth in a society, overseas investments for the benefit of future generations, and political regimes influence FPI. These variables have been understudied though they provide valuable indicators for policy makers and investors. We supplement our core analysis with realistic interactions between these new variables and with the increasing importance of tax havens. Our results hold throughout a variety of robustness checks.

Tail risk optimized portfolio across states in Asia-Pacific markets with higher-order dependence

ABSTRACT This paper investigates energy commodities’ ability to diversify an equity portfolio across Asia-Pacific Markets. The joint behaviour of the energy commodities and stock index as noted through its shape, changed both temporally and across regime changes. Restricting short selling of stock index by assigning a greater than zero weight on the equity index improved return from the portfolio across regimes. The tail risk optimized portfolio gave the best risk-return trade-off. Though this was the case, one could use VaR and variance as risk measures with higher-order dependence on copulas in the optimization, if there were no constraints on portfolio returns.

What Portfolio in Europe Makes Sense?

This article focuses on European bond and equity portfolios, and specifically the relevance of balanced portfolios. European equity and bond markets have undergone tremendous changes since the launch of the European Monetary Union (EMU) in 2000. Describing the risk–return profile of these markets provides valuable information about past structure and historical returns, and shifts the focus onto future expectations for institutional portfolios. The great volatility and low returns involved in European equity markets are a possible explanation for why investors prefer bonds that show Sharpe ratios higher than one. Taking into account five-year realized inflation, as well as strong bond market performance in the past 20 years with yields in the negative territory, the evidence indicates that the window for expected returns on balanced portfolios with large bond exposure is firmly shut. There are two challenging issues for European portfolio allocation. The first reflects the future of bond exposure in a balanced mandate. The second involves meaningful allocation to equity markets in a balanced portfolio. <b>TOPICS:</b>Security analysis and valuation, fixed income and structured finance, developed markets, portfolio construction <b>Key Findings</b> ▪ European bond markets have performed excellently in the last 20 years because of investor demand, capital inflows, and growth. The European bond market dominates in institutional portfolio allocations, and equity markets have been less attractive, given their risk–return characteristics. ▪ In a negative yield environment and where real equity returns are expected to be positive, it is questionable whether balanced allocation is capable of generating the desired financial outcomes. Foreign exchange, emerging market bonds, and global equities might provide desired returns for investors. ▪ Two challenging issues are involved in European portfolio allocation. The first reflects the future of bond exposure in a balanced mandate. The second involves meaningful allocation to equity markets in a balanced portfolio. Diversification has not disappeared, but finding expected returns might be challenging.

How Much to Invest, If Any, in Precious Metals? A 21st-Century Perspective

Studies that support an investment in precious metals, whether as a defense against severe financial market downturns, as a hedge against inflation, or for price appreciation potential, do not offer guidance on the percentage allocation for “buy-and-hold” investors. As a response to this issue, this study applies the Black–Litterman model of modern portfolio theory to well-known index mutual funds—one guided by the classic 60%/40% stock/bond allocation and one based on an all-equity allocation. The period under study is from January 2000 to September 2020. Although statistical evidence supporting the efficacy of a precious metal allocation is elusive, the results suggest an average allocation of about 2% for “buy-and-hold” investors who seek one. <b>TOPICS:</b>Commodities, portfolio theory, portfolio construction, performance measurement <b>Key Findings</b> ▪ In the 21st century, the prices of precious metals, such as gold and silver, registered robust runs, recording strong double-digit growth rates from 2000 to 2012. The years following, however, saw a reversal of fortunes. Such volatility naturally leads to contention about the efficacy of a precious metal allocation in well-diversified balanced and equity portfolios, with views ranging from 0% to 40%. ▪ Applications of the Black–Litterman model of modern portfolio theory to index-based balanced and equity mutual funds to 1-, 3-, 5-, and 10-year forward-looking holding periods reveal, at times, a place for a precious metal allocation. From 2003 to 2010 and from 2016 to 3Q2020, for example, the allocations are in the range of 5%–10%. Other periods, however, register little more than 0%. ▪ The statistical evidence supporting a precious metal allocation is elusive. Nonetheless, there is enough evidence supporting the holding of precious metals at times that an allocation of about 2% appears appropriate for buy-and-hold investors who prefer one.

Are clean energy assets a safe haven for international equity markets?

While clean energy assets have become new investment vehicles for market participants, their potential for diversification of traditional investments has not been fully explored in previous studies. To fill this void, this paper investigates whether diversifying into clean energy stocks or green bonds could reduce portfolio downside risk for investors holding dirty energy stocks or international equity indices. Specifically, the risks of equity portfolios are compared before and after they are blended with clean energy assets. The incremental impact on the portfolio risk profile is evaluated through variable weightings for clean energy assets. The persistence of diversification effects is then explored by changing the assessment period. Results show that both green bonds and clean energy stocks provide risk diversification benefits for investors with dirty energy stocks. However, green bonds reduce risk while clean energy stocks generally increase the risk of the international equity index portfolio. Further analysis indicates the robustness of the results for the recent COVID-19 period. The findings broaden the limited understanding of the risk reduction capacity of clean energy assets to conventional equities and provide useful implications for investors seeking to decarbonize their equities and portfolio managers designing optimal portfolios to hedge against downside risks.

Size and Operating Profitability Portfolio Returns and Return Premia in Japan—A Tour d’horizon

This study examines the Japanese equity returns and return premia by focusing on firm size- and corporate operating profitability-sorted portfolios over the period from 1990 to 2020. As a result of our explorations, this study derives the following much beneficial findings. (1) The effects of corporate operating profitability and firm size are generally continuously seen in the Japanese equity market. More specifically, (2) the size effect is much stronger in our latter half sub-period; while the operating profitability effect is similarly seen in both our former half and latter half sub-periods. Furthermore, (3) we stress that this study employs the data in US dollars, and calculates several key statistics and measures for not only our full sample period but also many different sub-periods, in which economic and business circumstances are much different. Therefore, for both Japanese and international equity investors, our findings shall be highly useful for enriching and furthering the understanding of returns and return premia of Japanese equity portfolios.

Equity Factor Timing With Kalman Filter

Extensive research literature has shown that equity factor premia is not constant over time. With the broad adoption of factor investing among active managers, to generate differentiated market views and returns, factor or style timing remains as one attractive meaning. We present an adaptive linear factor model to capture time-varying factor risk premia and discuss its application in equity portfolio investment. The model framework that allows time-varying factor returns can potentially capture more returns and allows an investor to understand the changes in cross-sectional factor returns. We estimate model coefficients through a Kalman filter model and discuss the results with an empirical example.

Time and frequency connectedness and network across the precious metal and stock markets: Evidence from top precious metal importers and exporters

This paper examines the time–frequency connectedness between major precious metals markets (gold, palladium, platinum and silver) and their importer and exporter countries’ stock indices (China, Germany, Japan, Korea, UK, Australia, Bulgaria, Mexico, and Russia). We use the time-frequency domain spillover index methodology of Baruník and Křehlík (2018). The results show that the UK stock market is the largest contributor to and receipt of short-term spillovers. Gold, palladium, Chinese, Japanese, Korean, Bulgarian, Mexican, and Russian stock markets are the next receivers of spillover. German and Australian stock markets are, respectively, the largest source and receipt of spillovers in the long term. Furthermore, the spillovers in the short term are higher than their counterparts in the long term, and they are more pronounced during the global financial crisis (GFC). Precious metals contribute more to the forecasting variance for stock markets in the top precious metal exporter economies than in the top precious metal importer economies. They receive more spillovers from stock markets in the top precious metal exporters irrespective of time horizons. In addition, the spillover effects in the short term are higher than their counterparts in the long term in top precious metal exporters. Precious metals provide a better hedging effectiveness than individual equity portfolios. Finally, the hedging effectiveness is higher in the short term relative to the long term for stock markets of precious metal-exporter economies.

Do limits to arbitrage explain the benefits of volatility-managed portfolios?

We investigate whether transaction costs, arbitrage risk, and short-sale impediments explain the abnormal returns of volatility-managed equity portfolios. Even using six cost-mitigation strategies, after transaction costs, volatility management of asset-pricing factors besides the market return generally produces zero abnormal returns and significantly reduces Sharpe ratios. In contrast, abnormal returns of the volatility-managed market portfolio are robust to transaction costs and concentrated in the most easily arbitraged stocks, those with low arbitrage risk and impediments to short selling. Moreover, the managed market strategy only provides superior performance when sentiment is high, consistent with prior theory that sentiment traders underreact to volatility.

Optimal hedge ratios and hedging effectiveness: An analysis of the Turkish futures market

The main purpose of this comprehensive study is to determine the optimal hedge ratios and hedging effectiveness of different futures contracts traded on the Borsa Istanbul (BIST), namely the BIST 30 equity index, US dollar–Turkish lira currency futures (USD-TRY), euro–Turkish lira (EUR-TRY) currency futures, and gold futures. The efficiency of hedge ratios estimated through constant and time-varying econometric models, such as ordinary least squares (OLS) and diagonal VECH—a multivariate generalized autoregressive conditional heteroskedasticity (GARCH) model—are compared with a minimum variance hedge ratio framework. The periods before and after the merger of the Turkish Derivatives Exchange are analyzed with the models to capture changes in the hedging effectiveness of the contracts. We find that the diagonal VECH and constant models produce almost identical positive results for both periods, suggesting similar high hedging effectiveness for BIST 30 equity futures contracts. We conclude that BIST 30 equity futures contracts provide an efficient hedging mechanism for investors aiming to protect their spot equity portfolios. However, after Turkey's foreign exchange regulation amendment in 2017, the percentage of variance reduction improves greatly for the dynamic GARCH model, compared to the static OLS model, for USD-TRY and EUR-TRY futures contracts. Furthermore, the hedging effectiveness of currency futures contracts is negatively affected during the COVID-19 pandemic period beginning in 2020. Unlike other contracts, the hedging effectiveness of gold contracts is low in all periods.

The Impact of Shareholder Litigation Risk on Equity Incentives: Evidence from a Quasi-Natural Experiment

ABSTRACT While prior studies generally support that equity-based compensation induces CEOs to manipulate financial reporting, there is limited direct empirical evidence on whether financial misreporting concerns affect compensation design. A key challenge for establishing a causal relationship is that misreporting incentives and compensation policies are often endogenously determined. Exploiting the exogenous reduction in litigation threat following a 1999 ruling of the U.S. Ninth Circuit Court of Appeals, we examine how heightened misreporting concerns in a less litigious environment affect CEOs' compensation design. Consistent with the theoretical prediction that misreporting concerns prevent companies from providing more powerful incentive pay that is otherwise optimal, we find that firms headquartered in Ninth Circuit states decreased CEOs' equity portfolio vega relative to the control firms after the ruling. We further document that this reduction was concentrated among firms facing greater misreporting concerns post-ruling. JEL Classifications: J33; K22; M52.

Practical Applications of Using Active Share to Evaluate Single- and Multi-Manager Portfolios

In <b>Using Active Share to Evaluate Single- and Multi-Manager Portfolios</b>, in the <b><i>April 2020 Fund Manager Selection</i></b> special edition of <b><i>The Journal of Portfolio Management</i>, Mark Higgins, Matthew Sturdivan, Janelle Booth,</b> and <b>Claire Illo,</b> all of <b>RVK, Inc.,</b> consider the use of active share to evaluate investment strategies and to select and monitor individual equity managers. Active share statistically measures the difference between a fund manager’s portfolio holdings and the weightings of the fund’s benchmark index. The authors analyze how investors can apply active share when assessing their strategies and managers’ performance and thereby improve their manager selection and portfolio building. Using a simulation approach to evaluate multi-manager US large-cap equity portfolios, the authors show how active share can help quantify the impact of managerial diversification on the quality and efficiency of multi-manager portfolios. They also demonstrate how investors can establish a conditional ideal number of managers for a portfolio. They note, however, that active share has several limitations and should be coupled with other quantitative and qualitative analytical measures to build multi-manager portfolios. <b>TOPICS:</b>Manager selection, performance measurement

Portfolio rebalancing in times of stress

This paper investigates time variation in the dynamics of international portfolio equity flows. We extend the empirical model of Hau and Rey (2004) by embedding a Markov regime-switching model into the structural VAR. The model is estimated using monthly data from 1995 to 2018, on equity returns, exchange rate returns, and equity flows between the United States and advanced and emerging market economies. We find that the data favor a two-state model where coefficients and shock volatilities switch jointly. In the VAR for flows between the United States and emerging market economies, the estimated states match periods of low and high financial stress, both in terms of the timing of regime switching and in terms of their volatility characteristics. Our main result is that for equity flows between the United States and emerging markets rebalancing dynamics differ between episodes of high and low levels of financial stress. A switch from the low- to the high-stress regime is associated with capital outflows from emerging markets. Once in the high-stress regime, the response of capital flows to exchange rates and stock prices is smaller than in normal (low-stress) periods.

International Portfolio Investments with Trade Networks

What determines the composition of international portfolio investments remains an open question in international finance. In this paper, I propose a theory of international portfolio choice where trade networks play a key role. I solve in closed form for the optimal equity and bond portfolio investments in a multi-country model with arbitrary global input - output linkages and taste differences. I show that a measure of international demand exposure, called the “International Domar Weights” (IDWs), is key in determining international equity portfolios. The IDWs extend the closed-economy “Domar weights” to the international setting and capture countries' interdependence through both direct and indirect trade linkages. Using data from the World Input - Output Database (WIOD) and Coordinated Portfolio Investment Survey (CPIS), I apply the framework to a network of 43 major developed and emerging economies and obtain four main results. First, the theoretical network portfolio is a significant predictor and explains almost half of the variation in international bilateral portfolio investments. The significance of the network portfolio is robust to controlling for gravity factors (market capitalization, distance, EU membership, etc.). Second, including the network-based portfolio in a gravity model for assets resolves the puzzle of why distance matters for asset trade at all. Third, indirect trade linkages matter for portfolio determination, highlighting the need to explicitly account for trade in intermediate inputs. Finally, the model predicts both the levels and the changes in equity home bias that have occurred since 2000.

A multivariate 4/2 stochastic covariance model: properties and applications to portfolio decisions

This paper introduces a multivariate 4/2 stochastic covariance process generalizing the one-dimensional counterparts presented in [Grasselli, M., The 4/2 stochastic volatility model: A unified approach for the Heston and the 3/2 model. Math. Finance, 2017, 27(4), 1013–1034]. Our construction permits stochastic correlation not only among stocks but also among volatilities, also known as co-volatility movements, both driven by more convenient 4/2 stochastic structures. The parametrization is flexible enough to separate these types of correlation, permitting their individual study. Conditions for proper changes of measure and closed-form characteristic functions under risk-neutral and historical measures are provided, allowing for applications of the model to risk management and derivative pricing. We apply the model to an expected utility theory problem in incomplete markets. Our analysis leads to closed-form solutions for the optimal allocation and value function. Conditions are provided for well-defined solutions together with a verification theorem. Our numerical analysis highlights and separates the impact of key statistics on equity portfolio decisions, in particular, volatility, correlation, and co-volatility movements, with the latter being the least important in an incomplete market.

Ideal Investment Protection in Optimistic Perceptions: Evidence From the Indian Equity Options Market

The study is an experiential assessment on the ability of the Indian equity options market to resist the adverse impacts that arise from unexpected changes in the underlying equity market, focusing on two distinct investor perceptions within optimistic dimension in the market, viz. the recovery phase and the growth phase, which were evident in the Indian market scenario post the period of financial upheavals due to global economic crisis during the latter half of 2000s. The risk mitigation capability of the options is examined in terms of long run integration and short run re-equilibrating relationship shown by near month calls and puts with varied stages of exercisability with their underlying equity segment in the National Stock Exchange of India. Further, the ideal hedge sizes of the options and the hedge gains resulting from affecting them in the investment profile are identified under minimum variance framework, using Diagonal BEKK GARCH. The results are indicative that all different options segments express to have the expected resistance ability during both bullish perceptions under consideration, and prove that optimal use of options with equity portfolio provides assured hedge gains in terms of reduction in un-anticipatable variances.

Equity Portfolio Optimization With Gold

Design/methodology/approach: The investment portfolio optimization procedure in the Markovitz environment is made. The study is devoted to investments made by Polish investors, that is stocks are reflected by the WIG index from the Warsaw Stock Exchange. The analysis is conducted in different periods of time in 2006–2019 covering bull and bear markets of gold. Findings: It is shown that gold can be used as a hedge asset; however, exact conclusions depend on the market situation. Including gold in the stock portfolio increases the portfolio rate of return and at the same time decreases risk measured with variance, however only during the bull market of gold. During the bear market, gold helps minimize risk but at the same time it lowers the portfolio rate of return compared to stocks-only portfolio. Besides, it turns out that during the bull market of gold, both skewness and kurtosis of the portfolio are more advantageous for an optimal portfolio covering both stocks and gold than for the stock one. Research limitations/implications: An important assumption of the study is in what way investments in gold are made. Here, they are made by the use of spot gold prices and they are recalculated into Polish zlotys in order to check the Polish investor perspective. In reality, it is not easy to invest directly in big amounts of gold, although in the literature spot gold prices are used for such research. Originality/value: The research contributes to the existing international literature on using gold in stock portfolio management by analyzing the problem from the point of view of a Polish investor.

Robust Conditional Variance Estimation and Value-at-Risk

A common approach to estimating the conditional volatility of short horizon asset returns is to use an exponentially weighted moving average (EWMA) of squared past returns. The EWMA estimator is based on the maximum likelihood estimator of the variance of the normal distribution, and is thus optimal when returns are conditionally normal. However, there is ample evidence that the conditional distribution of short horizon financial asset returns is leptokurtic, and so the EWMA estimator will generally be inefficient in the sense that it will attach too much weight to extreme returns. In this paper, we propose an alternative EWMA estimator that is robust to leptokurtosis in the conditional distribution of portfolio returns. The estimator is based on the maximum likelihood estimator of the standard deviation of the Laplace distribution, and is a function of an exponentially weighted moving average of the absolute value of past returns, rather than their squares. We employ the robust EWMA estimator to forecast the VaR of aggregate equity portfolios for the US, the UK and Japan using historical simulation. We find that the robust EWMA estimator offers an improvement over the standard EWMA estimator. In particular, the VaR forecasts that it generates are as accurate as those generated by the standard EWMA estimator, but are more efficient in the sense that the average level of capital required to cover against unexpected losses is lower and the root mean square deviation between the VaR forecast and actual returns is smaller. Moreover, the volatility of the VaR forecast itself is substantially lower with the robust EWMA estimator than with the standard EWMA estimator, reflecting its lower sensitivity to extreme returns.