Why CompanySpecific Risk Changes over Time Author(s): James A. Bennett and Richard W. Sias Source: Financial Analysts Journal, Vol. 62, No. 5 (Sep.  Oct., 2006), pp. 89100 Published by: CFA Institute Stable URL: http://www.jstor.org/stable/4480775 Accessed: 15/04/2010 23:40
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Why
over
Time
number of recent studies [e.g., Campbell, Lettau, Malkiel, and Xu 2001 (henceforth, CLMX); Morck,Yeung,and Yu2000;Goyal and SantaClara 2003] have demonstrated that, although marketand industry risk remained relativelystablein theU.S.marketbetweenthe early 1960s and the late 1990s, companyspecific risk climbedsteadilythroughoutthe period.Inaddition, as we demonstratein this study, companyspecific riskhas exhibiteda seculardeclinesince the market peak in 2000. Changes in companyspecificrisk over time affectportfolio managersfor a number of reasons. First, companyspecificrisk is directly related to portfoliodiversification: Active managersattempting to achievesome given level of companyspecific risk need to hold larger portfolios, all else being equal, during periods of high companyspecific risk. This aspect is especially importantin light of recent research revealing that diversification requires portfolio sizes much greater than previously believed.Forexample,we have demonstrated (see Bennettand Sias 2006)that in recentyears, one in five investorsholding a randomlyselectedequalweighted 50stock portfolio averaged an annual shock of 16 percent.Not surpriscompanyspecific ingly, we reported that valueweighted portfolios (correspondingclosely to most portfolios held in practice)exhibitedeven greaterlevels of companyspecific risk. Second,the level of companyspecific risk is directlyrelatedto both trackingerrorversus an index and the crosssectional dispersionof active
James Bennett, A. CFA, assistantprofessor is offinance at theUniversity Southern of Maine,Portland. Richard W. Sias is a professor GaryP. BrinsonChairof and Investment Management Washington at StateUniversity, Pullman.
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portfolio returns (De Silva, Sapra, and Thorley 2001; Bennett and Sias 2006). When companyspecific risk increases, managers have a greater likelihood of obtaining returns that differ (positively or negatively) from both indices and peers. Third, recent evidence (Goyal and SantaClara 2003; Jiang and Lee 2004) suggests that the aggregate level of companyspecific risk is positively related to future market returns. Hence, the recent decline in companyspecific risk portends lower future market returns if this pattern continues. Fourth, arbitrageurs' ability to exploit security mispricing is directly related to levels of companyspecific risk; because the difficulty of forming arbitrage portfolios increases with an increase in companyspecific risk, mispricings can persist longer during periods of high companyspecific risk. Thus, for an informed active manager, the payoff from investing in an undervalued stock may take longer to realize when companyspecific risk levels are high. Previous researchers have argued that changes in companyspecific risk over time may reflect fundamental changes in the economy and/or markets, such as decreases in operational diversification as companies narrow their product/market focus (CLMX), an increase in the use of stock options as executive compensation (CLMX), systematic increases in the volatility of return on equity or growth opportunities (Wei and Zhang 2006; Cao, Simin, and Zhao 2005), a decline in financial reporting quality (Rajgopal and Venkatachalam 2005), an increase in the role of institutional investors in the market and their tendency to herd (Xu and Malkiel 2003), increases over time in levels of informed trading (Morck, Yeung, and Yu 2000; Durnev, Morck, and Yeung 2004), an increase in capital market openness (Li, Morck, Yang, and Yeung 2004), and an increase in competition between companies (Irvine and Pontiff 2005).
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In the study reportedhere, we tested a simpler explanationthan previously proposed for changes in aggregate companyspecificrisk over time. To differsfrompreviunderstandhow our explanation considerthefollowing:The(valueous explanations, for risk, weighted)averagecompanyspecific FIRMt, the Njtsecuritiesin the marketat time t is simply the risk productof each securityj's companyspecific at time t, c2(j,t), and its time t weight in the market portfolio,wjt,summed acrosssecurities:
Njt
individual securities'betas. Following CLMX,we estimatedthe companyspecificreturnfor stockj in industry i on day s as the daily deviation between the stock'sreturnand its industry'sreturn; used we the 49 industries defined by Fama and French (1997).We then computed the estimated monthly companyspecificrisk for stock j in month t as the sum of the squared daily deviations over all days in month t:
(52(Ijiit) = set
is Ris) S(2)
FIRM, =
w W11& (jt) 
(1)
j=1
Previous explanations for changes in FIRMt focusedon factorsinfluencingthe companyspecific riskof individualsecurities,such as increaseduse of stock options, increased herding by institutional investors,or increasedcompetitionbetweencompanies. Our explanation focuses on changes in the weights of individual securities, which, in turn, determinethe relativeimportanceof industriesand smallcapstocksin the marketand also affecterrors in estimatesof companyspecific risk.1Specifically, we propose that threekey changes in the composition of the market explain changes in companyspecificrisk over time: * changesin the relativeimportanceof industries containing aboveaveragelevels of companyspecific risk,
where Rjsis securityj's returnon day s in month t and Ri, is the valueweighted industry return on day s.2 Aggregatecompanyspecificrisk in month t is the weighted averagecompanyspecificriskacross all securities:
Nj,
FIRM, =
j=l
Wjta
(it)
(3)
changes in the relative importance of small companiesin the market,and * changes in measurement error induced by changing withinindustryconcentration. Distinguishing between these explanations is importantin practicebecauseour analysissuggests that changes in companyspecificrisk faced by a given managerare a functionof the changesin that manager's portfolio. For example, as long as the manager does not have great exposure to smallstocks,the risein aggregatecompanycapitalization specific risk attributedto the growth of smallcap stocksin the marketwill not affectthat manager.In otherwords, accordingto our explanations, managers cancontroltheirexposureto timevarying aggregate companyspecificrisk through industry and securityselection.Previousexplanationssuggested risk thatchangesin companyspecific arepervasive, so a managercan do little to managesuch risks. *
Using Equations 2 and 3, we estimated companyspecific risk for each month between August 1962 and December 2003 for all NYSE, Amex, and NASDAQ securities in the CRSPdatabase. Figure 1 graphs the estimated annualized (i.e., monthly variance estimate times 12) valueweighted companyspecific volatility in the sample period. Figure1 reveals,as previously documentedby CLMX,an upward trend in companyspecificrisk in the 196299period.At approximatelythe market peak in 2000,however, companyspecificriskwent into a sharp decline. Following CLMX,we computed a linear trend coefficient(i.e., the coefficient from a timeseries regression of aggregate companyspecific risk on time) and a trend tstatistic that is robust to serial correlation (the Vogelsang t PST tstatistic).3Estimates for the entire sample period (19622003),the period with generallyrisingcompanyspecificrisk(19621999), and the period with generally falling companyspecific risk (20002003)are reportedin Table 1. The results in Table 1 reveal no evidence of a statistically significant trend in companyspecific risk over the entire sample period, but companyspecific risk displays a statistically significant uptrendin the 196299period followed by a statistically significant downtrend during the 200003 period. In fact, companyspecificrisk has declined so sharply since the marketpeak that it was lower in 2003thanthe averagecompanyspecific over risk the 1970s.4
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Figure 1.
ValueWeighted CompanySpecific
Risk, 19622003
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Table 1.
Measure Mean risk (%) Standard deviation (%) Autocorrelation (lst order) Linear trend x 105 1 TPS tstatistic (5%)
PS'
tstatistic (10%)
Notes: Companyspecific risk was computed monthly as the sum of the squared daily deviations between the stock's return and the valueweighted industry return weighted by the market value of the stock. These variance estimates were annualized by multiplying by 12. The critical values for the 10 percent and 5 percent levels for Vogelsang's t  PST tstatistic are, respectively, 1.720 and 2.152. The linear trend for each risk measure was calculated from a regression of the monthly risk measure on time. *Significant at the 10 percent level. **Significant at the 5 percent level.
increase over the 196299 period and the subsequent decline. In addition, most previous explanations implicitly assumed that changes in valueweighted average companyspecific risk are driven by changes in the returngenerating process itself (i.e., that the distribution of companyspecific shocks for each security changes over time) rather than changes in weighting. Equation 1, however, shows that given different levels of companyspecific risk among securities, changes in weighting will cause aggregate companyspecific risk to change over time. Therefore, we next present evidence that the
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three factorsassociatedwith changes in weighting largely explain the changes in companyspecific risk over time. Changes in Industry Weights. In August 1962(thefirstmonthin our sampleperiod),the four largestindustriespetroleum and naturalgas, utilities, telecommunications, and automobilesaccountedfor 44 percentof aggregatemarketcapitalization. By December 2003, those industries accountedfor only 14 percentof marketcapitalizathe tion. Similarly, four largestindustriesat the end of the sample periodbanking, business services, pharmaceuticals,and tradingaccounted for 36 percent of the market capitalizationin December 2003 but only 5 percent of the aggregate market capitalizationin 1962. As long as industries have different levels of companyspecificrisk, changes in industry weights will lead to changes in the weighted averagecompanyspecificriskover time. shocksarisingfrom Forexample,companyspecific a change in technologywill affecta greaterfraction of the market in today's environmentthan previously becausethe relativevalue of technologycompanies has increasedover time. To examine the possibility that changes in industryweights help explainchangesin companyspecific risk, we assigned each of the 49 industries to one of two groups"Risky" or "Safe."SpecifiFigure 2.
cally, we computed the valueweighted average companyspecific risk of securities within each industryover the August 1962July1964periodand then defined those industries with median and abovemediancompanyspecificrisk as Risky and risk as those with belowmediancompanyspecific eachmonth,the ratioof the Safe.Wethencalculated, total capitalizationof Risky industries to the total of capitalization Safeindustries.Figure2 graphsthis ratio, as well as aggregate companyspecificrisk, over time.Thepatternis clear:Aggregatecompanyspecificriskrises (falls)as riskierindustriesbecome a larger(smaller)partof the market. As a formal test that changes in industry weights help explain changes in aggregate companyspecificrisk, we computed the correlation between realized aggregatecompanyspecific risk and a hypothetical forecast of companyspecific risk calculated by assuming that companyspecificriskwithin each industryremainsconstant over time but industryweights vary over time. We beganby computingthe valueweightedcompanyspecificriskin eachindustryover the firsttwo years in the sample period as the (constant)estimate of the companyspecificrisk for each industry in the future.For each month subsequentto the first two of years in the sample,we computed the "forecast" companyspecificrisk as the sum (across indus
Ratio of Market Value of Risky Industries to Market Value of Safe Industries Compared with CompanySpecific Risk over Time, 19622003
of TotalCapitalization RiskyIndustriesto of TotalCapitalization Safe Industries 1.0 . CompanySpecific Risk2 ~~~~~~(left axis) 0.9
40 0 40
35 30 25
F
08 0.
0.7 0.6
RiskyIndustries/SafeIndustries
axis) 0
20:(right
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0.3
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tries) of the products of each industry's actual weight at time t and the constantestimate of companyspecific risk for that industry. That is, although we updated the industry weights each risk month,the estimateof companyspecific in each industrywas held constantat its averagevalue over the first two years in the sample period. The timeseries correlationbetween actual aggregate companyspecificriskand this monthlyforecastof companyspecific risk based solely on changing industryweights was found to be 51.47percentand statisticallysignificantat the 1 percentlevel. Company Size. The numberof small companies in the sample grew dramaticallyover time as the sample size increased from 2,039 securities in August 1962to a peak of 9,146securitiesin December 1997. The number of small companies subsequently declined as the number of companies fell from the 1997peak to 6,690securitiesin December 2003.Although aggregatecompanyspecificrisk is a valueweighted measure, the dramaticrise and subsequent fall in the number of securities in the sample suggests thatchangesin the relativeimportance of smallcap stocks in the market may help explain observed changes in aggregate companyspecific risk over time. We began to examinethis relationship partiby tioningstocksinto two groupseachmonth:"Large" (the largestcapstocks that, in total, accountedfor
half of the total marketcapitalization time t) and at "Small" (the remaining stocks, which also accountedfor half of marketcapitalization). Figure 3 graphsthe ratioof numberof Smallto numberof Largeand repeatsthe graphof aggregatecompanyspecific risk over time. Figure 3 reveals a strong positive relationshipbetween this ratio and valueweightedcompanyspecific At thebeginningof risk. the sample period, there were approximately37 smallcapstocksfor every largecapstock.Theratio closely tracked the pattern in aggregate valueweighted companyspecificrisk. The ratio rose to more than 100 smallcapstocks for every largecap stockby the end of 1999.Byyearend2003,however, the ratiohad fallen to 57 smallcapstocks for every largecapstock. Similarto our analysis of changes in industry weights, we generateda formaltest of the hypothesis that the rise and subsequentfall in the relative role of smallcapstocksin the markethelps explain changes in aggregate companyspecific risk by between realized aggrecomputing the correlation gate companyspecificriskand a hypotheticalforecastof companyspecific designed to isolatethe risk impactof changesin the weight of smallcapstocks over time.We rankedthe 2,039securitiesin the first month of the sample period (August 1962)by size and placed them in size deciles. Each of the first nine decilescontained204stocks;the remaining203 stocks were placed in the bottom decile (smallest
Figure 3. Ratio of Numberof Small Companies to Numberof Large Companies Compared with CompanySpecific Risk over Time, 19622003
ValueWeighted CompanySpecific Risk(%) 50 4540Numberof SmallCompanies/ Numberof LargeCompanies axis) ~~~~(right 100 Ratioof Smallto Large 120
80
30 25 20 15
60
10~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~1

Risk(left ~~~~~~~CompanySpecificaxis)
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companies).Then,holding the numberof securities in each of the top nine deciles constantat 204in each subsequentmonth,we placed all remainingsecurities into the bottom decile. Thatis, each month, the firstnine deciles containedthe largest 1,836securities (9 x 204) and the final decile contained all remaining securities. We then estimated each decile's weighted average companyspecific risk over the first two years in the sample period as our constantestimate of companyspecificrisk for that size decile in the future.In each subsequentmonth (excluding the first two years), we computed the risk forecastof companyspecific as the sum (across size deciles) of the products of each decile's time t market weight and the constant estimate of risk companyspecific for thatdecile.Thus,as in our industry analysis,although the sizedecile weights were updated each month, the estimate of companyspecificrisk within each decile was held constantat its averageover the firsttwo yearsin the sample period. As a result, changes in the level of the forecastedweighted averagecompanyspecific risk over time were completely a result of changes in the relativeweights of the size deciles. The timeseries correlationbetween this monthly forecastof companyspecific risk and actual aggregate risk companyspecific was found to be 24.88percent and statisticallysignificantat the 1 percentlevel. In summary,despite the factthatthe companyspecificriskmetricis value weighted, we found that the growth and subsequent decline of smallcap securities in the market play a substantialrole in accountingfor the changes in aggregatecompanyspecificrisk over time. Changes in WithinindustryConcentration. Theanalysisthusfarhas demonstrated changes that in market weights affect aggregate companyspecific risk by changing both the relative importance of industries with high versus low levels of companyspecificrisk and the relativeimportance of smallcapversus largecapstocks.Theimpacton risk caused by weighted averagecompanyspecific these changes in weights may be considered a "direct" effect. Changes in securityweights also have a more subtle, "indirect"effect on estimated companyspecificrisk,however, because of the estimationof returnsas the differencebetween companyspecific securityand industryreturns.All else being equal, returns the including themselves, estimatedcompanyspecific risk for a particularsecurity (and thus the aggregatecompanyspecificrisk for a given industry and the overallmarket)will vary with the distribution of marketcapitalizationamong companies within an industry. Specifically,assuming returns
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are generated by a linear factor model in which securitieswithin each industryhave homogeneous factor sensitivities (i.e., homogeneous betas), the estimated valueweighted average companyspecific risk of companies in the industry is given by (proofavailablefrom authorsupon request):
a2 a2( (i~=a2(i.~w2.ajii 2t (f(i,t)
(jit) j)
(4)
jcri
where c2(fiit) is the true (unobservable) weighted average companyspecificrisk in industry i and ca2(iit)is the estimatedweighted averagecompanyspecificrisk in industryi.5 Thefirsttermon therighthand of Equation side 4 is the "true"weighted averagecompanyspecific risk in the industry. The second term, however, demonstratesthat estimated companyspecificrisk will depend on the distributionof withinindustry weights; therefore, the second term represents a potentialsourceof bias.6 Two intuitive examples will demonstrate that this bias is likely to cause estimated companyspecific risk to increase (decrease) when withinindustry concentration declines (increases). First, consider the extreme case of industry concentrationan industry consisting of a single company.7 In this situation, industry returnswill equal the company's returnsand estimated companyspecific returns (and risk) will equal zero, even if the company truly does experience companyspecific shocks.8 Or consider a less extreme example, one in which the truevarianceof companyspecific shocks is some constant,C, across all securitieswithin an industry;that is, a2
(jit)=
(5)
for all securitiesin industry i. In such a case, Equation 4 simplifies to the industry's true average companyspecificrisk, C, times 1 less the industry portfolio's Herfindahlindex; that is,9
2
(JC(j i2
(6)
In otherwords, when securitiesin an industryhave the same level of companyspecific risk,an increase in industryconcentration leads to an increasein the downwardbias in estimatedcompanyspecific risk. In addition,the magnitudeof the bias will be minimized when marketcapitalizations equal across are companiesin the industry.Although not all securities in an industryare likely to possess equal levels of companyspecific risk, Equation4 demonstrates thatthenegativebiasin estimatedcompanyspecific risk for any industry is maximized when industry
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concentrationis maximized:As the weight of any company within an industry approaches 1, estimated companyspecific risk for the industry approaches0. In general,however, the set of weights wjitthat minimizes the bias term (i.e., the second term in Equation4) will depend on the specific values of
the true companyspecific risk,
2(ijit),
across
companies. The question of how concentration affectschanges in estimatedcompanyspecificrisk over time is ultimately an empirical one, and it cannot be ignored unless concentrationis either very low or constantover time. Empirically,U.S. marketconcentrationis both high and variable over time; less than half of 1 percentof securities,for example, made up the top quarterof the market'scapitalization,on average, between 1962and 2003. Over time, however, markets have become somewhat less highly concentrated. Figure 4 graphs the weighted average withinindustry Herfindahl index and aggregate companyspecific risk over time.10 The graph reveals a steady downtrend in withinindustry concentrationbetween 1962and 1999followed by a slight increasein concentrationsince then, which is consistent with the hypothesis that estimation errorinduced by changes in withinindustry con
centration contributes to changes in estimated companyspecificrisk over time.11In the absence of such a bias, this negative relationshipbetween industry concentration and estimated companyspecific risk may be counterintuitive.One might expect that as industry profitability declines, the industry will consolidate (i.e., concentrationwill increase) and companyspecificrisk will increase because of greateruncertainty(i.e., a positive relationship exists between concentration and companyspecificrisk).12 In our study, we next performed a simple examination of the potential role that changing industry concentration plays in explaining changes in companyspecificrisk over time. Using only returns from the first month in the sample period and holding the role of small companies and industry weights constant, we examined whether realized changes in industry concentration, by themselves, help explain changes in companyspecific risk over time. We began by computing industry weights and companyspecific riskmeasuresbased on the sample of 2,039 securities in 48 industries in August 1962.13We then identified the number of companies in each industry and ranked each security in its industry
Figure 4. Industry Concentration Compared with CompanySpecific Risk over Time, 19622003
ValueWeighted CompanySpecific Risk(%) 50 45 40 35 30 25 20 15
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a~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ i
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0.05
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based on its capitalization at the beginning of August 1962.Thus, in August 1962,the companyspecific portion of company j's return was estimated as
Nth lj,iJ,se8/62

Nth Rji,se8/6
R
E
Nth = Rj,ise8162 
NI ,j=l
(7)
In summary,the definitionof companyspecific returns as the difference between a company's return and an index that includes the company's return induced a dependency between estimated companyspecific risk and the distribution of weights acrosscompanies.As a result,measurement errorassociatedwith changingindustryconcentration contributedto changes in estimatedaggregate companyspecific over time. risk
where Ni securities were in industry i in August 1962and RN.th is the returnon the Nth largestj, i, S E8/62 cap securityin industry i on day s in August 1962. For August 1962, with is securityj's weight in its industry for that month and securityj is the Nth largestcapsecurityin its industry. We repeated this procedure each month and used updated securityweights only in the calculation of the industry return (i.e., withinindustry weights fromtime t were used to computeRiS E8/62). For all other calculations,weights were held constant at August 1962 values. Thus, in September i962,wNth in Equation7 was computed as the capitalizationof the Nth largestcapsecurityin industry i divided by the total capitalizationof the Ni largestcap securities in industry i in September 1962.As we moved forwardthroughtime,the number of securities in most industries grew as small companies were added. By limiting the sample to the Ni largestcapsecurities in each industry each month, we eliminated the changes in companyspecific risk resultingfrom changes in the number of small companiesin the sample.14 We then computed the estimate of companyspecific risk for a given company in the same fashion as before,by summing the squareddifferences between the August 1962 daily returns and the timevarying industry return computed with August 1962returnsbut time t industryconcentration (i.e., company weights at time t were used to compute industry concentration).The weighted average companyspecific risk across companies within an industry was then calculated by using August 1962 marketvalues to control for changes in companyspecificrisk arisingfrom directeffects of changing weights, and the weighted average of companyspecific risk for the market was computed by using August 1962 industry weights to controlfor changesin companyspecificriskresulting from the growth of riskierindustries.The timeseries correlation between aggregate companyspecific risk and the forecast of companyspecific risk that was fully driven by changing industry concentrationwas found to exceed 55 percent (statistically significantat the 1 percentlevel).
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Controlling the Sample. We examined changes in companyspecificrisk over time while controllingfor the threefactorsby holding industry weights,withinindustry and concentration, sample sizes constantat August 1962 levels. We began by limiting our sample in all months to stocks with a price of at least $1.00.15 This step reducedthe number of securitiesin August 1962from2,039to 1,989. We then computed companyspecificrisk for August 1962 as previously described, based on Equations2 and 3. Forsubsequentmonths,we limited the sample to the Ni largest companies in industry i (to controlfor changes in the numberof smallcap stocks in the market) and computed companyspecificreturns for the Nth largestcap securityin industryi at time t as
^Nth= RNth Nth Nth
where Ni is the numberof securitiesin industryi in Nth August 1962 and RJNthis the return for the Nth largestcapsecurity(securityj) in industryi on day s. To controlfor changes in industryconcentration, we used 1962 withinindustry weights (i.e., Nth= 8/62 is the August 1962industryweight of the Nth largestcapsecurityin industryi).16 We then estimated companyspecificrisk for each subsequentmonth on the basis of August 1962 withinindustryweights (which also controlledfor
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and changing industry concentration) August 1962 industry weights (to controlfor changing industry weights over time):
48
Wi,t=8/62
[N.
F Nth 21
WJ,t=8/62 j
(FIRM); is, we comparedthe trend coefficients that for the estimates in Figure 1 with the trend coefficients for the estimates in Figure 5. We then estimatedthe fractionof the unrestricted trendthatwas accountedfor by the three factorsas
%Trend resulting size,industry, concentration from and
Thus, FIRM*, graphed over time in Figure 5, denotes estimated companyspecificrisk aftercontrol for changes in the role of smallcap stocks, riskier industries, and the bias induced by changing industry concentration. The results in Figure5 reveal little evidence of a systematic rise in companyspecificrisk afterwe controlled for the three factors over the 196299 period. In addition, the rise in idiosyncratic risk during the technology/media/telecommunications (TMT)bubble is much more muted than in Figure 1. Nonetheless, even when the three factors were controlled for, companyspecificrisk can be seen to have increased during the bubble period and then to have declined. To quantify the differencebetween Figures 1 and 5, we estimated trend coefficientsfor the measure of companyspecificrisk after controllingfor all three factors(FIRM*) both the period of genfor erallyrising companyspecificrisk (19621999)and the period of generally falling companyspecific risk (20002003)and compared these trend coefficientswith those estimatedfor the same periods for the unrestrictedestimate of companyspecificrisk
Figure 5.
We found that the three factorsaccounted for 63 percentof the trendcoefficientduring the period of rising companyspecificrisk (19621999)and 56 percentof the trendcoefficientduring the period of falling companyspecific risk (20002003). Thus, even given the tremendousrisein companyspecific riskaroundthe TMT bubble,the resultssuggest that changes in the relative roles of smallcap stocks, riskierindustries,and estimationerrorinduced by changing industry concentrationaccounted for a majorityof the trend in both the periods.
Regression Tests: Controlling for Size, Industry, and Concentration Effects. We next
companyspecific risk on proxies for each factor and time. We used the ratio of the capitalizationof
Risky industries to Safe industries as a measure of
changesin the role of riskierindustries (as graphed in Figure2). Wemeasuredthe role of small companies in the samole at time t as the ratio of the
CompanySpecific Risk after Controlling for Size, Industry Weights, and Concentration, 19622003
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number of companies accounting for the bottom half of the market'stotal time t capitalizationto the number of companies accounting for the top half (as graphedin Figure3). Weaccountedfor changes by in withinindustryconcentration calculating,for each month, the weighted average (across industries) of each industry's Herfindahl index (as graphed in Figure4). We estimated regressions of valueweighted from Equation3) on companyspecificrisk (FIRMt time, the ratio of Small to Large, the valueweighted withinindustry Herfindahl index, and the ratio of the total capitalizationof securities in Risky industries to the total capitalizationof securities in Safe industries. Because of the serially correlatednatureof volatility (see Table1),we also repeated the analysis with lagged companyspecific risk included as an additional variable. Regression coefficients and associated tstatistics (based on NeweyWest 1987standarderrorswith six lags) are reported in Table 2. Table 2. Regression of ValueWeighted CompanySpecific Risk on Sample Characteristics and Time, 19622003 (tstatisticsin parentheses)
Variable Intercept(xlO) risk Laggedcompanyspecific Time (x103) Small/Large(x102) Industryconcentration Risky/Safe N (months) AdjustedR2 0.287 (3.81)*** 0.194 (5.90)*** 0.620 (3.48)*** 0.230 (3.58)*** 496 58.4% Regression1 0.520 (1.50) Regression2 0.285 (1.52) 0.522 (5.52)*** 0.143 (3.24)*** 0.091 (4.08)*** 0.315 (2.92)*** 0.114 (2.88)*** 496 69.8%
companyspecificrisk. In addition, the coefficient on time is negative, suggesting that once these factorshave been accounted for, the overall trend in companyspecificrisk is down. Moreover, the negative coefficienton time was not driven by the risk declinein companyspecific following the TMT bubble;limiting the sample to the 196299 period yielded qualitativelyidenticalresults. Other Explanations for Changes in CompanySpecific Risk over Time. As noted in the introduction,previous researchersproposed a numberof explanationsforthe systematicrisein the volatility of individual securitiesover the 196299 period, including a reductionin conglomerates,an increasein executivestockoptions,a systematicrise in the volatilityof returnon equityor growthopportunities, an increase in herding by institutional investors,an increasein the level of informedtrading, greatercapital market openness, a decline in financialreportingquality,and an increasein competitionbetween companies. Our results are not necessarily inconsistent with many of the previous explanations.Forexample, changesin the relativeimportanceof smallcap stocks and riskier industries over time will cause changesin the averagevolatilityof returnon equity and financialreportingquality over time. In addition, nearly all the other explanations for changes in companyspecific risk have attemptedto explainonly the uptrendin companyspecific risk in the 196299 period, not the decline in companyspecific since 2000.In contrast,our risk results suggest that the role of small companies, riskierindustries,and changes in industryconcentration contributedto the dramaticrise and fall of aggregate companyspecificrisk around the TMT bubble. However, although the rise and fall of companyspecificrisk around the TMTbubble in Figure5, which reflectscontrolfor the threefactors we suggest, is much more muted than in Figure 1, Figure5 still documentsa rise in companyspecific risk around the TMTbubble. Therefore,Figure 5 suggests that other factorsplayed a role in the rise and fall of companyspecificrisk at the time of the TMTbubble.Brandt,Brav,and Graham(2005)provided an additional likely explanationnamely', that excessive speculationat that time contributed to the rise in aggregatecompanyspecificriskin the late 1990sand its subsequentdecline since 2000. have noted that the numPreviousresearchers ber of small companies (which typically have higher levels of companyspecificrisk than large companies)increasedover the 196299period.Previous work, however, largely discounted the possibility that these securities played an important measure of role in changes in the valuewleighted companyspecificrisk.
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Notes: secondregressionincludedlagged companyspecific The risk as a controlvariable.The tstatisticsare based on NeweyWest standarderrorswith six lags. Significantat the 1 percentlevel.
Table 2 reveals statisticallysignificant coeffiand industry risk cients on the size, concentration, and these variables have the expected variables, signs: Valueweighted companyspecific risk increases as the role of small companies in the sample increases,as the relativeimportanceof riskier industriesgrows, and as industriesbecome less concentrated. The results held regardless of whether we accountedfor the serial correlationin
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No otherstudy has consideredthe influenceof changing industry weights or changes in estimation error induced by changing industry concentration on estimates of valueweighted companyspecific risk. In this work, we demonstratedthatboth of these factorsplay an important role in explaining the observed changes in companyspecificrisk over time.
Conclusion
Aggregate companyspecific risk exhibited a steady upward trend over the 196299 period and a steep decline in the 200003 period. Because risk changesin companyspecific affectthe number of securities needed to achieve a given level of diversification, tracking error, crosssectional returndispersion across managers,and the ability of arbitrageursto exploit mispricing and because companyspecific risk may be priced, an understanding of how and why companyspecificrisk changes over time is important. Previous work suggested that changes in companyspecificrisk are driven by fundamental changes in markets or the retumgeneratingprocess. We posited that changes in companyspecific
risk reflectchanges in the compositionof securities used to estimate companyspecific risk. Distinguishing between these explanationsis important in practicebecause our explanation suggests that managers can control their exposure to timevarying companyspecific risk through industry and security selection. If changes in companyspecificriskarepervasive (drivenby changesin the companyspecific risk of individual securities), however,a managercando littleto controlthe risks. Our empirical tests support our hypotheses: Changes in the relative importance of riskier industries, changes in the relative importance of small companies in the market, and changes in estimated companyspecific risk associated with estimation error related to changes in industry concentrationlargely drive changes in companyspecific risk over time. We thankTim Vogelsang kindlyproviding for Gauss code.Wethankseminar at participants the University ofMontana, University NewHampshire, the the of and 2004 Financial Management Association meetings for helpful comments.
This articlequalifies 1 PDcredit. for
Notes
1. Althoughwe focuson changesin weights,we do not assume to risk companyspecific forindividualsecurities be constant over time. In a recentworking paper, Fink,Fink,Grullon, and Weston(2005)arguedthatthe increasein the numberof young companiesgoing public largelyexplainsthe steady risk rise in companyspecific over time (i.e.,thatchangesin weights arisingfrom an increasein the numberof young thanchangesin riskitself,areresponsible companies,rather risk for the increasein companyspecific over time). capitalizations, 2. FollowingCLMX, usingbeginningofmonth we computed monthly industry returns as the valuewithintheindustry. for return allsecurities weightedaverage 3. The calculationof the Vogelsangtstatisticdepends on the desiredsignificancelevel. See Vogelsang(1998)for details. 4. The long uptrend(19621999)and subsequentdowntrend reportedin Table1 were not drivenby outliers. (20002003) in Specifically, unreportedtests,we excludedOctober1987 fromthe analysisand limitedthe uptrendperiodto August 1962 through December1998 (i.e., excluding the spike in companyspecificrisk in calendar year 1999). The linear trend coefficient fell only 18 percent (from the 1.195 reported in Table 1 to 0.976) and remained statistically significant at the 5 percent level. Similarly, when we excludedthe firstsix monthsof calendaryear2000fromthe downtrendperiod,the coefficientmagnitudefell 13percent significantat (from51.605to 44.876)and was statistically the 10 percentlevel. risk in 5. The weighted averageestimatedcompanyspecific is the market(FIRMt) simply the sum of Equation4 across the 49 industriesweighted by industrycapitalization. September/October 2006 6. All variablesin the second termof Equation4 arepositive, so this term will induce a downward bias in estimated companyspecificrisk. This bias does not influence total risk,only how risk is partitionedamong market,industry, and companyspecific risk. 7. Moregenerally,consideran industrywith manycompanies but only one of them is contained in the CRSPdatabase while the rest are eitherprivateor foreignlisted. 8. The idea that industry concentration affects estimates of risk companyspecific is informally recognizedin a number of studies. Forexample,authorsof studies of international data (whichusuallyincludemarkets with even greaterconthan found in the U.S. markets)commonlyesticentration matecompanyspecific forsecurityjas security return risk j's less the averagereturnon all stocksotherthanj (e.g.,Liet al. 2004).Note, however,thatas shown in Equation such an 4, will adjustment not generallyresultin an unbiasedestimate. 9. TheHerfindahl index,a measureof industryconcentration, is calculatedas the sum of the squared withinindustry it weights;therefore, has a maximumvalue of 1. Forexample, if an industrycontainsonly two securitiesof equalsize, the Herfindahlindex is 0.52+ 0.52. 10. Theweighted averagewithinindustry Herfindahlindex is the Herfindahlindex in each industry weighted by the industry'smarketweight at the beginningof the month. 11. Decliningconcentration reduces the negative bias in estimated companyspecificrisk (under the assumptionthat withinanindustryhave similarcompanyspecific securities in risk) and is thus associated with an expected increase risk. estimatedcompanyspecific 12. We thankan anonymousrefereefor pointingthis out. www.cfapubs.org 99
Financial Analysts Journal 13. No companieswere classifiedas in the "healthcare"industry in August 1962. 14. Fora few industries,samplesizes at somepointin timewere smaller(i.e., there were fewer securitiesin the industryat time t thanthe Ni securitiesin the industryin August 1962). In those cases, we simply computed the companyspecific portionof the returnbased on the remainingsecurities.For example, if there were 100 securities in the industry in 1962,withinindustry August 1962and only 99 in September were based on the sample of 99 securities(and still weights summedto 1). 15. As discussed later, we used security weights based on August 1962 levels but returnsfrom time t. Without this a constraint, stock with a very low price at time t could be assigned a relativelylarge weight in a shrinkingindustry. Forexample,in 2002,a single lowpricesecurity(Tramford International) a 1,600percentonedayreturnas its price had went from2 cents on 8 August to 33.91cents on 9 August. 16. If an industryhad moresecuritiesin a futuremonththanin August 1962,we implicitlyassigned the additionalsecurities a weight of zero. If the industryhad fewer securitiesin a future month, we scaled the assigned weights from August 1962to sum to 1;we used theseweights to calculate the month t industry return.Once companyspecificrisk was calculatedfor each security,we returnedweights to their unscaled August 1962 values and gave the smallest securitythe "missing"weight. This approachwas equivalent to assumingthe missingsecuritieshad the sameriskas the smallestsecurityin a shrinkingindustry.
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