Return Dispersion Research Articles

Practical Applications of The Impact of Market Conditions on Active Equity Management

<h3>Practical Applications Summary</h3> In <b>The Impact of Market Conditions on Active Equity Management</b>, from the Winter 2018 edition of <b><i>The Journal of Portfolio Management</i></b>, authors <b>Harsh Parikh</b> of <b>PGIM</b>, <b>Karen McQuiston</b> of <b>BlackRock</b>, and <b>Sujian Zhi</b> of <b>Huatai Securities</b> analyze the performance of active equity management approaches relative to a trio of measures of “market conditions”: (1) dispersion of returns across equities during a given period, (2) volatility of overall market returns over time, and (3) the overall level of market returns. The authors’ goal is to help investors meet their objectives through portfolio constructions suited to variations in those conditions. The authors explore how, between 1996 and 2016, the excess returns delivered by active equity managers—both quantitative and fundamental—fared in response to different market environments. The authors collected and arranged into quartiles 21 years of market-condition data from the large-cap U.S. equity space, modeling the relative performance of a potpourri of portfolio combinations—a mix of core, growth, and value styles and of high-, moderate-, and low-intensity management approaches—against the three market conditions. The authors uncovered correlations between certain active management approaches and predominating market conditions. They note that the reputation of active equity management, currently in question, might be boosted if markets begin to falter and greater dispersion is seen across individual stock returns, which could rekindle the effectiveness of judicious stock picking. <b>TOPICS:</b>Security analysis and valuation, manager selection

On The Role of Elite Law Firms in IPOs

IPOs with underwriters that retain an elite law firm exhibit a lower average first-day return. This empirical pattern remains after controlling for an extensive set of proxies associated with existing explanations of IPO initial returns. We rationalize this finding with a pre-IPO pricing model, in which underwriters convey their lack of conflicts of interest to the issuer by engaging an elite law firm. Consistent with this selection channel and our model's predictions, we find a lower incidence of elite law firm involvement and a larger difference in average first-day return associated with elite law firms during the dot-com period. We document similar findings with respect to the dispersion of IPO first-day returns and a pattern in the issuers' re-hiring decision of investment banks consistent with our theory.

Tax Aggressiveness, Market and Idiosyncratic Risks in Brazil

This study aims to analyze the relationship between tax aggressiveness and the risks associated with the variation of returns in Brazilian companies’ stock, particularly regarding the systematic and idiosyncratic risks. The sample was formed by companies that composed the IBOVESPA index in the period between 2011 to 2016. The measurements of tax aggressiveness were the effective tax rate and the temporary book-tax differences. The results showed a significant relationship between tax aggressiveness and risk, concluding that the higher the tax aggressiveness, the lower the beta and the higher the idiosyncratic risk. The finding for the direct relationship between tax aggressiveness and idiosyncratic risk is in line with the literature, reflecting the dispersion of probable returns due to tax deferral practices and associated tax risks. The inverse relationship between market risk and tax aggressiveness may represent a greater attractiveness for these stocks in investment portfolios that seek less exposure. Tax aggressive firms would behave as a hedge in a diversified portfolio because they are less sensitive to market variations. This study is essential because it maps the effect of tax aggressiveness on the financial risks related to Brazilian companies’ shares, as well as being useful to investors, portfolio and business managers.

Cross-sectional alpha dispersion and performance evaluation

Our paper explores the link between cross-sectional fund return dispersion and performance evaluation. The foundation of our model is the simple intuition that in periods of high return dispersion, which is associated with high levels of idiosyncratic risk for zero-alpha funds, unskilled managers can more easily disguise themselves as skilled. Rational investors should be more skeptical and apply larger discounts to reported performance in high dispersion environments. Our empirical results are consistent with this prediction. Using fund flow data, we show that a one standard deviation increase in cross-sectional return dispersion is associated with an 11% to 17% decline in flow-performance sensitivity. The effect is stronger for recent data and among outperforming funds.

Predicting firm level stock returns: Implications for asset pricing and economic links

We examine the predictive ability of stock price ratios, stock return dispersion and distribution measures for firm level returns. Analysis typically focusses on market level returns, however, for the underlying asset pricing model to hold, firm-level predictability should be present. Additionally, we examine the economic content of predictability by considering whether the predictive coefficient has the theoretically correct sign and whether it is related to future output growth. While stock returns reflect investor expectations regarding future economic conditions, they are often too noisy to act as predictor. We use the time-varying predictive coefficient as it reflects investor confidence in the predictive relation. Results suggest that a subset of stock price ratios have predictive power for individual firm stock returns, exhibit the correct coefficient sign and has predictive power for output growth. Each of these ratios has a measure of fundamentals divided by the stock price and has a positive relation with stock returns and output growth. This implies that as investors expect future economic conditions to improve and earnings and dividends to rise, so expected stock returns will increase. This supports the cash flow channel as the avenue through which stock return predictability arises.

Short-Term Momentum (Almost) Everywhere

Is there a short-term reversal effect outside the universe of individual stocks? To answer this, we investigate a comprehensive dataset of more than two centuries of returns on five major asset classes: equity indices, government bonds, treasury bills, commodities, and currencies. Contrary to stock-level evidence, we find a striking short-term momentum pattern: the most recent month’s return positively predicts future performance. The effect is not explained by established return predictors — including the standard momentum — and is robust to many considerations. The short-term momentum is strongest among assets of high idiosyncratic volatility and in periods of elevated return dispersion. Also, the strategy payoffs display partial commonality across different asset classes.

Consumption growth predictability and asset prices

Abstract We derive and test a consumption-based intertemporal asset pricing model in which an asset earns a risk premium if it performs poorly when expected future consumption growth deteriorates. The predictability of consumption growth combined with the recursive preference delivers news about future consumption growth an additional risk factor, in addition to news about current consumption growth. We model the consumption growth dynamics using a vector autoregressive (VAR) structure with a set of instrumental variables commonly used for forecasting future economic growth. Our VAR estimation provides strong empirical support for future consumption growth predictability. The cross-sectional test shows that the model explains reasonably well the dispersion in average excess returns of 25 portfolios sorted on size and book-to-market, as well as 25 portfolios sorted on size and long-term return reversal. Growth stocks and long-term winners underperform value stocks and long-term losers, respectively, because growth stocks and long-term winners hedge adverse changes in the future consumption growth opportunities.

Long-Run Reversal in Commodity Returns: Insights from Seven Centuries of Evidence

We perform the longest study of long-run reversal in commodity returns. Using a unique dataset of prices of 52 agricultural, industrial, and energy commodities, we examine the price behavior for the years 1265 to 2017. The findings reveal a strong and robust long-run reversal effect. The returns of the past one to three years negatively predict subsequent performance in the cross-section of returns. The effect is robust to extensive subsample and subperiod analysis, and not driven by statistical biases, extreme events, or macroeconomic risks. Our findings support the explanation that the long-term reversal originates from supply and demand adjustments following price changes. Finally, the phenomenon is elevated in more volatile commodities and in periods of high return dispersion.

Equity Return Dispersion and Stock Market Volatility: Evidence from Multivariate Linear and Nonlinear Causality Tests

We employ bivariate and multivariate nonlinear causality tests to document causality from equity return dispersion to stock market volatility and excess returns, even after controlling for the state of the economy. Expansionary (contractionary) market states are associated with a low (high) level of equity return dispersion, indicating asymmetries in the relationship between return dispersion and economic conditions. Our findings indicate that both return dispersion and business conditions are valid joint forecasters of stock market volatility and excess returns and that return dispersion possesses incremental information regarding future stock return dynamics beyond that which can be explained by the state of the economy.

Return Dispersion and Fund Performance: Australia – the Land of Opportunity?

We examine the relation between cross-sectional stock return dispersion and active fund performance in Australia, drawing on the concept that higher return dispersion provides greater opportunity for skilled managers to generate value. In contrast with findings using US data that outperformance occurs only for the most active funds and in the highest return dispersion environments, Australian data show that active funds earn positive returns when return dispersion is in the moderate-to-high range. We also find meaningful differences between large-cap funds, where outperformance is modest and significant only for the most active funds, and small-cap funds, where active returns are larger in magnitude and do not depend greatly on fund activeness. Applying a switching strategy between active funds and passive investment reveals that investors would be advantaged by retaining exposure to active funds in Australia in all but low return dispersion months in the absence of buy-sell spreads. However, imposing spreads eliminates the added value from switching, concluding in favour of maintaining an active exposure regardless of the dispersion environment.

Herding behaviour in Indian equity market: a quantile regression approach

This study examines the presence of herding behaviour in the Indian equity market using average daily data from BSE-500 Index stocks for January 2000 to December 2018. The study employs model developed by Chang et al. (2000) using cross sectional absolute deviation of return dispersion as a measure of herding behaviour. The empirical results of OLS regression reveal absence of herding behaviour for pre, during and post crisis period in normal market return and the asymmetric market condition. Similarly, no evidence of herding behaviour is found by examining trading volume and volatility. Further, robustness checked by applying non-parametric techniques of quantile regression, the result remains consistent with OLS findings. Overall, herding behaviour does not prevail in the Indian equity market. The outcome of increased return dispersion may be due to the efficient micro information in the Indian equity market.

Herding behaviour in Indian equity market: a quantile regression approach

This study examines the presence of herding behaviour in the Indian equity market using average daily data from BSE-500 Index stocks for January 2000 to December 2018. The study employs model developed by Chang et al. (2000) using cross sectional absolute deviation of return dispersion as a measure of herding behaviour. The empirical results of OLS regression reveal absence of herding behaviour for pre, during and post crisis period in normal market return and the asymmetric market condition. Similarly, no evidence of herding behaviour is found by examining trading volume and volatility. Further, robustness checked by applying non-parametric techniques of quantile regression, the result remains consistent with OLS findings. Overall, herding behaviour does not prevail in the Indian equity market. The outcome of increased return dispersion may be due to the efficient micro information in the Indian equity market.

HIP, RIP, and the robustness of empirical earnings processes

The dispersion of individual returns to experience, often referred to as heterogeneity of income profiles (HIP), is a key parameter in empirical human capital models, in studies of life‐cycle income inequality, and in heterogeneous agent models of life‐cycle labor market dynamics. It is commonly estimated from age variation in the covariance structure of earnings. In this study, I show that this approach is invalid and tends to deliver estimates of HIP that are biased upward. The reason is that any age variation in covariance structures can be rationalized by age‐dependent heteroscedasticity in the distribution of earnings shocks. Once one models such age effects flexibly the remaining identifying variation for HIP is the shape of the tails of lag profiles. Credible estimation of HIP thus imposes strong demands on the data since one requires many earnings observations per individual and a low rate of sample attrition. To investigate empirically whether the bias in estimates of HIP from omitting age effects is quantitatively important, I thus rely on administrative data from Germany on quarterly earnings that follow workers from labor market entry until 27 years into their career. To strengthen external validity, I focus my analysis on an education group that displays a covariance structure with qualitatively similar properties like its North American counterpart. I find that a HIP model with age effects in transitory, persistent and permanent shocks fits the covariance structure almost perfectly and delivers small and insignificant estimates for the HIP component. In sharp contrast, once I estimate a standard HIP model without age‐effects the estimated slope heterogeneity increases by a factor of thirteen and becomes highly significant, with a dramatic deterioration of model fit. I reach the same conclusions from estimating the two models on a different covariance structure and from conducting a Monte Carlo analysis, suggesting that my quantitative results are not an artifact of one particular sample.

Investment and the Cross‐Section of Equity Returns

ABSTRACTThe data show that, upon being hit by adverse profitability shocks, large public firms have ample latitude to divest their least productive assets, reducing the risk faced by shareholders and the returns that they are likely to demand. In the one‐factor production‐based asset pricing model, when the frictions to capital adjustment are shaped to respect the evidence on investment, the model‐generated cross‐sectional dispersion of returns is only a small fraction of that documented in the data. Our conclusions hold even when operating or labor leverage is modeled in ways shown to be promising in the extant literature.

Wage Growth and Equity Risk Premia

We develop a simple three-factor consumption-based asset pricing model that includes wage growth as a risk factor, and evaluate whether the model explains six major CAPM anomalies: book-to-market, investment, operating profitability, long-term return reversal, net share issues, and residual variance. Wage growth arises in the pricing kernel by using a non-separable utility over consumption and leisure, and represents the growth in the opportunity cost of enjoying leisure hours. In the model, wage growth earns a negative price of risk, that is, higher wage growth leads to a decline in leisure demand, which increases the marginal utility of consumption for an investor with risk aversion above one. The empirical cross-sectional tests show that the model explains around 50% of the cross-sectional dispersion in average returns of the joint six CAPM anomalies (160 equity portfolios). Further, the proposed model compares favorably with alternative return-based multifactor models widely used in the literature. The risk price estimates for wage growth are significantly negative, while the implied preference parameter (share of leisure) estimates are economically plausible in most cases. Overall, our results suggest that aggregate wage growth can help explaining cross-sectional equity risk premia.

Confucius and Herding Behaviour in the Stock Markets in China and Taiwan

It has been argued in the literature that financial markets with a Confucian background tend to exhibit herding behaviour, or correlated behavioural patterns in individuals. This paper applies the return dispersion model to investigate financial herding behaviour by examining index returns from the stock markets in China and Taiwan. The sample period is from 1 January 1999 to 31 December 2014, and the data were obtained from Thomson Reuters Datastream. Although the sample period finishes in 2014, the data are more than sufficient to test the three hypotheses relating to the stock markets in China and Taiwan, both of which have Confucian cultures. The empirical results demonstrate significant herding behaviour under both general and specified markets conditions, including bull and bear markets, and high-low trading volume states. This paper contributes to the herding literature by examining three different hypotheses regarding the stock markets in China and Taiwan, and showing that there is empirical support for these hypotheses.

Market Risk and the Momentum Mystery

This paper employs the ZCAPM asset pricing model of Liu, Kolari, and Huang (2018) to show that momentum returns are highly related to market risk arising from return dispersion (RD). Cross-sectional tests show that momentum risk loadings and RD risk loadings are similarly priced in momentum portfolios. Comparative analyses find that zero-investment momentum portfolios and zero-investment return dispersion portfolios earn high returns relative to other risk factors. Further regression tests indicate that zero-investment momentum returns are very significantly related to zero-investment return dispersion returns. We conclude that the momentum mystery is explained by market risk associated with return dispersion for the most part.

Practical Applications of An Empirical Analysis of Investment Return Dispersion in Emerging Market Private Equity

<h3>Practical Applications Summary</h3> Is private equity investment really riskier in emerging markets than in developed markets? In <b>An Empirical Analysis of Investment Return Dispersion in Emerging Market Private Equity</b>, published in the Fall 2017 issue of <b><i>The Journal of Private Equity</i></b>, <b>Josh Lerner</b> (<b>Harvard Business School</b>) and <b>Mark Baker</b> (then an analyst at <b>Bella Research</b>) tackle this question by looking at the dispersion of returns at the level of individual transactions. Through analysis of deal-level data, they show that internal rates of return are not significantly more dispersed in emerging markets than they are in developed markets, and-interestingly-that ratios of total value to paid-in capital are actually more widely dispersed in developed markets. <b>TOPICS:</b>Private equity, emerging, performance measurement, statistical methods

Herding in the cryptocurrency market: CSSD and CSAD approaches

We analyse the existence of herding in the cryptocurrency market through the cross-sectional standard (absolute) deviation of returns. Our results show that extreme dispersion of returns is explained by rational asset pricing models although it is possible to observe herding during down markets, which highlights the inefficiency and risk of cryptocurrencies. We also observe that the smallest digital currencies are herding with the largest ones, thus traders base their decisions on the performance of the main cryptocurrencies. However, the herding phenomenon cannot be solely attributed to Bitcoin, since the rest of the market is not herding with the main cryptocurrency.

Net Buybacks and the Seven Dwarfs

During the last two decades, the relationship between economic growth and equity returns has been weak across global stock markets. Economic growth has not been a good proxy for dividend-per-share growth. In the majority of the stock markets, issuance has exceeded buybacks and has resulted in a dilution effect. In several markets, however, buybacks have exceeded issuance, resulting in an accretion effect. The main finding of our study is that, whether investors use a dividend model or a total payout model to decompose equity returns, net buybacks explain more than 80% of the cross-sectional dispersion of stock market returns.