Mean-variance Spanning Tests Research Articles

Implementing mean–variance spanning tests with short-sales constraints

Implementing mean–variance spanning tests with short-sales constraints

Risk optimizations on basis portfolios: The role of sorting

This paper investigates the mean–variance and diversification properties of risk-based strategies executed on style or basis portfolios. We show that the performance of these risk strategies is highly sensitive to the sorting procedure used to form the basis assets. Whereas the extant literature provides mixed support for the outperformance of smart beta strategies based on scientific diversification, our designed strategies outperform both the market model and multifactor model. Our testing framework is based on bootstrapped mean–variance spanning tests and shows valid conclusions when controlling for multiple testing, transaction costs, and luck from random basis portfolio construction rules. Economically, our results are supported by diversification-based properties. • The dependent sorting procedure improves the efficiency of basis portfolios. • Low-risk optimizations on dependent basis portfolios outperform traditional portfolios. • Maximum diversification and minimum variance deliver very strong outperformance. • Smart betas on dependent portfolios span a larger set of traditional portfolios.

Are Stock-Market Anomalies Anomalous After All?

We propose a stochastic spanning to evaluate whether anomalies are genuine under factor-model framework. Our approach is nonparametric and does not rely on any assumption of return distribution and investor risk preferences. It depends on the whole distribution of returns, rather than only on the first two moments. Of the anomalies we consider, only a few expand the opportunity set of the risk-averter and have real economic content. Our approach is consistent in identifying genuine anomalies in and out of samples. This is in contrast to mean-variance (MV) spanning tests where anomalies identified in-sample, not out-of-sample.

Strategic Asset Allocation in the Times of Financialized Commodity Markets

The paper concentrates on the benefits of passive commodity investments in the context of the phenomenon of financialization. I investigate the implications of increase in the correlation between equity and commodity investments for commodity investors. The paper is composed of several parts. First, I describe the attributes of commodity investments and their benefits in the portfolio optimization. Second, I define the phenomenon of the finanzialization and develop my research hypothesis. Third, the section includes a description of data sources, research methods employed. Next, I present the results of the empirical analysis. I simulate the mean-variance spanning tests to examine the benefits of commodity investments before and after accounting for the impact of financialization. I proceed separate analysis for pre- and post-financialization period. The empirical research is based on asset classes’ returns and other related variables from years 1991-2012. The performed research indicates that the market financialization may have significant implications for commodity investors. Because of the increase in correlations, the inclusion of the commodity futures in the traditional stock-bond portfolio appears to be no longer reasonable.

Do Sukuk provide diversification benefits to conventional bond investors? Evidence from Turkey

We investigate the contribution of Sukuk in diversification of bond portfolios. We do so by comparing Turkish bond funds that invest exclusively in conventional bonds (pure conventional bond funds), in Sukuk (pure Islamic bond funds), and in both (mixed bond funds) among each other for the period of 2014–2019. We employ tests of differences in means and variances of various risk-return measures as well as mean-variance spanning and intersection tests in order to uncover the diversification potentials of Sukuk in the portfolio management industry. Our results suggest that bond funds, of which the portfolios are composed of a combination of Sukuk and conventional bonds (i.e. mixed bond funds), have a relatively “lower risk-higher return” profile. Moreover, including Sukuk to conventional bond portfolios theoretically offers significant diversification opportunities for investors, particularly when the economy worsens.

Does Factor Investing Improve Investor Welfare? A Multi-Asset Perspective

Investment decisions in delegated money management are typically made in two stages. In the first stage, a centralized decision maker allocates capital to the different asset classes. In the second stage, asset managers decide how to allocate available wealth to the individual securities within the corresponding asset class. Although commonly used in investment practice, this approach potentially involves a loss of efficiency compared with a single-step optimization procedure. The authors show that this welfare loss is zero if, and only if, the benchmarks completely explain the cross section of expected returns of the securities. This theoretical proposition justifies factor investing as an investment method that constructs investable proxies for pricing factors. Mean-variance spanning tests confirm that investment opportunities offered by standard equity, bond, and commodity factor benchmarks are not spanned by corresponding broad asset class benchmarks. The authors then conduct out-of-sample tests with these factors and find that they improve the risk-return profile of multiclass portfolios with respect to the case in which these portfolios are invested in broad asset class benchmarks. TOPICS:Wealth management, factor-based models, portfolio theory, portfolio construction Key Findings • A set of benchmark portfolios made of individual securities offers the same investment opportunities as these securities if, and only if, their returns are asset pricing factors, meaning that they collectively explain differences in expected returns. • Mean–variance spanning tests lead the authors to reject the hypothesis that traditional broad equity, bond, and commodity asset class benchmarks generate the same efficient frontier as factor benchmarks drawn from these three classes. • Out of sample, introducing factor benchmarks in multi-asset portfolios that contain traditional asset class benchmarks improves their Sharpe ratio.

Cryptocurrencies from the perspective of euro investors: a re-examination of diversification benefits and a new day-of-the-week effect

We examine diversification benefits of several cryptocurrencies between 11 August 2015 and 7 August 2018 using mean–variance spanning tests. Among the eight cryptocurrencies under study, we find that all single cryptocurrencies besides one as well as a combination thereof yield significant diversification benefits when being added to a well-diversified benchmark portfolio. However, the improvement solely stems from an increase in portfolio returns, not a reduction of risk. Along with that distinction, we find that the overall beneficial impact of cryptocurrencies only holds for bullish market phases throughout our observation period, but vanishes completely throughout the price collapse of cryptocurrencies in 2018. Furthermore, we model daily differences in the returns and volatility of cryptocurrencies with an EGARCH model. Throughout the observation period considered, returns of all eight cryptocurrencies on Sundays are significantly lower than those on other days. A similar but less distinctive pattern is also observable for their conditional variance. One possible reason for the negative Sunday effect is the lower trading volume observed on Sundays, in connection with the assumption of a causal relationship between trading volume and asset returns and volatility as suggested by the mixture of distributions hypothesis.

An Investigation into the Benefits of Investing in Chinese Multinational Companies

We provide a unique longitudinal analysis into firm-level multinationality of Chinese firms between 2002 and 2012 using two measures of multinationality—the Aggarwal, Berrill, Hutson and Kearney (2011, International Business Review, 20, 557–577) system and foreign sales as a percentage of total sales. We find that Chinese firms have low levels of multinationality with most foreign sales in the triad regions of Asia, Europe and North America. We use mean variance spanning tests to investigate the benefits from investing in Chinese multinational corporations (MNCs). We find that Chinese MNCs offer little diversification benefits to domestic investors and firms with greater multinationality levels do not result in greater benefits.

Smart Equity Investing: Implementing Risk Optimization Techniques on Strategic Beta Portfolios

This paper investigates the mean-variance and diversification properties of risk-based strategies executed on style or basis portfolios. We show that the performance of these risk strategies is highly sensitive to the sorting procedure used to form the basis assets. Whereas the extant literature provides mixed support for the outperformance of smart beta strategies based on scientific diversification, our designed strategies outperform both the market model and multifactor model. Our testing framework is based on bootstrapped mean-variance spanning tests and shows valid conclusions when controlling for multiple testing, transaction costs, and luck from random basis portfolio construction rules. Economically, our results are supported by diversification-based properties.

Is Commodity Index Investing Profitable?

Using a comprehensive dataset of first, second and third generation commodity indices, we investigate the potential diversification benefits of commodities in equity–bond portfolios. To this end, different approaches of mean–variance spanning tests and out-of-sample portfolio optimization are implemented. The results show that first generation commodity indices fail to diversify traditional portfolios and are outperformed by enhanced indices. The diversification benefits of second generation indices are indicated by slightly increased portfolio Sharpe ratios but at the same time challenged as they are spanned by benchmark assets. For third generation commodity indices, the mean–variance spanning hypothesis is rejected but they show heterogenous out-of-sample performances. We thus present new evidence showing that the portfolio performance of the third generation of commodity indices is less clear-cut than found in existing studies.

The Curious Case of Portfolio Selection: Analysis of Correlations and Diversification over Time

This paper revisits the Modern Portfolio Theory (Markowitz, 1952) by investigating correlations between countries and for various bonds, stocks and real estate indices over time from an U.S. perspective. Analyzing the changes over time can provide information for investors on the question whether they should construct portfolios dynamically by taking possible changes into account. The goal of this thesis is to come to a generalized statement about (1) the degree of stability of correlations over time, (2) the pattern of correlations over time, (3) the movement of the efficient frontier over time and (4) the diversification benefits over time. First, stability of correlations is tested with the Jennrich-Test (Jennrich, 1970). Subsequently, the pattern of the correlations is examined with three methods: rolling-window, EWMA and the DCC(1,1)-GARCH(1,1) model. In addition, the impact over time of these correlations on the efficient frontier is analyzed in two ways. In one way, sub-period efficient frontiers are created in order to investigate the effect of possible unstable correlations in a dynamic setting. In the other way, several variants of the mean-variance spanning tests, as laid out by Kan & Zhou (2008), are computed in order to gain information about the significance of the movements of efficient frontiers and possible diversification gains over time. Results show that correlations of stocks and real estate seem to be stable over time, but have the tendency to increase during a crisis. However, the strong increase seems to stabilize over time. These findings confirm the fact that correlations tend to be higher during bear markets than in bull markets, implying stabilization on the long-term. In contrast, correlations of bonds are not stable over time and could be the result of country-differences in the dynamics of risk characteristics of bonds and monetary policy. Correlations of bonds did not substantially increase during the crisis. Correlations of bonds have in fact fallen for a short period of time during the recession, although they do show small upward shocks. This implies possible short-term demand shifting from high (sovereign debt) risk to low risk government bonds. With regard to the effects of correlations on the risk-return trade-off, it has been found that this trade-off resembles the pattern of the correlation coefficients. Only stocks and real estate have an increase in risk over time and a substantial upward shock in risk during a recession. In contrast, bonds appear to be relatively resistant to a possible increase in risk, especially during a recession. Adding a short-selling restriction does not change the main findings, but it did show that a short-selling restriction limits (potential) diversification gains. Finally, on the basis of various spanning tests, it can be indicated that spanning tests need to be corrected for normality, as the spanning tests under normality can lead to distorted results and conclusions due to the nature of financial data in this study and in general. Results of the asymptotic spanning tests show that (1) an investor benefits from diversification (over time), (2) these benefits have the tendency to decline during recessions and that (3) a relatively large portfolio could make diversification gains quite resistant during recessions.

Portfolio Diversification with Commodities in Times of Financialization

The study concentrates on the benefits of passive commodity investments in the context of the phenomenon of financialization. The research investigates the implications of increase in the correlation coefficients between equity and commodity investments for investors in financial markets. The paper is composed of several parts. First, the attributes of commodity investments and their benefits in the portfolio optimization are explored. Second, the phenomenon of the financialization is described and the research hypothesis is developed. Next, an empirical analysis is performed. I simulate the mean-variance spanning tests to examine the benefits of commodity investments before and after accounting for the impact of financialization. I proceed separate analysis for pre- and post-financialization period. The empirical research is based on asset classes’ returns and other related variables from years 1991-2012. The performed investigations indicate that the market financialization may have significant implications for commodity investors. Due to increase in correlation coefficients, the inclusion of the commodity futures in the traditional stock-bond portfolio appears to be no longer reasonable.

Accounting for market risk in microfinance investments

Microfinance is primarily designed to have social impact. However, little is known about the financial attractiveness of investing in microfinance. Most microfinance institutions are private instead of publicly listed on a stock exchange. Hence, existing research relies on accounting-based returns to determine the diversification characteristics of microfinance investments relative to other asset classes. These prior studies use accounting-based risk measures as a proxy for market-based risk measures. We document that for a sample of publicly listed microfinance institutions, accounting-based and market-based risk measures have low correlation. Therefore, using accounting-based risk measures might underestimate the (market) risk embedded in investing in microfinance institutions. In addition, we show that mean-variance spanning tests that use accounting-based returns of microfinance institutions overstate the added value of microfinance institutions in investment portfolios. Taken together, our results indicate that previous research on the attractiveness of investments in microfinance institutions could be exaggerated.

Cost Growth and Stock Returns

This paper shows that investors fail to fully incorporate cost behavior information into valuation. Firms with higher growth in operating costs generate substantially lower future stock returns. A long-short spread portfolio earns an average return of about 12% per year after controlling for extant risk factors and firm characteristics. Mean-variance spanning tests show that an investor can benefit from investing in this spread portfolio in addition to well-known factors. Firms with high cost growth also suffer from deterioration in future operating performance. The negative cost growth-return relation is much stronger around earnings announcement days, among firms with lower investor attention, higher idiosyncratic volatility, and higher transaction costs, suggesting that investor underreaction and limits to arbitrage mainly drive the effect.

Multifactor risk loadings and abnormal returns under uncertainty and learning

Abstract We explore the time variation of factor loadings and abnormal returns in the context of a four-factor model. Our methodology, based on an application of the Kalman filter and on endogenous uncertainty, overcomes several limitations of competing approaches used in the literature. Besides taking learning into account, it does not rely on any conditioning information, and it only imposes minimal assumptions on the time variation of the parameters. Our estimates capture both short- and long-term fluctuations of risk loadings and abnormal returns, also showing marked variation across US industry portfolios. The results from mean-variance spanning tests indicate that our baseline model yields accurate predictions and can therefore improve pricing and performance measurement.

Implications of Financialization for Strategic Asset Allocation: The Case of Correlations

The study concentrates on the benefits of passive commodity investments in the context of the phenomenon of financialization. The research investigates the implications of increase in the correlation coefficients between equity and commodity investments for investors in financial markets. The paper is composed of several parts. First, the attributes of commodity investments and their benefits in the portfolio optimization are explored. Second, the phenomenon of the financialization is described and the research hypothesis is developed. Next, an empirical analysis is performed. I simulate the mean-variance spanning tests to examine the benefits of commodity investments before and after accounting for the impact of financialization. I proceed separate analysis for pre- and post-financialization period. The empirical research is based on asset classes’ returns and other related variables from years 1991-2012. The performed investigations indicate that the market financialization may have significant implications for commodity investors. Due to increase in correlation coefficients, the inclusion of the commodity futures in the traditional stockbond portfolio appears to be no longer reasonable.

What Matters in International Equity Diversification?

Over the past decade, investors and financial advisors have shown renewed interest in increasing international equity exposure. Investors confront one of two key issues in making decisions on their strategic allocations, depending on the starting point of their portfolios: 1) for a U.S.-only equity portfolio, the issue is which strategies produce the most beneficial international exposure; 2) for a portfolio already with significant international exposure, the issue is what benefits are there in exploring small cap, micro cap, and new frontiers in international equity investing. We use mean-variance spanning and optimization tests of indexes to assess the comparative benefits of competing paths to international diversification of the equity segment of an investor’s portfolio. We find that for investors with a U.S.-only stock segment in their portfolios, any of the international indexes examined substantially improve risk and return characteristics — more evidence that home bias is costly. No clear winners emerge among the indexes, however. For the investor who already has a diversified portfolio of U.S. large and small cap, developed ex-U.S. large cap, and emerging markets large cap, an extension to frontier markets would be beneficial. The additional diversification and return benefits from extending to developed ex-U.S. small and micro cap as well as emerging markets small and micro cap are small.

Emerging Markets Inflation-Linked Bonds

We investigate the added value of inflation-linked bonds in an investment portfolio. Recently, several studies questioned the added value of inflation-linked bonds based on empirical analyses on developed markets. We extend the cross-section of countries with a set of nine emerging markets and conclude that for many of these countries the inclusion of inflation-linked bonds improves the risk-return characteristics of investment portfolios. We also document that inflation-linked bond returns correlate more with realized inflation than nominal bonds, even on the short run. Hence, investors that invest in nominal bonds and equities should also allocate a significant amount to inflation-linked bonds. Furthermore, our mean-variance spanning tests indicate that US investors that already invest in emerging markets nominal bonds and emerging markets equities benefit from adding emerging markets inflation-linked bonds to their investment portfolio.

Hedge funds and optimal asset allocation: Bayesian expectations and spanning tests

This paper analyzes the contribution of hedge funds to optimal asset allocations between 1993 and 2010. The preferences of specific institutional investors are captured by implementing a Bayesian asset allocation framework that incorporates heterogeneous expectations regarding hedge fund alpha. Mean-variance spanning tests are used to infer the ability of hedge funds to significantly enhance the mean-variance efficient frontier. Further, a novel democratic variance decomposition procedure sheds light on the dynamics in the co-movement of hedge fund returns with a set of common benchmark assets. The empirical findings indicate that portfolio benefits of hedge funds are time-varying and strongly depend on investor optimism regarding hedge funds’ ability to generate alpha. In general, allocations to hedge funds improve the global minimum variance portfolio even after controlling for short-selling restrictions and minimum diversification constraints. However, due to dynamics underlying the composition of the aggregate hedge fund universe, the factor structure of hedge fund returns has become more similar to the benchmark assets over time.

Hedge Funds and Optimal Asset Allocation: Bayesian Expectations, Time-Varying Investment Opportunities and Mean-Variance Spanning

In this paper we analyze the contribution of hedge funds in optimal asset allocations for different investor clienteles. The preferences of specific institutional investors are captured by implementing a Bayesian asset allocation framework that incorporates heterogeneous expectations regarding alpha. Mean-variance spanning tests are used to draw inferences on the ability of hedge funds to enhance the efficient frontier. A novel variance decomposition procedure is employed for analyzing the co-movement of hedge fund returns with the benchmark assets. The empirical findings strongly indicate that portfolio benefits of hedge funds are time-varying and crucially depend on investor optimism regarding hedge fund alpha. Allocations to hedge funds improve the global minimum variance portfolio even after controlling for short-selling restrictions and minimum diversification constraints. However, the factor structure of hedge fund returns has become more similar to the benchmark assets due to dynamics underlying the composition of the aggregate hedge fund universe.