Mean-variance Spanning Research Articles

Family firms, founders, and the cross-section of stock returns

In the light of the large number of signals found empirically to predict firms’ stock returns, some researchers in this field speak of data mining. To avoid this, newly proposed so-called return predicting signals should be based on a theoretical foundation. Building on research on identity and entrepreneurial orientation, I propose that firm status (i.e., “founder CEO” and “family” firms) is a viable signal that predicts part of firms’ stock returns. My results suggest that a “founder CEO firm” indicator has predictive value for explaining part of the cross-section of stock returns while controlling for established risk factors, whereas a “family firm” indicator does not. Additionally, the performance of a risk factor created from a “founder CEO firm” indicator cannot be explained by the common risk factors currently used. Finally, the results from a mean-variance spanning test suggest that it would be beneficial to include a “founder CEO firm” risk factor in the set of common risk factors currently established in the asset pricing literature. My results have several implications for both research and practice.

Identification-robust beta pricing, spanning, mimicking portfolios, and the benchmark neutrality of catastrophe bonds

This paper proposes inference strategies for conditional and unconditional asset pricing models, which cover beta pricing, the zero-beta rate, risk prices, Jensen’s alphas, mean–variance spanning and intersection. We derive analytical conditions that link the identification of the zero-beta rate to spanning. Following finite-sample statistical considerations, the proposed procedures correct for measurement error with mimicking portfolios, and are invariant to fund repacking as well as and robust to: (i) missing factors, (ii) identification of risk price, and (iii) the quality of conditioning information. Empirically, we study benchmark neutrality of Catastrophe bond mutual funds. Results show that potential for diversification is significant before the 2008 financial crisis, yet lack support thereafter.

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.

Are Strategies for International Diversification by Country, Industry and Region Equivalent?

In this study, we examine whether international portfolio diversification still matters despite an increase in the cross-country correlations of assets returns. More specifically, we explain why an increase in global return correlations does not necessarily imply a reduction in the benefits of international portfolio diversification. We also propose to compare empirically two traditional strategies of international diversification (by country and industry) in addition to a new strategy (by region) using two different methodological approaches, namely the mean variance spanning and multivariate cointegration analysis. Over the full sample period (1994- 2008), our results suggest that the three strategies of international diversification remain effective despite the secular increase in the cross-country return correlations. When we divide the sample into two different sub-periods (1994-2000 and 2000-2008), the findings indicate that the strategy based on regional diversification proved to be a new competing strategy during the second period in comparison to the other two traditional strategies.

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.

The Tracking Efficiency of Physical and Synthetic Equity Index ETFs

This article evaluates the tracking efficiency of physical and synthetic Exchange Traded Funds (ETFs). Theoretically, synthetic ETFs should provide greater tracking efficiency. We study this using ETFs domiciled in Europe tracking the European, United States and Emerging Markets. We calculate the tracking error differences and use univariate analysis across both replication and regional strategies. Our contribution is in identifying the variables that influence ETF tracking efficiency. We find the total expense ratio remains the pre-eminent explanatory variable, but the type of replication strategy is a significant secondary factor. We observe that the counterparty risk in synthetic strategies is not rewarded relative to physical replication strategies, but the synthetic ETFs increase returns of tangency portfolios compared to physical ETFs when analyzed using mean-variance spanning techniques. This suggests investment in synthetic strategies is suited to risk tolerant investors and investment in physical strategies is more suited for risk averse investors. TOPICS:Exchange-traded funds and applications, analysis of individual factors/risk premia, VAR and use of alternative risk measures of trading risk, risk management, interest-rate and currency swaps Key Findings • The type of replication strategy employed by an ETF is a significant secondary factor in its tracking efficiency. • Synthetic ETFs’ replication increases returns of tangency portfolios compared to physical ETFs when analyzed using mean-variance spanning techniques. • Investment in synthetic strategies is suited to risk tolerant investors, while investment in physical strategies is more suited for risk averse investors.

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.

MICRO-FINANCE AND PORTFOLIO DIVERSIFICATION

The purpose of this paper is to investigate the impact on diversification benefits if microfinance stocks are included in a portfolio. Prices of different micro-finance stocks and data regarding stocks indices of respective countries are taken from Thomson One Banker database. To investigate whether diversification benefits may be enhanced or not by including microfinance stocks in one’s portfolio, the mean-variance spanning test is applied. Although the lesser or sometimes negative correlation between microfinance stocks and international portfolio is spotted no diversification benefits are identified by the inclusion of microfinance stocks in the portfolio. It may be because of the reason that most of the microfinance stocks are offering negative returns and therefore not attractive for the investors. The poor performance of micro-finance institutions maybe because of the two-fold objective of sustainability and social welfare or may be attributed to high operating cost bear by microfinance institutions. It means that microfinance may not offer good diversification opportunities. This is the first study of its kind that investigates to investigate the role of microfinance stocks in international diversification.

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.

EXPLORING DIVERSIFICATION BENEFITS IN ASIAN EQUITY MARKETS

This paper examines the benefits of international diversification from the perspective of local investors in 15 Asian markets whose initial portfolio holdings consist of assets from the respective domestic markets. We employ the step-down approach of the mean–variance spanning test to examine the statistical significance of regional and global diversification benefits. The analysis is conducted using three portfolio groups based on relative strength ranking technique. The empirical evidence suggests greater benefits from regional diversification compared to global diversification, in most instances. For Asian economies with restrictions on international investing, these findings suggest a further liberalization of their markets.

Measuring the diversification benefits of investing in highly internationalised firms

A vast literature exists investigating if Multinational Companies (MNCs) provide indirect international exposure to investors. These studies produce mixed results. Unlike previous studies, we distinguish between various types of MNCs, in particular firms that are consistently international versus firms that are in the process of internationalising. We provide a unique longitudinal dataset of firm-level multinationality of 396 Russell 1000 firms between 1996 and 2010, and estimate the diversification benefits of investing in these firms using mean variance spanning and Sharpe ratio tests. We find that the most consistently international firms provide the greatest diversification benefits. Rapidly internationalising firms provide little benefit, suggesting that the costs of rapid firm-level internationalisation are substantial. This distinction between firms at differing stages of internationalisation adds to the debate on the benefits of investing in MNCs and provides a possible explanation to the conflicting findings in the literature.

Inflation-Linked Bonds as a Separate Asset Class: Evidence from Emerging and Developed Markets

One of the key goals of strategic asset allocation is protection against inflation. High inflation eats up real returns, causing a damaging effect on a portfolio of bonds and equities. Inflation-linked bonds (ILBs) were introduced to shield the purchasing power of a portfolio from inflationary conditions by linking portfolio returns to inflation, over a bond’s life term. The current research evaluates the acceptability of ILBs as a separate asset class and as an inflation hedge. It uses data from four emerging and four developed markets for a period of five years, that is, 2011–2016. The study employs multiple regression, cross-correlations and mean-variance spanning techniques to demonstrate the abovementioned benefits of ILBs. The findings of the study establish an advantage of excess returns provided by ILBs over nominal bonds under varying inflationary conditions. An improvement in mean-variance efficiency is found when ILBs are added to a portfolio. Overall, the study contributes to the body of knowledge by suggesting that ILBs can be included in a portfolio to hedge, as well as to improve its strategic asset allocation.

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.

Erratum to: Searching for a listed infrastructure asset class using mean–variance spanning

The article Searching for a listed infrastructure asset class using mean–variance spanning written by Frederic Blanc-Brude, Timothy Whittaker, Simon Wilde was originally published Online First without open access.