Country Asset
Allocation
Quantitative Country Selection Strategies in Global
Factor Investing
Adam Zaremba Jacob Shemer
Poznan University of Economics AlphaBeta, Tel Aviv, Israel
and Business
Poznan, Poland
Viewed from one angle, different country economies are nothing less than
aggregate investment entities of various firms and industries. As such,
investing across markets may simply be viewed as constructing a portfolio
of individual securities. In consequence, the investor should expect similar
return patterns surfacing both at the stock and the country level. Let’s
take the momentum effect. It implies that the best performing securities
will keep outperforming the past losers. If certain behavioral biases trigger
momentum among individual securities, this phenomenon can also arise
in country indices. Investors may as well chase, and overreact to, high
returns of the entire economies and underreact to other data. Perhaps,
analogous parallels could also be found among other cross-sectional pat-
terns setting value against growth or quality.
This book takes the new paradigm of factor investing—the innovative
practice of extracting abnormal returns and exploiting market anomalies—
and applies it to asset allocation at the global level. Contrary to the con-
ventional stock-level approach focusing on individual securities, the set
of investment strategies presented in this book captures entire economies
at the equity index level. The book details a range of strategies relying
on tactical asset allocation among different countries based on the latest
factors and anomalies discovered through empirical scientific research in
recent decades.
My personal career in the asset management industry throughout the
years has transitioned from traditional active management based upon
fundamental research to a complete quantitative approach. The reason for
this shift was very simple: if, to predict returns, one must confront both
v
vi FOREWORD
limited resources and his own limited attention span, employing quantita-
tive tools stemming from the science of asset pricing seems the best way of
overcoming these hurdles.
One striking finding from the science of asset pricing is both the range
and significance of the information encapsulated in prices and returns,
which might be used to predict the stock price movement. In days gone
by, analysts strongly relied on the traditional fundamental analysis. The
dominant paradigm dictated that stock prices reflected nearly all the infor-
mation available in the markets, and neither prices nor returns offered
any help in predicting future returns. As famously captured by the econo-
mist Paul Samuelson: “… there is no way of making an expected profit
by extrapolating past changes in the futures price, by chart or any other
esoteric devices of magic or mathematics. The market quotation already
contains in itself all that can be known about the future and in that sense
has discounted future contingencies as much as is humanly possible”
(Samuelson 1965, p. 44).
As a result, financial analysts were there to find stocks with the intrinsic
value exceeding the market price in the hope to generate above-average
returns and any technical analysis was branded “voodoo economics”.
However, ever since Jegadeesh and Titman documented the momentum
anomaly in 1993, the studies of price-based patterns have proliferated. The
groundbreaking research by Jegadeesh and Titman (1993) has spurred
the discovery of many other anomalies in the cross-section returns based
solely on stock prices: low volatility, trend and time series momentum,
liquidity, skewness, and so forth. All these patterns enable us to extract
valuable information about future returns. Even if, to a large extent, these
anomalies result from various behavioral biases like herding or overre-
action, being aware of them can improve forecasting returns, which is
precisely the point of asset pricing and this book focusing on the country
factor investing. As many of these patterns emerge not only at the stock
level but also in the country prices space, they can be utilized for country
asset allocation.
Many anomalies identified in the cross-section of stock returns converge
with the traditional way of thinking of the fundamental researcher, with
profitability and accruals as flagship examples. On the other hand, plenty
of the discovered anomalies go against the grain of standard intuitive
thinking, such as low volatility, asset growth, intermediate momentum,
and many more. No traditional investment manager ever imagined that
one could find so much rich information in prices alone to help forecast
FOREWORD vii
relative returns across different security groups. This has been only pos-
sible thanks to the advancements in the science of asset pricing, which has
brought much welcome order to the asset management profession. In my
opinion, no investor will in future be able to ignore this scientific “new
deal”, especially given the limited attention span in the fast spinning world
of big data.
The main contribution of this book is to introduce academically proven
quantitative tools to the major sphere of global investing: country asset
allocation. By applying quantitative country selection strategies investors
will no longer need to rely solely on the analysis of the fundamental macro
conditions of the particular economy to select the right countries for their
portfolios.
AlphaBeta,
Tel Aviv, Israel Jacob (Koby) Shemer
REFERENCES
Samuelson, P. A. (1965). Proof that properly anticipated prices fluctuate randomly.
Industrial Management Review, 6(2), 41–49.
Jegadeesh, N., & Titman, S. (1993). Returns to buying winners and selling losers:
Implications for stock market efficiency. Journal of Finance, 48, 65–91.
PREFACE
ix
x PREFACE
succeed on both fronts. The review is informed and succinct, and the
empirical investigation is thorough and impartial. Anyone interested in
global asset allocation should read this book.”
—Sandro C. Andrade, Associate Professor of Finance, School of
Business Administration, University of Miami, USA
“This is a terrific book about country asset allocation. If you want to
improve your chances of investing well in the stock market, you must
read this book. The summary of empirical content is excellent. I highly
recommend this book for individual investors, portfolio managers, and
fund pickers.”
—Joseph D. Vu, Associate Professor, DePaul University, USA
“This book blends the best and latest research across a wide spectrum
of asset classes and investment strategies. Zaremba and Shemer indeed
provide a modern and insightful introduction to how global investment
practice could be improved in the twenty-first century.”
—George Wang, Assistant Professor of Finance, Division of Accounting
and Finance, Manchester Business School, The University of Manchester, UK
“This book gives the reader a good introduction into the growing body of
literature on factor investing. It also gives empirical evidence by translating
these academic insights into a country selection strategy.”
—Pim van Vliet, Portfolio Manager, Conservative Equities at Robeco
“This book offers readers an accessible, well-cited, and appropriately criti-
cal review of popular equity return factors, a praiseworthy task given the
quantitative subject matter. More importantly, Zaremba and Shemer apply
these factors to the most important determinant of excess returns in inter-
national equity portfolios: country allocation. The results are informative,
illuminating the non-stationarity of factors, and are not to be overlooked
by anyone responsible for investing international assets.”
—Marshall L. Stocker, Global Macro Equity Strategist and Portfolio
Manager, Eaton Vance Management
ACKNOWLEDGMENTS
xi
CONTENTS
1 Introduction 1
Part I 7
xiii
xiv CONTENTS
Part II 121
15 Conclusions 241
Appendix A 245
Appendix B 251
References 253
Index 259
LIST OF FIGURES
xv
xvi LIST OF FIGURES
xvii
xviii LIST OF TABLES
Introduction
There are no free lunches in investing—but there is a very cheap one: diver-
sification. Since Harry Markowitz, a graduate student at the University
of Chicago, published his seminal essay on portfolio selection, we have
learnt that there are two sources of volatility in a portfolio.1 One being the
riskiness of the individual securities and the other the interrelations among
their prices. The lower is the correlation among the returns on the portfo-
lio components, the bigger the reduction of risk. Consequently, it should
not come as a surprise that investors continuously seek low-correlation
assets to improve the performance of their portfolios.
Where, then, is this low correlation among the financial markets? One
idea is to venture abroad. Different economies and diverse business cycles
should provide a source of return largely uncorrelated with the investor’s
home capital market. This concept has been proven to work for many years
now. Yet in the recent two decades, the landscape of international equity
investment has undergone dramatic changes. Some of them seem adven-
turous for investors while others more ominous for portfolio management.
In previous years we saw a huge proliferation of passive investment
products, which gave investors easy access to international markets.
Futures markets, index funds and exchange-traded funds (ETFs) offer
liquid and cheap investment opportunities across global markets. Now,
more easily than ever before, investors can allocate their money in foreign
markets. With just one click of the mouse they can quickly relocate capital
from Brazil to Japan, capitalizing on the trends and changes in the global
economy. As of December 2014, there were over 1500 ETFs operating
The book ends with our conclusions of the country level strategies,
also showing the potential limitations to our considerations and poten-
tial directions for further research, which could shed more light on the
country-selection methods and help in developing new tools for interna-
tional investors.
The book also contains an appendix, discussing in detail our data. The
appendix shows our sample of country returns and shows how we formed
the portfolios and assessed their performance.
NOTES
1. Harry Markowitz’s initially prepared a dissertation on portfolio selection as
a graduate student. Later in 1952 the study was published in Journal of
Finance as a paper entitled Portfolio Selection.
2. See Bekaert and Harvey (2000) or Quinn and Voth (2008).
3. See also Hester (2013).
4. Similar evidence was found by Dimson et al. (2005), MSCI (2010), and
O’Neill (2011).
5. See, e.g., Hou et al. (2014), Green et al. (2014), Bulsiewicz (2015), Jacobs
(2015), or Harvey et al. (2015).
REFERENCES
Authers, J. (2010). The fearful rise of markets: Global bubbles, synchronized melt-
downs, and how to prevent them in the future. London: FT Press.
Bekaert, G., & Harvey, C. R. (2000). Foreign speculators and emerging equity
markets. Journal of Finance, 55, 565–613.
Bulsiewicz, J. (2015). Sample selection and the relation between investor sentiment and
profitable trading strategies. Retrieved November 29, 2015, from SSRN: http://
ssrn.com/abstract=2572707or http://dx.doi.org/10.2139/ssrn.2572707
Dimson, E., Marsh, P., & Staunton, M. (2005). Global investment returns yearbook
2005: Global strategy. London: ABN AMRO Equities (UK).
Goetzmann, W., Li, L., & Rouwenhorst, G. (2005). Long-term global market
correlations. Journal of Business, 78, 1–38.
Hester, W. (2013). Fed leaves punchbowl, takes away free lunch (of international
diversification). Hausman Fundas Investment Research & Insight. Retrieved
November 29, 2015, from http://www.hussmanfunds.com/rsi/intldiversifi-
cation.htm
Hou, K., Xue, C., & Zhang, L. (2014). A comparison of new factor models. NBER
Working Paper No. 20682. Retrieved November 29, 2015, from http://www.
nber.org/papers/w20682
6 A. ZAREMBA AND J. SHEMER
Value investing is probably the oldest and most popular method of select-
ing stocks. It harkens back to the famous books of Benjamin Graham––
one of the first gurus of the stock market––which were first published over
80 years ago (Graham 2006, 2008). Since then, value investing has been
supported by a large amount of academic evidence and a solid portion
of anecdotal evidence. Many of the world’s most respectable investors—
including Warren Buffet—declare themselves value investors.
So what is value investing? In terms of equity selection, the common
sense definition states that a value investor is someone who tries to buy
stocks for less than they are worth. This, however, seems rather too broad
a label. In fact—has there ever been an investor who tried to buy stocks for
more than they are worth? We may need a more precise definition.
We can divide the intrinsic value of a company into two underlying
sources: (1) the assets in place which already bring cash and profits for
shareholders, and (2) future investment and growth opportunities. What
sets value investors apart is their main focus on the first source of value,
and their effort to identify companies whose current business is generally
underpriced by the market (Damodaran 2012a: 260). In other words,
value investors are bargain hunters, looking for opportunities to buy cheap
and undervalued assets that are already in place, as opposed to growth
investors who concentrate on future growth.
ratios usually vary from the normal distribution curve. It is thus difficult
to combine them with other sorts, using for example the z-scores. Thirdly,
computing the average ratio of a set or a portfolio of companies is hardly
worthwhile. Such averages are highly influenced by extreme values of the
multiples. Thus, in our world of quantitative investment strategies it is
more common to use inverted ratios, i.e. with the fundamental as the
numerator and the market value as the denominator. For example, the
price-to-earnings ratio is usually substituted with the earnings-to-price
ratio (E/P ratio). This approach is also commonly employed by the major-
ity of studies across the academic literature.
The value strategies that rely on fundamental ratios were initially
employed to select stock-level investments. Nonetheless, their parallels can
be easily applied at the index level. These methods rely on aggregating the
stock-level ratios in order to obtain their country-level counterparts. The
most common practice is to weight the reverse ratios, for example the E/P
ratio, according to the index methodology. The country-level multiples
obtained in this way may be subsequently used for value-based country
selection strategies.
Let us now review the most popular valuation ratios adopted by market
practitioners.
Earnings-to-price ratio. Earnings-to-price ratio (in other words earn-
ings yield) is the reciprocal of the P/E ratio. It compares earnings in the
numerator to the current total stock market capitalization in the denomi-
nator. As for most valuation ratios, the P/E ratio (and analogously the
earnings yield) is usually calculated in one of the two variants: trailing or
forward. The trailing P/E ratio is based on the sum earnings over the
previous four quarters. On the other hand, the forward P/E ratio is based
on analysts’ forecasts for the next calendar year. While the first one looks
backward, the other gazes into the future. Both ratios are based on the
profit generated during a full year. In practice, although the forward P/E
ratio is more popular in stock valuations, the trailing version prevails in
quantitative asset management. The trailing version is free from any ana-
lytical mistakes and biases and is simply available for a larger number of
companies.
The earnings-to-price ratio is one of the oldest and most popular
ratios used for market valuation. The strategy that calls for buying stocks
with low earnings multiples could be traced back to the famous book
by Graham and Dodd, who suggested that “a necessary but not a suffi-
cient condition is a reasonable ratio of market price to average earnings”
12 A. ZAREMBA AND J. SHEMER
(Graham and Dodd 1940). They advocated that the P/E multiplier
should not exceed 12. In the world of academia, the P/E ratio was first
scrutinized by Nicholson (1960), who extensively examined the relation
between this metric and future returns. The most cited author, however,
is Basu (1975, 1977, 1983), who investigated portfolios sorted by E/P
ratio in the US equity market. In his paper of 1977 he ranked stocks on
P/E ratio and tested a hypothetical strategy that assumed buying the
quintile of lowest P/E stocks and short selling the quintile of the high-
est P/E ratio. This simple strategy, disregarding the commissions and
transaction costs, yielded the abnormal average annual return of 6.75 %
over the 1957–1975 period. These findings were later replicated by
Reinganum (1981) over a sample extending to 1979 and analyzing both
the NYSE and AMEX stocks.
The evident effectiveness of the strategies based on P/E ratio or its
reciprocal, earnings yield, sparked an immediate interest and initiated fur-
ther research. The evidence for its profitability has been found in numer-
ous markets, both developed and non-developed,2 and the findings have
been subsequently confirmed by many other researchers within much
larger and longer research samples.3 In other words, the earnings yield
effects seems strong and pervasive.
Despite its unquestionable popularity, price-to-earnings ratio is bur-
dened with a number of technical deficiencies, which force investors to
search for alternative measures. The two most important shortcomings
are:
– Lack of stability. Earnings are one of the most changeable items
in financial statements. They can dramatically rise and fall follow-
ing the swings of the business cycle. As a result, the P/E ratio
may drastically change, being low in one quarter and surging in
another. Earnings may be influenced by one-off items, such as, for
example, a single large transaction. This lack of stability may pro-
pel significant portfolio turnover and transaction costs, although it
does not necessarily reflect the changes in intrinsic value.
– Susceptibility to manipulation. A popular stock market adage
teaches that “cash is a fact, while profit is an opinion”. Indeed,
the final value of earnings is not only determined by the oper-
ational performance of the company but also by its accounting
policy. The amortization methods and asset valuation techniques
may markedly affect the reported earnings, blurring the picture
for investors.
VALUE VERSUS GROWTH: IS BUYING CHEAP ALWAYS A BARGAIN? 13
McQueen et al. (1997) argues that the seemingly abnormal returns are
simply a compensation for taxes on dividends and the risk of holding a
poorly diversified portfolio. Hirschey (2000) has also reached similar con-
clusions. He performed careful and scrupulous calculations using data
from 1961 to 1998 and discovered that excluding taxes and transaction
costs, the Dow dogs outperformed the Dow by merely 1.55 %. Moreover,
additional expenses from transaction costs and taxes amounted to approxi-
mately 1.58 %. Consequently, any abnormal returns on this strategy were
effectively reduced to zero.
Interestingly, a number of stock level studies suggest that it is not solely
the level of dividends that matter—it is also what happens with the divi-
dends across time that may provide clues for investors about its future
performance. There are a few identified phenomena which indicate that
the information on dynamic changes in dividends might be used for suc-
cessful stock selection:
– Dividend initiation: Companies that start paying cash dividends
beat the market (Michaely et al. 1995).
– Dividend resumption: Stocks that resume paying cash dividends
outperform the market (Boehme and Sorescu 2002).
– Change in dividends: Both the changes in absolute dividend pay-
outs and in dividend yields positively predict returns. The more
positive (negative) the change in dividends is, the higher (lower)
the future return (Livnat and Mendenhall 2006; Doyle et al.
2006; Hirshleifer et al. 2009).
To sum up, the dividends offer a much wider set of opportunities for
investors to design successful strategies than simple sorts by dividend
yields.
Revenue multiples. The revenue multiples are another attempt to
answer the investors’ demand for more reliable value indicators. Revenue
multiples have three unquestionable advantages over the most popular
earnings multiples. First, they are less susceptible to accounting decisions.
The reasoning behind it is very straightforward: the higher you move up
in the income statement, the less suspicious the number is. Second, the
revenue multiples are more stable. Profits may simply vanish during peri-
ods of economic downturns whereas in the case of sales, it is not that
likely. Third, with the use of revenue multiples, you can assess and per-
form valuation of the companies bearing losses. Naturally, it is not equally
VALUE VERSUS GROWTH: IS BUYING CHEAP ALWAYS A BARGAIN? 17
as easy with the most common P/E ratio; you simply cannot calculate it
when there are no earnings.
Analogous to the other flow-based measures, revenue multiples usually
utilize tailing four-quarter sales; they may, however, be computed with the
use of the expected sales derived from analysts’ estimations.
In practice, there are two common revenue-based measures that are
employed for both equity valuation and stock screening.
Although the sales ratios are as popular as earnings or book value mul-
tiples, they have their enthusiasts in the investment industry. One of them
is James P. O’Shaughnessy, author of the bestselling book What works on
Wall Street, in which he advocates the Cornerstone Growth Approach—
i.e. purchasing growth stocks at a reasonable price. In his method the
price-to-sales ratio should never exceed 1.5. This was also the favorite
valuation ratio of Phillip Fisher, a widely admired manager in the 1950s;
as well his son Kenneth Fisher, author of the popular investment guide-
book Super Stocks (Fisher 1996, 2007). Also Martin Leibowitz, a well-
known money manager, was a strong advocate of the price-to-sales ratio
(Leibowitz 1997).
Apart from this anecdotal evidence, the academic investigations into
the sales multiples are rather modest, at least in comparison with other
multiples. Moreover, the evidence seems quite shaky. Senchack and Martin
(1987) tested the performance of P/S-based portfolios within a sample of
the NYSE and AMEX stocks for years 1976–1984. They found that the
18 A. ZAREMBA AND J. SHEMER
low P/S stocks indeed outperformed the high P/S stocks. Furthermore,
the screen worked even on companies that were losing money. However,
the strategy was actually dominated by sorting stocks by the mere P/E
ratio, which turned out to be better predictor of future winners and losers.
In approximately every two out of three months the strategy based on the
P/E ratio delivered better returns than its P/S-based counterpart. In two
subsequent studies, Jacobs and Levy (1988a, b) examined the P/S ratio
together with many other return-predicting indicators. While they found
it helpful even when compared to other metrics (for example the size and
P/E ratio) the P/S ratio strategy performed poorly in comparison with
other quantitative strategies: the low P/S stocks outperformed the market
by a modest 2 % a year.10 In general, one of the weaknesses of the port-
folios formed on the price-to-sales multiple is that they gravitate strongly
towards tiny companies, and if the smallest firms are excluded from the
universe, the returns on the P/S based strategy are no longer abnormal
(Lewellen 2015).11
Finally, the quantitative evidence on the EV/S ratio is even more con-
fined—so much so that in fact, it has been more interesting for market prac-
titioners than for academics. In a research paper of 2013 Toniato, Lee, and
Jose from Barclays tested the performance of a range of investment strate-
gies based on popular valuation ratios in the 2002–2013 period. (Toniato
et al. 2013). They found that although the low EV/sales stocks indeed out-
performed the high EV/sales stocks, the difference was actually the poor-
est of all of the investigated multiples. The low EV/S companies delivered
mean annual returns that were only 3.9 % higher than the high EV/S stocks
and 0.5 % higher in comparison with the market. Such small outperfor-
mance could not have even compensated for the transaction costs.
EBITDA-to-EV ratio. EBITDA-based ratios belong to the most
powerful return predicting signals. They have gained significant popularity
amongst valuation tools, being advocated by popular financial textbooks
on investment valuation (e.g. Damodaran 2012b). The use of EBITDA
multiples is an another attempt to alleviate the concerns of investors
searching for cash-based measures of greater stability than the P/E ratio
(Damodaran 2012a), which, in turn, suffers from varying tax rates, impact
of non-monetary expenses, and influence of profits generated from the
changes in prices of the marketable securities held on the balance sheet. To
a great extent, EBITDA multiples resolve all of these issues.
In practice, investors use two popular ratios for stock picking and com-
pany valuation.
VALUE VERSUS GROWTH: IS BUYING CHEAP ALWAYS A BARGAIN? 19
The risk story. The risk-based explanation was first laid out by Fama
and French in their famous paper of 1992, in which the authors argued
that value stocks are cheaper for a reason, and the reason is—bankruptcy
risk. In other words, the value companies are more prone to encounter
financial distress.13
The risk story is to some extent supported by the data: the value port-
folios indeed tend to lean heavily on financially distressed stocks and the
value stocks are more exposed to credit risk.14 Furthermore, the value pre-
mium is substantially influenced by the financial leverage (Ozdagli 2012;
Cao 2015). Nonetheless, this explanation has one problem: in practice
distressed stocks underperform the market. We have plenty of evidence
that high distress risk is in fact associated with lower returns (Dichev
1998; Griffin and Lemmon 2002; Piotroski 2000; Campbell et al. 2008).
Furthermore, a research conducted by de Groot and Huij (2011) indi-
cates that, contrary to popular beliefs, the value portfolios sometimes out-
weigh the least distressed stocks—and not the most distressed ones.
The non-market risk of the companies may also be related to invest-
ments and production technologies used in companies. This concept is
further explored by Cochrane (1991, 1996), Zhang (2005), and Garlappi
and Song (2013) who research asset pricing framework in production com-
panies. The key point to their explanation is that the value firms are heav-
ily burdened with hard assets and unproductive capital, which may turn
against them in harsh economic periods. During economic downturns they
cannot easily and quickly divest, close factories, or sell unproductive assets.
This lack of flexibility may translate into serious losses or even a default risk.
On the other hand, growth firms rely more on human capital and intan-
gible assets,15 and as it is easier to dismiss a high-salary employee than to sell
a factory, the underlying structure of production companies poses a funda-
mental risk which should be compensated with additional risk premium.16
Another explanation of the value premium offers the concept of real
options. While the explanations pointing to production technologies sug-
gest that values stocks are perceived as riskier than they really are, the idea
of real options implies to the contrary. The reason is that such companies
enjoy more growth options, which could be then utilized in the right
circumstances; for example, during times of economic downturns. These
options are not fully captured by the traditional asset pricing models which
reflect market risk only. Smit and van Vliet (2002) call this phenomenon a
“growth discount” and argue that the risk of the growth companies may
be overestimated by investors.17
VALUE VERSUS GROWTH: IS BUYING CHEAP ALWAYS A BARGAIN? 21
there are real differences in the growth rates between the growth and
values stocks, albeit insufficient to justify the spread in valuation ratios.
The behavioral bias particularly affects individual investors who are less
professional and more prone to such psychological traps. Consistently, the
profitability of value strategies is higher across stocks with low institutional
ownership (Phalippou 2004).
The mispricing effect that results from the extrapolation biases
described above is subsequently amplified by agency problems. In their
efforts to generate commissions, stock market analysts try to persuade
customers into buying stocks and one of the best ways to do it is to use
good past performance and growth rates as a winning argument (Chan
et al. 1995). Moreover, growth stocks frequently concentrate in the
“shiny” and exciting industries, like new technologies, which attract a
lot of media attention and analyst coverage (Bhushan 1989; Jegadeesh
et al. 2004) Thus, professional money managers who gravitate towards
glamour growth stocks may fall for it lured by the potential benefit for
their future careers.
Although such fad-induced mispricing may last for years (Shleifer and
Vishny 1997), the valuation gap eventually closes: the earnings announce-
ments awake the investors to the truth about the company’s potential and
its growth prospects, and thus help the prices move towards the “intrinsic
value” (La Porta et al. 1997).
Another explanation of the value premium within the behavioral strain
has been offered by Barberis and Huang (2001), who identify two psy-
chological biases: mental accounting and loss aversion. The concept of loss
aversion implies that investors suffer from losses more than they rejoice
from equivalent gains.19 Thus, a series of losses is a painfully distressing
experience for all stock market investors. In addition, biased by mental
accounting, investors consider the performance of stocks in their portfo-
lios individually, rather than looking at the overall gains and losses across
the entire portfolio. According to Barberis and Huang, the undervalua-
tion of value stocks may result from a very poor prior performance. The
investors, regarding the stocks with dismal prior returns as more risky,
demand higher returns on their investments. In other words, what triggers
the value premium is not the risk that is real, but the risk that is perceived
by investors influenced by behavioral biases. This explanation is consistent
with the observations of De Bondt and Thaler (1985) who have found
that the performance of value stocks tend to be correlated with the returns
on companies that suffered long term losses over past 4–6 years.
VALUE VERSUS GROWTH: IS BUYING CHEAP ALWAYS A BARGAIN? 23
a company that will inevitably shortly disappear from the market. What
next? If the situation improves and the company is out of the woods,
the prices may skyrocket and everyone who invested in the stocks earns
substantial returns. On the other hand, if the company does go bankrupt,
then it … drops out of the sample. It does not count. So we have a win-
win situation: the deep value stock either recovers or we disregard their
performance. We can only make money on paper; in real life, however,
we can also lose it when the company eventually goes under. Indeed, the
survivorship bias may significantly contribute to the value premium (Banz
and Breen 1986; Kothari et al. 1995). If this is the case, then in the most
extreme conditions the value effect may even cease to exist. It would be
“consumed” by the survivorship bias.
Academics attempt to tackle the survivorship bias in a number of ways.
One is to exclude some reasonable amount of time before the bankruptcy.
For instance, Lakonishok et al. (1994) required five years of prior data to
classify their returns, additionally focusing on 50 % of the largest NYSE
and AMEX companies, which are less affected by the bias (La Porta 1996).
The authors found that the survivorship bias definitely distorts the results,
but it is far from being the main factor contributing to performance. Even
in the emerging or frontier markets, the survivorship bias does not wipe
out the profitability of the value strategy. For example, Anghel et al. (2015)
carefully examined the returns from Romania in order to account for the
survivorship bias, but the value portfolios still consistently outperformed
the growth stocks. Still, we also have slightly less optimistic conclusions
reached by Andrikopoulos et al. (2006). In their study, Andrikopoulos
examined the UK equity market for the period 1987–2002. Having
employed a different approach to Lakonishok’s and utilized a survivor-
ship bias-free database, which included both listed and delisted stocks,
they thus accounted for losses when the company went bankrupt. Having
accounted for various statistical biases, including the survivorship bias,
they found that the performance of value strategies deteriorated so much
that they were no longer significant either statistically or economically. In
fact, their results may be period-specific, but although the survivorship
bias does not explain the value premium entirely, it certainly contributes to
some extent. Its potential influence should not be left unattended.
Data mining. The final explanation of the value premium offers that the
premium simply does not exist. In recent years researchers have reported
literally hundreds of return predictive signals (RPS) that allegedly exist in
the market. Harvey et al. (2015) lists over 300 asset pricing factors that
VALUE VERSUS GROWTH: IS BUYING CHEAP ALWAYS A BARGAIN? 25
were documented across equity markets and already discussed in the top-
tier academic journals. Given this “factor zoo”, it would be by no means
surprising if some of the returns patterns were in effect random phenom-
ena emerging in the data, as is suggested by the infinite monkey theorem:
If a bunch of monkeys pound on a typewriter, eventually one will compose
Hamlet. Indeed, the stock market anomalies are governed by some of
Murphy’s laws. Once discovered, their profitability tends to fade (Dimson
and Marsh 1999; McLean and Pontiff 2016). No matter whether it is
down to the exploitation of the anomaly by professional investors or
due to the false discovery, this phenomenon presents a challenge to the
value anomaly. For this reason, the researchers Lo and MacKinlay (1990)
expressed their concerns that the data mining issue may underlie some of
the stock market anomalies, including the value effect.
Is it possible that the value strategy indeed is merely a result of data
mining. While it seems improbable, it is still possible. The value strategy
itself has also some weak spots. The seminal studies of Fama and French
(1992, 1993) were carried out over the period 1963–1991. Given that
this is only a 28-year period for a single equity, it is plausible that it was
a unique period in which the value stocks delivered abnormal returns.
Indeed, a study by Israel and Moskowitz (2013) comprehensively exam-
ined the value premium over a much longer research period: from 1927 to
2011 they identified the value premium but only within the small-caps and
mid-caps companies, while the abnormal returns on the value stocks were
insignificant across the largest 40 % of NYSE companies! Subsequently,
when they examined the subperiods, they found that the two largest quan-
tiles exhibited no reliable value premium of 3 out of 4 investigated sub-
periods. In fact, the value strategy worked for large-caps only within the
1970–1989 period, so roughly similar to the findings of Fama and French
(1992, 1993).
Another Achilles heel of the Fama and French (1992, 1993) studies
was pointed out by Kothari et al. (1995), who examined a similar sample
using a different data source. Interestingly, they find no evidence of any
significant positive relationship between the book-to-market ratio and the
expected returns, and finally concluded that the seeming value premium
could have just resulted from the selection bias.
Finally, one of the deadliest shots to the value premium was fired by
Fama and French (2015) themselves. In their study of 2015 entitled “A
five-factor asset pricing model” they successfully replaced the value fac-
tor with a combination of profitability and investment intensity. In other
26 A. ZAREMBA AND J. SHEMER
words: their new research suggested that the value premium may not be
an anomaly per se, but rather a manifestation of some other phenomena
in the market.
To be fair though, given the current state of research we should admit
that apparently among all of the discovered anomalies and asset-pricing
factors the value premium is not one of those resulting from data mining.
The strongest argument is its pervasiveness. As we described earlier, the
value effect has been discovered across numerous stocks markets, and dif-
ferent asset classes (Asness et al. 2013). In fact, the evidence is so perva-
sive, that the statement regarding the overperformance of the value stocks
being just a random event must be considered at least risky if not outright
implausible.
To sum up, current academic evidence offers a few reasonable expla-
nations of the value premium. While the discussion to what extent each
of them contributes to the effect is still open, the existence of the value
premium is certainly theoretically justified.
The potential explanations of the value effect, along with the explana-
tions for different patterns in stock returns, are presented in a synthetic
way in Table B1 in the Appendix B.
***
The theoretical background combined with solid empirical evidence
makes value-based stock selection one of the most convincing and popular
strategies in the stock market. In
Part 2 of this book we will check whether it could be also applied for
successful country selection.
NOTES
1. Damodaran (2012a) brings two additional forms of value investing apart
from the passive screening. The first is a contrarian approach under which
the investor buys assets currently rejected by other market participants due
to, for instance, negative news or poor past performance. The second is
activist investing, which may be difficult to implement by most of individ-
ual investors, as in this variant, where the investor not only seeks underval-
ued assets but also uses his position and power to improve the management
of the company and create a trigger that would spur growth of the stock
price.
VALUE VERSUS GROWTH: IS BUYING CHEAP ALWAYS A BARGAIN? 27
2. Examples include the United Kingdom (Levis 1989; Strong and Xu 1997),
Japan (Aggarwal et al. 1988), Singapore (Wong and Lye 1990), Taiwan
(Chou and Johnson 1990; Ma and Chow 1990), New Zealand (Gillan
1990), Korea (Kim et al. 1992), and Poland (Waszczuk 2013), or other
emerging markets (Serra 2003; van der Hart et al. 2003).
3. An incomplete list of studies that investigate the predictive properties of
earnings yield include: Campbell and Shiller (1988a, b), Ferson and Harvey
(1997), Bekaert et al. (1997), Claessens et al. (1998a, b), Lamont (1998),
Fama and French (1998), Patel (1998), Rouwenhorst (1999), Campbell
and Yogo (2006), Polk et al. (2006), Campbell and Thompson (2008),
and Goyal and Welch (2008).
4. For example in the United Kingdom (Griffin 2002), Japan (Daniel and
Titman 1997; Daniel et al. 2001), Hong Kong (Lam 2002), Australia
(Halliwell et al. 1999; Faff 2001; Gaunt 2004), New Zealand (Bryant and
Eleswaparu 1997; Vos and Pepper 1997), or Poland (Waszczuk 2013;
Czapkiewicz and Wojtowicz 2014; Zaremba 2015b).
5. See for example Fama and French (1988), Campbell and Shiller (1988a, b),
Cochrane (1992), Cochrane et al. (1993), and Jorion (1995), Wolf (2000),
Goyal and Welch (2003, 2008), Campbell and Yogo (2006), Campbell and
Thompson (2008), Ang and Bekaert (2007), Maio and Santa Clara (2015),
or Zaremba and Konieczka (2015).
6. Nonetheless, not all the evidence on dividend yield-based strategies is so
optimistic. Lewellen (2015) show that dividend yield has little predictive
power for future returns while Goetzmann and Jorion (1995) and Goyal
and Welch (2003) cast doubts on the possibility of forecasting stock
returns using the dividend yield, especially in the long term. Finally, Ang
and Bekaert (2007) suggest that dividend yields prove useful only in pre-
dicting over very short time horizons.
7. Although the book by O’Higgins and Downes (1991) is the most fre-
quently cited source, the Dogs of the Dow strategy appeared first in the
Wall Street Journal in 1988 (Dorfman 1988). Its profitability was also later
confirmed by Knowles and Petty (1992: 232) and Domain et al. (1998).
8. Further academic evidence indicates that the Dogs of the Dow strategy
could be successfully replicated in Australia (Alles and Shen 2008), Canada
(Visscher and Filbeck 2003), China (Wang et al. 2011), Finland (Rinne
and Vähämaa 2001), Germany (Kottkamp and Otte 2001; Nilsson 2011),
Latin America (Da Silva 2001), Nordic Region (Dahlstedt and Engellau
2006), Poland (Brzeszczynski and Gajdka 2008), Sweden (Andersson
et al. 2010), and the United Kingdom (Brzeszczynski et al. 2008).
9. In the case of these ratios, the term “revenue” is used interchangeably with
“sales”.
28 A. ZAREMBA AND J. SHEMER
10. More promising results are delivered by Barbee et al. (2008), who demon-
strate that among the various multiples the authors examined, the P/S
ratio has both the most consistently significant negative relation and the
highest explanatory power.
11. The usefulness of the price-to-sales ratio in stock selection in global equity
markets was also investigated in other studies for Australia (Gharghori
et al. 2013), Finland (Pätäri and Leivo 2009), Turkey (Kayaçetin and
Güner 2007), and the United States (Barbee et al. 1996, 2008; Jensen
et al. 1998; Dhatt et al. 2001; Vruwink et al. 2007).
12. The evidence on the price-to-EBITDA ratio is rather modest and not
widely discussed in renowned academic journals. Individual papers, e.g.
Mesale (2008), confirm that it may prove applicable for stock picking
purposes.
13. For further discussion see also Fama and French (1996).
14. See Kang and Kang (2009), Avramov et al. (2013), Elgammal and
McMillan (2014), Janssen (2014), Choi (2013), or Blitz et al. (2014b).
15. The importance of human capital in explaining the value premium was also
the subject of investigations by Hansson (2004), Santos and Veronesi
(2006), Jank (2014), and Sylvain (2014).
16. For further discussion see also Carlson et al. (2004) and Cooper (2006).
17. The concept of growth options as an explanation of risk premia in the
financial market was developed by Berk et al. (1999, 2004) and Gomes
et al. (2003).
18. For further discussion on this issue see Erb et al. (1995, 1996b), Bekaert
et al. (1996), Dahlquist and Bansal (2002), Harvey (2004), and Andrade
(2009), Zaremba (2015c).
19. For further explanation of the concepts of loss aversion and mental
accounting see Szyszka (2013).
20. This observation was later confirmed for the international markets by
Chaves et al. (2012). On the contrary, Chui et al. (2013) found the behav-
ior of the value premium consistent with the risk-based explanation but
failed to support the mispricing hypothesis.
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CHAPTER 3
WHAT IS MOMENTUM?
The momentum strategy exploits the well-established tendency of assets
with good past performance to continue to outperform in the future, with
poor past performers also continuing to disappoint. Although individual
momentum strategies may differ in the level of sophistication and other
details, like sorting periods, predictive indicators, and so on, their funda-
mental rule is surprisingly simple: stick to the past winners and shy away
from the losers. The trend is your friend, as it is often repeated by market
practitioners.
Effectively, momentum strategies can be divided into two broad cat-
egories, based on the method the past outperformance is measured.
foundation for all trend following strategies. In fact, Ricardo had success-
fully walked his talk, as he was said to have retired at 42 with his fortune,
which would be worth today $65 million.
Momentum principles also dominated investment literature of the
early twentieth century with the famous book of Edwin Lefevre (2010)
Reminiscences of a Stock Operator unraveling the investment approach
of the well-known trader Jesse Livermore. Livermore advocated buying
stocks at their new heights, which exemplifies a popular trend following
strategy depending on breakouts (Jaffarian 2009). Livermore’s famous
saying that “Prices are never too high to begin buying or too low to begin
selling” encapsulates very well the trend following concept.
Trend following was later immensely popular among many early leg-
endary speculators and investors including Richard Wyckoff (1924),
George Seamans (1939), Arnold Bernhard, the founder of the Value
Line Investment Survey (Antonacci 2015, p. 14), and Robert Rhea, the
Dow theorist (Rhea 1932; Gartley 1935, 1945). But it was not until the
study of Alfred Cowles III and Herbert E. Jones (1937) that momentum
became a subject of scientific research.
Especially impressive was the work of Cowles and Jones (1937), metic-
ulously performed with no computer assistance. The authors collected
stock return data from the 1920 to 1935 period, a painstaking accomplish-
ment in its own right, and unearthed probably the first scientific proof of
momentum. In their paper, they noted: “Taking one year as the unit of
measurement for the period 1920–1935, the tendency is very pronounced
for stocks which have exceeded the median in one year to exceed it also in
the year following”. Thus, good performance over the previous year tends
to carry on into the future. In other words, there is momentum.
The relative popularity of momentum among the prominent inves-
tors continued also in the post-war era. A great example is the book by
Nicolas Darvas (1960) with a captivating title How I made $2,000,000 in
the stock market. Darvas was a professional dancer who travelled around
the world while simultaneously buying and selling stocks using a cable
connection with his broker. He had a simple strategy of buying stocks
that made new heights and systematically replacing them with new
leaders. Following this straightforward method he allegedly made his
$2,000,000.
Another interesting story of momentum was propelled by Richard
Donchian, who issued a weekly commodity newsletter describing his
42 A. ZAREMBA AND J. SHEMER
laureate, Eugene Fama and French (2008), called the momentum “the
center stage anomaly of recent years”. At the time of writing this book, a
search for “momentum” in the Social Science Research Network eLibrary
produces 2922 manuscripts, of which almost a thousand have been writ-
ten in the past three years. The academic investigations of momentum
evolved in four main directions: (1) examining momentum across differ-
ent markets and asset classes, (2) explaining the reasons why momentum
exists, (3) improving the momentum-based strategies, and (4) researching
the statistical properties of momentum returns.
The studies have showed that momentum could be both the most
ubiquitous and most robust of all the discovered anomalies. It has been
documented across many stock markets and asset classes over various time
periods. Outside the US equity market (e.g., Fama and French (2008),
Chan et al. (2012)), momentum has been documented in developed
(Rouwenhorst 1998; Chan et al. 2000; Griffin et al. 2005), emerging
(Rouwenhorst 1999), and frontier markets (de Groot et al. 2012). Recent
years have brought a number of studies that examine momentum look-
ing over broad spectra of various countries and spanning over substantial
timeframes, as displayed in Table 3.1. For instance, Chui et al. (2010)
have tested momentum within 55 countries in the period from 1980 to
2003.
Not only has stock market momentum proved pervasive, but also
impressively long-standing. As indicated by recent evidence, the momen-
tum strategy has worked for well over two centuries. In 2009 Chabot et al.
proved momentum profitable even in the Victorian age. Furthermore, six
years later Geczy and Samonov (2015) made a tremendous research effort
Market price
Intrinsic value
4. The trend ends
small. It affects both individual investors (Barber and Odean 2000, 2004)
and professional futures traders (Locke and Mann 2005) as it does for
many types of securities, including treasury futures (Heisler 1994) and
mutual funds (Ivkovic and Weisbenner 2009).
The disposition effect may contribute to the initial underpricing, and
thus to the emergence of a trend, in two ways. First, the investors who sell
too early after gains create a downward price pressure, slowing down the
price adjustment. Second, the late sellers following losses keep prices from
falling as quickly as they should have (Hurst et al. 2013).10
These two behavioral phenomena may lead to initial underreaction
and, in consequence, emergence of the trend. Once the trend appears in
the market, other behavioral biases contribute to its continuation and the
subsequent delayed overreaction: herding, feedback trading, confirmation
bias, and representativeness (Hurst et al. 2013).
Herd behavior. It is a tendency of individuals to mimic the actions
of larger groups, even if individually they would have taken a different
decision (Bikhchandani et al. 1992). There are at least two reasons for
herding. First, it is fueled by the social pressure of conformity. The second
rationale is the belief of most people that a large group cannot be incor-
rect. In financial markets, the herd behavior may push investors to buy
the same stocks as others, thus reinforcing the trend. Indeed, herding was
documented not only among individual investors but also among pro-
fessionals who prepare recommendations (Welch 2000) and investment
newsletters (Graham 1999).
Feedback trading. The herd behavior is closely related with another
psychological phenomena: feedback trading. This concept refers to a pat-
tern of investors’ actions in which a positive outcome, such as a successful
trade, gives them confidence to pursue the same behavior in the future,
e.g. buying the same stocks. As a result, investors purchase stocks when
the market is rising and sell when it is falling. Such a cycle of positive feed-
backs may markedly strengthen a trend in the market.11
Confirmation bias and representativeness. Usually, when an investor
analyzes an investment, he has a preconceived opinion about it, which usu-
ally makes them selectively filter new information: paying particular atten-
tion to the news that supports their opinion, at the same time ignoring or
rationalizing the rest. Thus, the investor would be probably more likely to
seek information confirming his initial opinion about the company, than
50 A. ZAREMBA AND J. SHEMER
NOTES
1. An interesting review of the early evidence on momentum is provided by
Antonacci (2015).
2. Other popular books depicting famous momentum traders include
Chestnutt (1961), Haller (1965), Soros (2003), Covel (2007, 2009),
O’Neil (2009), and the “Market wizards” series (Schwager 1994, 2003,
2012a, b).
3. Later, in 1968, Levy expanded his thoughts to a full book on investing.
4. Further discussion and evidence is provided in the following papers: for
industries: Pan et al. (2004), Moskowitz and Grinblatt (1999), Faber
(2010), Chan et al. (2012), Andreu et al. (2013), Szakmary and Zhou
(2015); for government bonds: Luu and Yu (2012), Asness et al. (2013),
Duyvesteyn and Martens (2014), Hambusch et al. (2015); for corporate
bonds: Gebhardt et al. (2005), Pospisil and Zhang (2010), Kim et al.
(2012), Jostova et al. (2013); for interest rates: Durham (2013); for cur-
rencies: Okunev and White (2000), Bianchi et al. (2005), Menkoff et al.
(2011), Burnside et al. (2011), Pojarliev and Levich (2013), Kroencke
et al. (2013), Amen (2013), Accominotti and Chambers (2014),
Olszewski and Zhou (2014), Grobys et al. (2015), Orlov (2015), Bae
and Elkamhi (2015), Filippou et al. (2015); for commodities: Pirrong
(2005), Miffre and Rallis (2007), Fuertes et al. (2010), Gorton et al.
(2013), de Groot et al. (2014), Szymanowska et al. (2014), Fuertes et al.
(2015), Miffre and Fernandez-Perez (2015); for real estate and REITs:
Hung and Glascock (2010), Beracha and Skiba (2011), Goebel et al.
(2012), Ro and Gallimore (2013), Feng et al. (2014); for cross-assets
effects: Blitz and van Vliet (2008), Kessler and Scherer (2010), Faber
(2010), Keller and Putten (2012), Kim (2012), Geczy and Samonov
(2015).
5. For evidence across investment styles, see: Chen and De Bondt (2004),
Tibbs et al. (2008), Clare et al. (2010), Chan et al. (2012), Zaremba
(2015).
6. See Fama and Blume (1966), van Horne and Parker (1967, 1968), and
Jensen and Benington (1970).
7. The noisy rational expectations model in its most original form does not
fully allow for technical analysis, because Grossman and Stiglitz (1976,
1980) assume that uninformed investors have rational expectations about
future prices. Nevertheless, this gap has been filled by subsequent varia-
tions of this model, e.g., Hellwig (1982), Brown and Jennings (1989),
Blume et al. (1994).
8. This example is inspired by Hurst et al. (2013).
TREND IS YOUR FRIEND: MOMENTUM INVESTING 55
9. For further discussion on the anchoring effect and its implications for
underreaction, see also: Edwards (1983), Slovic and Lichtenstein (1971),
Watson and Buede (1987), Reidpath and Diamond (1995), Barberis et al.
(1998).
10. The key references for the disposition effect include Shefrin and Statman
(1985), Weber and Camerer (1998), Frazzini (2006), and Barberis and
Xiong (2009). Furthermore, an interesting review of theory and evidence
is provided by Kaustia (2010).
11. Theoretical models of feedback trading were developed, among others, by
Shiller (1984), De Long et al. (1990a), Cutler et al. (1990), Hong and
Stein (1999), and Shleifer (2000). Empirical evidence on this phenome-
non could be found in Shiller (1988), De Long et al. (1990b), De Bondt
(1993), Nosfinger and Sias (1999), and Bange (2000).
12. Important studies regarding the confirmation bias include Lord et al.
(1979), Forsythe et al. (1992), Pouget and Villeneuve (2012), and Bowden
(2015). Further references are provided in Rabin and Schrag (1999) and
Pouget and Villeneueve (2008).
13. The representativeness heuristic was initially discussed in a series of papers
authored by Kahneman and Tversky (Kahneman and Tversky 1972;
Tversky and Kahneman 1971, 1974, 1982). The impact on stock market
investors, which eventually leads to overreaction, was presented in the
papers of Kaestner (2006), Frieder (2008), Alwathainani (2012), and
Boussaidi (2013).
14. Evidence of the long-run underperformance is provided by, among others,
De Bondt and Thaler (1985), Moskowitz et al. (2012), and Asness et al.
(2013).
15. The explanations for the momentum effect are presented in a synthetic way
in Table B1 in the Appendix B.
16. To investigate the link between the small-cap premium and the January
effect see Easterday et al. (2009), Haug and Hirschey (2006), or Zhang
and Jacobsen (2012).
17. Key references include: for size: Jegadeesh and Titman (1993), Hong et al.
(2000), Zhang (2006); for age Zhang (2006); for book-to-market ratio:
Asness (1997), Daniel and Titman (1999), Sagi and Seasholes (2007);
credit rating: Avramov et al. (2007); analysts coverage: Hong et al. (2000);
idiosyncratic risk: Zhang (2006), Jiang et al. (2005), mutual fund owner-
ship: Chen et al. (2002).
18. Da et al. (2014a) argues that it is not only important how the information
is processed by the market but also how it is fed thereto as momentum
tends to be stronger among the companies with information arriving in
small amounts.
56 A. ZAREMBA AND J. SHEMER
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66 A. ZAREMBA AND J. SHEMER
The size effect is one of the most controversial cross-sectional return pat-
terns in equity markets. On the one hand, it is well-rooted in both the
investment practice and academic research. On the other, while there are
plenty of funds focused on small-cap investing, the performance of the
size-based strategies over the last decades was at least disappointing. Most
intriguingly, the size effect might not only be a stock-level phenomenon: a
number of studies claim the outperformance of not only small stocks but
also small markets.1 If confirmed, this might add a new promising founda-
tion to the country asset allocation strategies.
Note: The table reports monthly outperformance of the small-cap portfolio over the large-caps. Own
elaboration
100000
The smallest firms
10000 The largest firms
1000
100
10
1
1926 1933 1941 1948 1956 1963 1971 1978 1986 1993 2001 2008
Fig. 4.1 Long-term performance of small and large firms in the US stock
market
Note: The figure displays cumulative return on the quintiles of either the smallest
companies and the largest companies in the US stock market. It is our own elabora-
tion based on the data from Kenneth R. French’s’ data library: http://mba.tuck.
dartmouth.edu/pages/faculty/ken.french/data_library.html (accessed 31 October
2015)
we presented it in Fig. 4.1, over shorter periods they can be very volatile. In
the 1980s, for instance, it was the large caps that excelled in performance.
A much closer look at this instability was endeavored by Pradhuman
(2000), who divided the 1926–1999 period into 11 equal subperiods.
As he discovered, small caps outperformed in five periods while under-
performing in six! In other words, in any given year the small companies
were more likely to underperform than outperform, and the underperfor-
mance could drag for many years. It thus takes a lot of self-confidence and
patience to succeed as an investor.
Is it small-cap or micro-cap effect? One of the interesting features of
small cap investing is that a growing number of studies points to abnor-
mally high returns on micro caps, defined as publicly traded companies
with very low, or micro, market capitalization. Although such companies
might appear highly illiquid and costly for investment purposes, they can
yield truly exceptional high returns.4 Many recent studies show evidence
for the outstanding performance of the decile and the quintile of the small-
est stocks.5 In a study of a broad international sample from 39 countries in
period 1980–2009 de Moor and Sercu (2013a) found that the decile of the
smallest stocks delivered an outstanding average monthly return of 3.17 %,
whereas the return pattern in other portfolios remained flat. The size anom-
aly appears to be rather L-shaped than monotonic, with high returns in the
micro caps and normal in the remaining firms (de Moor and Sercu 2013b).
of 0.31, and large stocks only 0.34. This observation has its parallels also
at the country level. Often individual small markets are much more vola-
tile than large ones; thus, not surprisingly, investors shy away from invest-
ing in them, pushing the prices down.
Data mining. This last explanation of the size premium is probably also
the most disappointing to equity investors. It assumes that the small-cap pre-
mium . . . simply does not exist. It was just one lucky period in the past
that turned out to be so gracious for small companies. The future, however,
may well be very different. Given that there are dozens of research papers on
return-predictive signals published every year, some of them may well be spu-
rious products of data mining.12 Alas, the size premium might be one of them!
The recent evidence for the size effect is indeed very weak. While the
returns on small-companies in the “pre-Banz” era were very high, the stud-
ies investigating the recent decades are unable to identify any small-firm
effect. It is difficult to state why the small-cap effect disappeared: if the mar-
kets become more efficient and arbitraged the size-effect away, or if it simply
was a weaker period, or perhaps the size-effect had never existed, despite
the overwhelming evidence of its disappearance from the US and UK mar-
kets.13 The evidence, however, comes pouring in from all over the world.
In conclusion to his strict review of studies on the size effect spanning over
30 years, Van Dijk (2011) asserts that the effect disappeared entirely in the
early 1980s. Having conducted a series of regressions on a sample of 26,000
individual stocks from 48 countries, Hou et al. (2011) has found no reliable
relation between the stock returns and the firm size. Van Holle et al. (2002),
having researched 15 European countries, show that measurement of size
against the average firm size within one country producing a statistically
insignificant size effect. Also, Fama and French (2012) find no evidence of
the size premium in international markets, and Dimson et al. (2002), who
examined stocks from 20 developed markets, claim that the size effect has
actually reversed in the recent years and led to the outperformance of big
companies over small ones. Finally, the study by Barry et al. (2002), which
included 35 emerging markets, shows no evidence of the small cap effect. As
a result, the existence of the size premium does seem uncertain.
Could the small-country effect be similar? Could it be only a random effect
that blipped in the markets in the 1980s and 1990s? Perhaps so. Some stud-
ies suggest the link between the total stock market capitalization and future
returns was not so strong in the recent decade (e.g. Zaremba 2015b). As a
result, the evidence for the country-size effect may now seem a little shakier.
We will examine this issue more deeply in the second part of this book.
IS SMALL BEAUTIFUL? SIZE EFFECT IN STOCK MARKETS 75
NOTES
1. See Keppler and Traub (1993) and Keppler and Encinosa (2011).
2. The early evidence on the US market includes Reinganum (1981), Brown
et al. (1983), Keim (1983a, b), Handa et al. (1989), and Lamoureux and
Sanger (1989).
3. The key references include: Keim (1983), Reinganum (1981), Roll (1983),
Horowitz et al. (2000a, b), Easterday et al. (2009).
4. The outstanding returns often remain undetected by most cross-sectional
asset pricing models. The evaluation of micro caps’ performance represents
a considerable challenge for multi-factor asset pricing models (Fama and
French, 2008, 2012; Karolyi and Wu 2012).
5. See, e.g., Fama and French (2008), de Moor and Sercu (2013a, b), or
Zaremba (2015c).
6. The possible explanations are also depicted in Table B1 in the Appendix B.
7. For a discussion on trading costs in small equity markets, see, e.g., Ghysels
and Cherkaoui (1999), Domowitz et al. (2002), or Silva and Chaves
(2004).
8. See Hong et al. (2000), Fortin and Roth (2007), Damodaran (2012b,
pp. 337–338).
9. For turnover see: Brennan et al. (1998); for turnover ratio: Datar et al.
(1998) or Easley et al. (2002); for bid-ask spread: Amihud and Mendelson
(1986); for review and other measures: Amihud (2002), Amihud et al.
(2005).
10. For treasuries: Goyenko et al. (2011) or Musto et al. (2015); for treasuries:
Chen et al. (2007) or de Jong and Driessen (2012).
11. For hedge funds: Kapadia and Pu (2012); for private equity: Franzoni
et al. (2012), for real estate: Qian and Liu (2012).
12. See Lo and MacKinlay (1990), Black (1993), MacKinlay (1995), Harvey
et al. (2015).
13. For the USA: Eleswarapu and Reinganum (1993), Dichev (1998), Chan
et al. (2000b), Horowitz et al. (2000a, b), Roll (2003); for the UK:
Dimson and Marsh (1999), Michou et al. (2010).
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CHAPTER 5
et al. (2006a) focused on the downside risk and showed that a cross-sec-
tion analysis of stock returns reflects a significant downside risk premium.
Surprisingly, the results of so many papers seem to directly contradict
these theories. This phenomenon—also called a “low-risk anomaly” (Ang
2014, p. 332)—indicates that very frequently the relationship is reversed:
in other words, the safer investments generate higher both risk-adjusted
and even raw returns.
There is mounting evidence of the anomaly pouring in from numer-
ous studies conducted since its first discovery in the early 1970s. In their
paper of 1970, Friend and Blume examined the stock returns for the period
1960–1968 with the use of both the CAPM beta and volatility, concluding
that “risk-adjusted performance is dependent on risk. The relationship is
inverse and highly significant” (Friend and Blume 1970). Shortly afterwards,
this observation was confirmed by Haugen and Heins (1975) who analyzed
the US stock market in the period between 1926 and 1971, reaching the
conclusion that “over the long run, stock portfolios with lesser variance in
monthly returns have experienced greater average returns than their ‘riskier’
counterparts” (Haugen and Heins 1975). Market beta also appeared far
from ideal as a predictor of stock returns. The first challenge was probably
posed by Jensen et al. (1972) who wrote that despite the positive relation-
ship between beta and returns, the correlation was probably “too flat” com-
pared to the CAPM predictions. This fact results in abnormal returns on
low-beta stocks. The relevance of the CAPM was finally undermined in the
influential paper of Fama and French (1992) which proved that when con-
sidering the size and value effects “beta shows no power to explain average
returns” (Fama and French 1992). These studies led to the proliferation of
further studies providing plenty of evidence on the relationships between
risk and future returns in the US and other international equity markets.3
In investing, risk is usually understood as the unpredictability of future
returns and can be measured in various ways. Most of the recent studies
lead to the conclusion that the risk-return relationship is rather more neg-
ative than positive. At the same time, a few studies considering downside
risk or value at risk lead to quite contradictory conclusions. Let’s shortly
review the most popular measures employed in low-risk investing.
outperformed the safe ones. For instance, when the daily returns volatility
was computed over the 6-month period, the portfolio of the safest coun-
tries earned on average 0.81 % a month, while the portfolios of the most
volatile countries delivered the mean return of 1.45 %. In all the variants,
the volatile portfolios would always outperform the stable portfolios by at
least a half a percentage point. In other words, the low-volatility anomaly
seems nonexistent at the country level as the higher the risk grows, the
higher the return follows.5
Systematic risk. The total volatility of each security could be split into
two parts depending on the underlying source. The first category is sys-
tematic risk, which results from the market-wide price movements, i.e.
directly from the fluctuations of the business cycle, interest rates, credit
risk, and so forth. The other category is idiosyncratic (or specific) risk and
relates to a single security, reflecting its operations, products, people, and
so on.
Using appropriate measures, we can easily attribute the extent to which
the two risks contribute to the company’s total risk. The systematic risk is
usually measured with beta, which, econometrically, is simply the regres-
sion coefficient of the portfolio excess returns on the excess returns on the
market portfolios.
The CAPM model looks upon beta coefficient as the key determi-
nant of the expected returns. Higher beta means higher expected return.
This, however, as we know from Frazzini and Pedersen’s research (2014),
couldn’t be further from the truth.
In their famous paper of 2014 entitled “Betting against beta” Frazzini
and Pedersen formed portfolios of various securities based on their past
betas and found the low-beta assets delivering significantly higher risk-
adjusted returns, i.e. alphas, than the high-beta assets, which actually
underperformed. Frazzini and Pedersen proved this phenomenon not
only in 19 out of 20 country stock markets they examined but also in the
case of treasuries, credit indices, equity indices, commodities, sovereign
bonds, and foreign exchange. In all these markets, lower risk was associ-
ated with higher risk-adjusted returns!6
How convincing is the evidence given by Frazzini and Pedersen can
also be seen in Fig. 5.1. For asset pricing purposes, they also constructed
a factor portfolio: a long/short portfolio from sorts by beta. Its long leg
comprises low-beta stocks; the short leg the high-beta stocks. In the same
time the short leg is so leveraged that both legs bear the same system-
atic risk. Figure 5.1 details the performance of the betting-against-beta
IS RISK ALWAYS REWARDED? LOW-VOLATILITY ANOMALIES 85
1400
Betting Against Beta
1200
Global market portfolio
1000
800
600
400
200
0
1988 1990 1992 1994 1997 1999 2001 2003 2005 2007 2009 2011 2013
-200
1.60
1.40
1.20
1.00
0.80
0.60
0.40
0.20 High idiosyncratic volatility
0.00 Medium idiosyncratic volatility
Small Low idiosyncratic volatility
Medium
Big
world may pose a significant challenge. Firstly, these are really small mar-
kets, with investment infrastructure far less developed than in the USA,
Japan, or the eurozone; thus, it might be difficult to quickly transfer capital
between countries. Secondly, the volatility of the strategies implemented
in the small markets is also markedly higher.12
Value at risk. Value at risk (VaR) has gained a significant popularity in
recent decades as a statistical tool used to quantify financial risk within an
investment portfolio. The power of value at risk lies in the fact that it is
a single number intuitive measure. It could be defined either in absolute
terms (value, in US dollars for example) or in relative terms (percent-
age). Formally, VaR is defined as “an estimate of a loss over a fixed time
horizon that would be equaled or exceeded with a specified probability”
(Alexander and Sheedy 2004, p. 76). The value at risk is measured in three
variables. A portfolio manager may determine to have 1 % month value at
risk of 20 %, which means that in any given month there is a 5 % chance
the portfolio could lose more than 20 %. In other words, the loss of 20 %
of more is expected to happen every 100 months.
In practice, VaR is usually calculated in one of the three variants: (Jorion
2007, pp. 241–264):
– historical VaR—calculated based on past track record;
– Monte Carlo VaR—calculated using simulation methods;
– analytical VaR—calculated assuming usually normal or log-
normal distribution of rates of return, standard deviations, and
correlations.
From the standpoint of a stock investor, value at risk can provide addi-
tional information on risk that escapes many classical measures like in stan-
dard deviation. As VaR concentrates on the tail risk, i.e. the risk of extreme
negative events, it would be interesting to verify whether this risk is priced
in by investors—in other words, whether investors demand higher returns
for the stocks with high VaR.
This very question was researched in 2004 by Bali and Cakici. The pair
tried to find whether there had been any relationship in the US market
between VaR and future returns in the years 1965–2001—and the answer
was: Yes! Bali and Cakici simplified VaR to a percentile of past returns and
then sorted stocks into decile portfolios based on their metric. It trans-
pired that, for example, the decile of stocks with the highest 5 % VaR
outperformed the decile of stocks with the lowest 5 % VaR by 0.96 % per
month. The abnormal returns resulted from the specific methodological
IS RISK ALWAYS REWARDED? LOW-VOLATILITY ANOMALIES 89
PANEL A PANEL B
Fig. 5.3 Skewness of return distributions. Panel A left skewed distribution. Panel
B right skewed distribution
Note: Own elaboration
90 A. ZAREMBA AND J. SHEMER
the investor usually earns frequent steady, small, positive returns, which
sometimes are interrupted with single large losses resulting from defaults.
On the other hand, a private equity fund offers a good example of positive
skewness as 9 out of 10 start-up companies are likely to fail, and one stands
the chance to become a new Microsoft.
Investors generally favor positive skewness over negative which is usu-
ally explained by behavioral finance and means that investors are willing
to pay more for stocks displaying positive skewness. As a consequence, the
stocks with right skewed distributions are usually overvalued relative to
the left skewed ones, and deliver lower returns.14
Skewness might be measured and tested in a numerous ways. The
first and most obvious measure is total skewness, as depicted in Fig. 5.3.
Similar to volatility, skewness can be divided in two parts: the systematic
one, called coskewness, and the idiosyncratic part, the diversifiable skew-
ness. While academic evidence suggests that both measures may be related
to future returns15 some researchers experiment with alternative metrics
to predict the future skewness, for example Bali et al. (2011) testing the
maximum daily return.
Skewness has been proved to be a powerful determinant of future
returns across numerous markets and assets, not only for US equities but
also for many other national markets, including China, India, Russia, and
Poland.16 In 2014 Barberis et al. researched 46 international equity mar-
kets and confirmed the findings in the majority of the markets, identifying
fairly promising outcomes not only at the level of individual security but
also at the country level.17 More broadly, skewness preference has also
been observed in individual equity options (Boyer and Vorkink 2013),
commodities (Fernandez-Perez et al. 2015) and bonds (Yang et al. 2010).
Other risks. While standard deviation, beta, idiosyncratic volatility, and
VaR are all useful metrics in stock-level investing, measuring risk exposure
in allocating assets across countries poses additional challenges. Investors
face different risks and “shocks” associated with expropriation, currency
devaluation, coups, or regulatory changes (Bekaert et al. 1996; Dahlquist
and Bansal 2002). Today these risks seem particularly timely as the global
financial turmoil forced various governments to seize the assets of its cit-
izens, and military conflicts and political instability spread chaos across
numerous countries in Africa, Europe, and the Middle East.
If these alternative risks also pose threats to investors’ portfolios, it seems
only rational that they also be rewarded with additional profits. Indeed,
a number of authors indicate that the financial, political, and economic
IS RISK ALWAYS REWARDED? LOW-VOLATILITY ANOMALIES 91
risks are priced at the country level, which means that riskier countries
are associated with higher expected returns.18 Unfortunately, most studies
have predominantly focused on asset pricing and to some extent disregard
its practical applicability to international investors. One of the rare excep-
tions is the article by Erb et al. published in 1995. Having examined the
impact of country credit risk, the authors found it a powerful predictor of
future returns, especially within emerging markets. After forming quar-
tile portfolios based on the Institutional Investors’ semiannual surveys,
the researchers calculated mean returns in the 1980–1993 period, hav-
ing based their analysis on 40 markets, both developed and emerging.
As it turned out, the quartile portfolio of the riskiest countries delivered
returns on average 11.6 percentage points higher per annum than the safe
markets. Still, the differences in returns across the developed markets were
relatively small, and predominantly driven by the emerging markets. While
the lowest credit risk emerging market portfolio earned on average only
7.9 % per year, the riskiest markets delivered the mean annual return of
34.3 %, with the level of volatility staying very similar for both portfolios.
In other words, Erb et al. (1995) strongly supported the concept that the
high sovereign credit risk provides additional premium for global equity
investors. Nonetheless, the relatively short study period and lack of reli-
able robustness tests may still be considered as weak spots of the research.
If the short selling is impossible, then the risk-return relation in the mar-
ket might be markedly distorted (de Giorgi et al. 2013; Hong and Sraer
2015). Even early financial models, e.g. Miller’s (1977), indicated that
where only little short selling is available, the prices might be determined
by a small minority with the most optimistic expectations about the com-
pany. This may directly contribute to the volatility anomaly.
Regulatory constraints. Most of the investment regulations, both
international and national, fail to recognize low-volatility stocks as a sepa-
rate asset class, as opposed to equities or bonds. An investment policy
may, for instance, indicate that a portfolio manager is allowed to allocate
at maximum 60 % of his portfolio into stocks and 40 % into bonds. In
fact, the same level of risk could be achieved via investment of, let’s say,
80 % of the portfolio into low-volatility stocks and 20 % in the bond; this,
however, stretches beyond the opportunities available to the asset man-
ager. Therefore, if a manager wants to maximize his equity exposure, he is
forced to go for high beta stocks. Such regulations may also boost demand
for risky companies (Blitz et al. 2014a).
Beside these main explanations, we also have supplemental theories which
offer only partial justifications. Some papers point to data mining concerns
as the results are to some extend sensitive to liquidity effects and portfolio
weighting schemes.27 Still, as we have reviewed in previous studies, the volatil-
ity effect seems too pervasive to be a mere data mining anomaly. Furthermore,
Martellini (2008) provides evidence that the low-volatility anomaly may be
related to the bankruptcies and delisting of the stock market companies. Once
the volatility-based strategies are implemented within the survivors only, the
high risk companies substantially outperform the safe ones.
Finally, an interesting experiment was performed by Hou and Loh in
2016. Having examined a set of various explanations, they found the lot-
tery preference the most promising. On the other hand, Hou and Loh
(2016) argue that the set of explanations linked to lottery preferences
can explain away a half the puzzles in individual stocks with the other half
unexplained. The conclusion? Although the current academic knowledge
offers an array of explanations of the low-risk anomaly, some important
phenomena still seem waiting to be discovered.28
***
Summing up the considerations in this chapter, the relationship between
risk is quite intriguing. Dependent on the precise risk measure used, it
might be positively or negatively related with future returns. In fact, the
most intuitive measures turn out to be negatively related to risk, which
96 A. ZAREMBA AND J. SHEMER
NOTES
1. Examples include Black et al. (1972), Fama and MacBeth (1973), Blume
(1970), Miller and Scholes (1972), Blume and Friend (1973).
2. See Levy (1978), Tinic and West (1986), Merton (1987), Malkiel and Xu
(2004).
3. For the US equity markets: Black (1993), Haugen and Baker (1991,
1996), Falkenstein (1994), Chan et al. (1999), Jagannathan and Ma
(2003), Clarke et al. (2006), Ang et al. (2006b), Clarke et al. (2010); for
global equity markets Blitz and van Vliet (2007), Ang et al. (2009), Baker
et al. (2011), Dimitriou and Simos (2011), Baker and Haugen (2012),
Blitz et al. (2013), Walkshausl (2014).
4. The evidence is provided in the following studies: for commodities: Blitz
and de Groot (2014) and Szymanowska et al. (2014); for treasury bonds:
de Carvalho et al. (2014); for corporate bonds: Houweling et al. (2012),
de Carvalho et al. (2014), Houweling and Zundert (2014), Ng and Phelps
(2015).
5. Additional evidence is provided in Liang and Wei (2006) and Zaremba
(2015).
6. In another study Asness et al. (2014) documented that profitability of low-
beta investing is not simply a consequence of industry bets that favor stable
industries.
7. See Liang and Wei (2006) or Zaremba (2015a).
8. See Alexeev and Tapon (2012) for review of relevant studies.
9. See Merton (1987) and Malkiel and Xu (2004).
10. For further evidence see Bali and Cakici (2008), Fu (2009), Clarke et al.
(2010), van Vliet et al. (2011), Chen et al. (2012), and Fink et al. (2010).
11. See Bernard et al. (2013), Fernandez-Perez et al. (2014) or Fuertes et al.
(2015).
12. Further evidence on the relationship between idiosyncratic volatility and
future returns in the cross-country section can also be found in Hueng and
Yau (2013).
13. For Taiwan: Chen et al. (2014); for Pakistan: Iqbal et al. (2013), Iqbal and
Azher ( 2014); for hedge funds: Bali et al. (2007).
14. Barberis and Huang (2008) indicate that investors with cumulative pros-
pect theory preferences are willing to pay more for stocks with greater
idiosyncratic skewness. According to the prospect theory (Kahneman and
Tversky 1979), investors overvalue small and undervalue large probabili-
ties. As a result, large payoffs with small probabilities seem more attractive
IS RISK ALWAYS REWARDED? LOW-VOLATILITY ANOMALIES 97
than they should, leading investors to prefer stocks with high positive
skewness.
15. For coskewness: Kraus and Litzenberger (1976); for idiosyncratic skew-
ness: Barberis and Huang (2008), Boyer et al. (2010).
16. For the US market: Harvey and Siddique (2000), Dittmar (2002), Kapadia
(2006), Barberis and Huang (2008); for China: Chen et al. (2011a); for
India: Narayan and Ahmed (2014); for Russia: Teplova and Mikova
(2011); for Poland: Nowak and Zaremba (2015).
17. See Harvey (2000) or Zaremba and Nowak (2015).
18. See Erb et al. (1995, 1996), Bekaert et al. (1996), Dahlquist and Bansal
(2002), Harvey (2004), Andrade (2009).
19. Interestingly, some studies argue that low-volatility anomaly to be just a
manifestation of various skewness related effects, see, e.g. Schneider et al.
(2015).
20. See, for example, Tversky and Kahneman (1992), Barberis and Huang
(2008), or Bali et al. (2011).
21. The seminal papers on this issue include Fischhoff et al. (1977).
22. See Ferrer-i-Carbonell (2005), Luttmer (2005), Clark and Oswald (1996),
and Knight et al. (2009).
23. See Abel (1990), Gali (1994), Campbell and Cochrane (1999), Heaton
and Lucas (2000), Lettau and Ludvigson (2001), DeMarzo et al. (2004),
or Roussanov (2010).
24. See Sharpe (1981) or Roll (1992).
25. For further models and references, see Falkenstein (2009, 2012), Blitz
et al. (2013), and Brennan et al. (2012).
26. See, e.g., Brennan (1971), Black (1972, 1993), Frazzini and Pedersen
(2014).
27. The evidence is provide by, e.g., Bali and Cakici (2008) and Han and
Lesmond (2011).
28. We review the existing anomalies of the low-risk effect in Table B1 in the
Appendix B.
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IS RISK ALWAYS REWARDED? LOW-VOLATILITY ANOMALIES 103
Does investing in “quality” in the stock market pay off? The answer to this
question is anything but straightforward. First, we need to define what
quality strategies actually are. This is by no means an easy task. Unlike
value, there is no universally accepted definition of quality in the stock
market.1 Some are narrower, other broader. The narrowest definition boils
down to a single financial ratio, while the most comprehensive assumes
quality to engulf four grant areas: profitability, payout, growth and safety.
What is the relation between quality and future returns? It seems only
rational to assume that investors should be willing to pay more for compa-
nies displaying higher quality characteristics. Consequently, higher prices
should imply lower expected returns. Put simply: the higher the quality,
the lower the returns. We have a handful of anecdotal evidence support-
ing this idea. In 1994 Clayman reviewed the performance of both excel-
lent and “non-excellent” companies, to find the non-excellent companies,
which are entities in a more inferior position as measured by ROA, ROE,
or profit margin, significantly outperform the excellent companies. Also,
Cooper et al. (2008) provides evidence that rapid asset growth indicates
poor performance whereas Damodaran (2004) observes that stocks with
lower credit ratings usually yield higher returns. Plenty of other studies
confirm the negative relation between stock liquidity and expected returns2
and the positive relation between indebtedness and market returns is well
grounded in the literature dating back to Bhandari in 1988.
Indeed, five of these seven criteria refer more to quality than valuation.
In fact, the last two, which strictly concern valuation, are hardly precise:
oftentimes P/E ratios below 15 or P/BV ratio under 1.5 characterize
most of the listed companies.
This affirmation of quality was further inherited by Graham’s prob-
ably best-known follower—Warren Buffett. Three out of four groups of
Buffet’s tenets refer to quality rather than valuation (Damodaran 2012a, b,
pp. 266–267):
1. Business tenets:
(a) The business model of the firm should be simple and
understandable.
(b) The company should be characterized by consistent operating
history, i.e. both stable and predictable operating earnings.
(c) The business of the firm should have favorable long term
prospects.
2. Management tenets:
(a) The managers should be candid and trustworthy.
(b) The management should consist of leaders rather than
followers.
3. Financial tenets:
(a) The profitability should be reflected by high return on equity.
(b) The firm should have high and stable profit margins.
108 A. ZAREMBA AND J. SHEMER
4. Market Tenets:
(a) The company’s market value should be lower than the dis-
counted value of future earnings.
12,000
10,000
MSCI USA Quality Gross Index
8,000
MSCI USA Gross Index
6,000
4,000
2,000
0
1975 1979 1982 1985 1989 1992 1995 1999 2002 2005 2009 2012
Fig. 6.1 Performance of MSCI Quality Gross Index in the 1975–2015 period
Note: Own elaboration based on data from the 12/31/1975–30/09/2015
sourced from Bloomberg. Both indices rebased at 100 as of 12/31/1975
The calculation of net profit for Bill seemed easy: $200 of revenue
minus $120 of costs gave $80 in both net profit and net cash inflow at the
same time. Ted, on the other hand, needed an accountant to handle the
depreciation of his equipment following the accrual method. The accoun-
tant calculated Ted’s expenses at $120 on the first day, so his net profit
also equaled $80. Net cash flow, however, was very different as Ted spent
$2100 and received $200, generating a negative cash flow of $1900 due
to owning both the stand and supplies for the next 99 days.
While on the next day Bill may just as well wind up his lemonade busi-
ness and start afresh, Ted owns his stand and has to carry on. Which of
the men bears more risk? What if they will have to weather a few rainy
days that dampen the sales? What if the customers will opt for orange
juice instead of lemonade? What if the stands get broken? Clearly, Ted’s
situation appears riskier. The question is whether such risk can be properly
assessed and evaluated by the stock market.
The answer is probably negative. The seminal study by Sloan (1996) proved
that that the shares of companies with small or negative accrual ratios mark-
edly outperform (+10 % annually) those of companies with high accrual ratios.
This anomaly turned out to be very consistent in time as the study
has been replicated and the phenomenon appears to survive its discovery
(Livnat and Santicchia 2006).12 It also appears across many markets: In
2005 LaFond (having investigated the quality of earnings in 17 countries
confirmed its true global status, which was further reaffirmed by Leippold
and Lohre (2010) in 22 out of 26 country markets.
Other studies have attempted to redefine the accrual anomaly to improve
its performance. First narrowing it to operating accruals (Sloan 1996) then
expanding the definition to total balance sheet accruals (Richardson et al.
2005) and also researching stocks with particularly abnormal accruals
relative to the company’s past financial statements (Xie 2001) or the indus-
try (Chan and Jegadeesh 2006). Finally, a number of studies explored the
specific components of accruals and their power to predict future earnings
(e.g. Thomas and Zhang (2002), Belo and Lin (2012)).13
So far we have reviewed a number of cross-sectional anomalies related
to quality. Despite being backed up by strong empirical evidence, the
theoretical motivation is far from well-grounded. Quality investing is a
generic and comprehensive concept, which lacks a uniform explanation as
in the case of value or momentum investing. Individual anomalies related
to specific company characteristics usually have their own explanation,
which, nonetheless, sometimes fail to gain universal acceptance.
IS GOOD COMPANY A GOOD INVESTMENT? QUALITY INVESTING 115
NOTES
1. See, e.g., Novy-Marx (2012b), Asness et al. (2014b), Hunstad (2014), or
Hanson and Dhanuka (2015).
2. See, e.g., Korajczyk and Sadka (2008), or Amihud (2002).
3. The evidence is provided in, e.g. for leverage and credit standing: Penman
et al. (2007), Campbell et al. (2008), Hahn and Lee (2009), George and
Hwang (2010); for growth: Mohanram (2005); for accruals: Sloan (1996),
Richardson et al. (2005); for balance sheet liquidity: Palazzo (2012); for
profitability: Griffin and Lemmon (2002), Fama and French (2006),
Novy-Marx (2013); for aggregated measures: Asness et al. (2014b).
4. For ROA: Fama and French (2006), Balakrishnan et al. (2010), Kogan and
Papanikolaou (2013); for ROE: Haugen and Baker (1996), Chen et al.
(2011b), Wang and Yu (2013).
5. See Lev and Thiagarajan (1993), Abarbanell and Bushee (1998),
Witkowska (2006), and Soliman (2008).
6. See Ohlson (1980), Shumway (2001), Campbell et al. (2008a), Hahn and
Lee (2009).
7. See also, e.g., Ou and Penman (1989) or Zaremba (2014a).
8. The review of studies on IPO pricing could be found, among others, in
Ritter and Welch (2002) or Eckbo et al. (2007).
9. The key reference papers include: Richardson and Sloan (2005), Daniel
and Titman (2006), Bradshaw et al. (2006), Fama and French (2008),
Pontiff and Woodgate (2008), and Walkshäusl (2016).
10. See Fairfield (2003), Titman et al. (2004), Anderson and Garcia-Feijoo
(2006), Cooper et al. (2008).
11. This example is also given by Robbins (2011).
12. A study by Mohanram (2014) indicated that the accrual anomaly has
apparently weakened since 2002 arguing that one of the plausible factors
contributing to the decline is the increasing number of cash flow forecasts
providing the markets with forecasts of future accruals.
13. A comprehensive review of the accruals-based anomalies can be found in
Dechow et al. (2011).
14. See, e.g., Ball (1978), Berk (1995), or Novy-Marx (2013).
IS GOOD COMPANY A GOOD INVESTMENT? QUALITY INVESTING 117
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PART II
CHAPTER 7
used for all the country markets we examined. The reason for employ-
ing the MSCI indices is to maintain a unified methodology of return cal-
culation across all the countries. Furthermore, the MSCI indices cover
approximately 85 % of each stock market capitalization they represent
(MSCI 2014a) and are computed for the markets accessible for investors.
Another reason for the choice of MSCI indices is the need to align
research with the investment practice. This family of indices serves as the
foundation for numerous futures contracts and plenty of exchange-traded
funds all over the world. (MSCI 2015a). The MSCI indices are con-
structed and managed with a view of making them fully investable from
the perspective of an international institutional investor (MSCI 2014b).
If a given market is not investable, the MSCI discontinues the calculation
of its index. For example, on 1 January 2008, MSCI discontinued their
index coverage of Venezuela due to the continued presence of investability
restrictions.
Finally, for the markets accessible for investors where there is no MSCI
index available, our second choice index is Dow Jones and the third,
STOXX. It is worth highlighting here that the country-level perfor-
mance is usually independent of the index choice. In fact, Zaremba and
Konieczka (2014) tested cross-country value, size, and momentum effects
using both the MSCI and local country indices under varying computation
and weighting methodologies. They found no important qualitative results.
Considering corporate events that may influence the returns, we use
total return indices, which account for the impact of dividends and other
corporate actions that influence the stock price, e.g. splits, reverse splits,
or preemptive rights.
Our sample includes both existing and discontinued country indices
(for example MSCI Venezuela) to avoid any form of survivorship bias. We
present performance based on the returns and accounting data from the
period January 1995 to June 2015. At times, accounting or return data
for some or all of the countries is available for shorter periods, in which
case we use them. The detailed list of all countries investigated in this
study, along with the representative indices and sample periods, is pre-
sented in Appendix B.
We collect the initial data in local currencies as comparisons based on
various currencies could be misleading (Liew and Vassalou 2000; Bali et al.
2013). This holds especially true for the emerging and frontier m arkets,
where inflation and risk-free rates are very high and differ significantly
among the markets. Most studies adopt the dollar-denominated approach
TESTING THE COUNTRY ALLOCATION STRATEGIES 125
unavailable then. For this reason, whenever the metric we use for sorting
the country equity markets rely on accounting data, we lag it 3 months
(e.g. when sorting at the end of month t−1, we use data from t−4).
Having ranked the markets by the investigated characteristics, we
determine the 33rd and 67th percentile breakpoints for each measure.
Consequently, we obtain three roughly equal subgroups. Finally, we
weight the respective country equity indices to form portfolios.4
In practice, there seems to be no perfect weighting scheme for this type
of strategy backtest. Although the common practice in country-level stud-
ies is to weight the indices equally in portfolios (e.g. Asness et al. (2013)),
this approach has two important drawbacks. First, it overestimates the
importance of small and illiquid markets where investing might be dif-
ficult. Second, the returns on equally weighted portfolios may be poten-
tially distorted by the so-called returns on rebalancing or diversification
(Willenbrock 2011). This phenomenon may lead to emergence of addi-
tional profits due to pure systematical rebalancing.5 Furthermore, the less
correlated and the more volatile the portfolio’s constituents are, the more
pronounced this effect is (Erb and Harvey 2006). An alternative solu-
tion is to employ the capitalization-weighting scheme. In other words,
returns are weighted according to the total stock market capitalization at
the end of the previous month (month t−1). The main disadvantage of
this approach is the possibility of heavily influencing, or even dominat-
ing, the tested portfolios by the largest equity markets. We use both these
alternative weighting schemes to ensure a more comprehensive picture of
the examined strategies.
Beside the simple tertile portfolios from sorts on various characteristics,
we usually add returns on zero-investment portfolios. These are portfolios
that assume a long position in the tertile portfolio with the highest expected
return and a short position in the tertile portfolios with the lowest expected
return. This type of portfolio involves purchasing and short selling the same
amount of securities, so theoretically requires no money (hence the name:
zero-investment portfolio). It is also called the dollar-neutral portfolio.
We calculate zero-investment portfolios in both the gross-return and
net-return approach. Examining such portfolios on a net returns basis has,
however, a soft spot. As the treatment of dividends and dividend taxes
in short sale transactions vary across countries and time, the returns on
the zero-investment portfolios in the net approach should be essentially
looked upon as returns on differential portfolios that accentuate the out-
performance of the top portfolios over the bottom portfolios.
TESTING THE COUNTRY ALLOCATION STRATEGIES 127
R
SR =
s (7.1)
William Sharpe—for three main purposes: to explain the reasons for port-
folio diversification, to create a framework for the valuation of assets in
conditions of risk, and to explain differences in the long-term returns on
various assets.10 The CAPM provided a basis for many methods of perfor-
mance evaluation in investment portfolio management.
The fundamental assumption of the model is that volatility of a financial
instrument can be broken down into two parts: a systematic and specific
risk. The systematic risk stems from general changes in the market condi-
tions and relates to the volatility of the market portfolio. The specific risk
also relates to volatility, which is, however, driven not by the market but
by the internal situation in the company. In other words, losses ensuing as
a result of a market crash are rather of a systematic nature while the losses
due to an employee strike in a firm belong to the specific risk.
The CAPM model has some vital implications for portfolio construc-
tion and diversification. When we build a portfolio, systematic risks of indi-
vidual stock simply add up; however, specific risks, not being correlated,
set each other off. Therefore, in a well-diversified portfolio, the influence
of the specific risk is generally negligible, and in a well-functioning market,
a rational investor may ignore the specific risk and concentrate solely on
the systematic part. After all, would the investor even consider the specific
risk, if it could be easily diversified away at no cost?
This important implication of the CAPM mode, stating that the inves-
tors should be only compensated for the systematic risk because the spe-
cific risk can be easily almost entirely eliminated, is reflected in its most
basic equation:
Ri ,t = a i + R f ,t + b rm ,i × ( Rm ,t - R f ,t ) + e i ,t (7.2)
where Ri,t, Rm,t and Rf,t are returns on the analyzed security or portfolio
i, the market portfolio and risk-free returns at time t, and αi and βrm,i are
regression parameters. βrm,i is the measure of the systematic risk. It informs
us how aggressively the stock reacts to changes of prices in the broad mar-
ket. Basically, the CAPM formula implies that the excess returns on the
investigated security or portfolio should increase linearly with the systematic
risk measured with beta: the higher the risk, the higher the expected return.
Finally, the αi intercept measures the average abnormal return, the so-
called Jensen-alpha. It is defined as the rate of return earned by the port-
folio or a strategy in excess of the expected return from the CAPM model.
TESTING THE COUNTRY ALLOCATION STRATEGIES 129
( )
a i = R1E - b i × RmE (7.3)
where αi is the Jensen’s alpha on the investigated portfolio, R1E is its mean
excess return over the examined period, βi is the market beta, and RmE is
the mean excess return on the market portfolio.11 Throughout the book,
we use the capitalization-weighted return as the proxy for the market
portfolio. The portfolio is calculated based on either gross or net returns,
according to the approach of a strategy examination, and the risk-free rate
is consequently represented by the US 3-month Treasury Bill. Importantly,
however, when a zero-investment portfolio is examined, there is virtually
no need to subtract any risk-free rate.
The decisive rule for the Jensen’s alpha is that alpha is the better one.
When this intercept from the CAPM model turns negative, it signals that
the investment in the analyzed strategy or portfolio would be unreason-
able, as higher return with comparable risk could be achieved via invest-
ments in the risk-free asset and market portfolio.
Statistical significance. One important difficulty in examining invest-
ment strategies is to distinguish when seemingly abnormal returns are
truly abnormal, and when it is pure coincidence. If a trader earned 10 %
annually, 5 years in a row, how can we tell whether he follows a superior
investment strategy or he just got lucky? For this reason, whenever we
report some mean returns or alphas, we will simultaneously report the
statistical significance. The statistical significance is a concept that at least
to some extent helps us differentiate real return patterns from mere luck.
When some mean return or alpha exceeds 0 at the 5 % level, it indicates a
5 % risk of no real pattern in the returns, even though we have identified it
in the historical data. In other words, the returns could turn positive only
in our specific sample, and this result may not be replicated in another
sample. Thus, this 5 % threshold could also be seen as the probability
of the returns plunging below zero when implementing this strategy to
another sample.
The statistical significance test may be one-sided, i.e. informing us
whether the returns are significantly higher than 0, or two-sided, i.e.
informing us whether the returns depart from 0 (either lower or higher).
130 A. ZAREMBA AND J. SHEMER
Notes
1. This approach was used in numerous studies of the cross-section of stock
returns. Examples include: Liu et al. (2011), Bekaert et al. (2007), Brown
et al. (2008), Rouwenhorst (1999), Barry et al. (2002), Griffin (2002),
Bali and Cakici (2010), Chui et al. (2010), Hou et al. (2011), de Groot
et al. (2012), de Moor and Sercu (2013a, b), and Cakici et al. (2013).
2. Waszczuk (2014a, b) indicates that the discrete-time asset pricing theory
provides no information on the relevant interval of expected returns (Fama
1988). Thus, we choose monthly intervals, which are also the most widely
used in similar studies. The reasons are twofold. On the one hand, it offers a
sufficient number of observations to ensure power of the conducted tests.
On the other hand, monthly intervals avoid excessive exposure to the micro-
structure issues (de Moor and Sercu 2013a, b). Lower frequency could be
adequate for the estimation of capital cost, but not for asset pricing tests, for
which shorter time intervals markedly improve their quality. In practice, it is
used rather rarely and usually when the research additionally encompasses
macroeconomic data. The paper by Avramov and Chordia (2006), who
investigate the Consumption CAPM, may serve as an example.
3. The index-level fundamental and financial ratios used in this book have two
limitations that may be potentially important. First, if the financial state-
ments were revised, then our financial ratios are based on the revised data.
Nonetheless, we estimate that the impact of this issue on the results is lim-
ited. There are both upward and downward revisions, so we do not expect
any systematical bias in this case. Second, the necessary financial data are not
always available for every index constituent, even though the indices are
predominantly composed of large and liquid companies. Thus, we require
at least 50 % coverage to generate a value. The precise values of financial
ratios are sourced from Bloomberg and computed within its software.
4. The type of quantile portfolios highly depends on the number of available
constituents and it is a trade-off between the number of assets available and
TESTING THE COUNTRY ALLOCATION STRATEGIES 131
the grid resolution (Waszczuk 2014b). The most widely considered alterna-
tives are quintiles, e.g. Banz (1981), Chan et al. (1998), and deciles, e.g.
Jegadeesh and Titman (1993, 2001), Lakonishok et al. (1994). We decided
that 78 diversified index portfolios are sufficient for the 20th and 80th break-
points, but insufficient for the 10th and 90th breakpoints. Among alternative
approaches, Achour et al. (1998) works with tertile portfolios, and Brav et al.
(2000) uses the 50 % cut-off. In our case, due to a relatively small number of
assets in the portfolios, we mostly rely on tertile portfolios.
5. For further discussion, see Ang (2014).
6. In the literature, by default the term volatility means a yearly standard devi-
ation of returns. Both terms are used in this book in the same meaning.
7. In financial studies we have two main methods of converting prices to
returns: the arithmetic (simple) and logarithmic return approach. The lat-
ter is usually preferred for three basic reasons: (1) better arithmetical prop-
erties (including compounding over time), (2) return distributions that
represent a larger degree of normality than arithmetic returns, and (3)
reduced heteroscedasticity in logarithmic returns series (Waszczuk 2014b).
This type of returns are not fully additive over assets, but the bias is rather
small, especially for the short time intervals, so they are also used in the
cross sectional studies (e.g, Liew and Vassalou (2000), Diacogiannis and
Kyriazis (2007)). In the calculations used in this book, we use a two-step
approach. We first use arithmetic returns when aggregating stocks into
portfolios. Then, for the time-series aggregation and statistical inferences,
we use log-returns. For further discussion on the return calculation for
financial studies see Roll (1984) or Vaihekoski (2004).
8. The Sharpe ratio was later frequently revised and modified by many
authors, including its inventor; across this book, however, we rely on the
simplest and most intuitive definition described by Sharpe (1966). For
more examples of the modifications and revisions of the Sharpe ratio see:
Sharpe (1994), Vinod and Morey (1999), Dowd (2000), Israelsen (2005),
or Le Sourd (2007).
9. The detailed characteristics of the Sharpe model were extensively presented
in a number of financial textbooks, e.g. Francis (1990), Elton and Gruber
(1995), Campbell et al. (1997), Cochrane (2005), or Wilmott (2008).
10. Treynor (1961, 1962), Lintner (1965a, b), and Mossin (1966) developed
a similar model at the same time, so all four of them—including Sharpe
(1964)—are now considered to be the fathers of the CAPM model. See
also French (2003).
11. For simplicity, in the book we use the Jensen’s alpha in its most basic form.
Nonetheless, this performance measure has been frequently updated and
modified over time (Zaremba 2015). For example, Black (1972) suggested
132 A. ZAREMBA AND J. SHEMER
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TESTING THE COUNTRY ALLOCATION STRATEGIES 135
various stock exchanges are strongly interrelated. Over the short term the
returns on international markets tend to move in synchrony; over the long
term, however, the differences in risk premia could grow really huge.
In 2011 Dimson et al. (2011) tracked the average annual risk premia
across 19 different countries back to 1900 and discovered the profits from
stocks to vary substantially. In the 1900–2010 period the South African
market generated a monthly mean annual risk premium of 6.7 % while
for Belgium, this was merely 2.9 %. Over the course of these 110 years,
this seemingly insignificant 3.8 % difference would grow to huge 5400 %.
In other words, an average Australian would have earned over 50 times
more in the stock market than one Belgian, just because of mere luck,
and leaving so much money to luck surely does seem unwise. It is all the
more significant as the century-long investment horizon is so far beyond
the scope of an average investor, and over a shorter period—a decade or
two—the risk premia, cross-sectionally, could be even more volatile. Let’s
remember the case of Japan, which struggled to recover after the 1990s
crash for over two decades.
A much wiser solution would be to diversify the portfolio and spread
these long-term risks across various markets: Dimson et al. (2011) calcu-
lated that throughout the years 1900–2010 the global risk premia out-
grew bills by 4.5 % per annum. Yet even a diversified portfolio shows some
weak spots. Let’s take a closer look at the performance of a diversified
global portfolio over more recent years.
Figure 8.1 and Table 8.1 present the performance of the MSCI All
Country World Total Return Index. This index captures returns on large
and medium companies across 23 developed and 23 emerging markets.
As of October 2015, the index comprised 2476 constituents and covered
approximately 85 % of the global investable equity opportunities, so it
provided a fair representation of global equity markets.
Since 1998, the global equity market earned on average 4.97 %
per annum in the gross approach and 4.50 % adjusted for taxes on divi-
dends.2 These numbers translate to the mean monthly returns of 0.41 %
and 0.37 %, respectively. After subtracting the returns on US T-bills, the
gross (net) annual risk premium amounts to 3.35 % (2.87 %) per annum.
Clearly, this is well below the century-long statistic computed by Dimson
et al. (2011). What is probably the most unpleasant aspect for investors is
the volatility. While the standard deviation of monthly returns exceeded
16 %, the maximum drawdown statistic indicates that the investor had to
exercise enough patience to survive cumulative losses of over 50 %. That
seems a difficult feat for an average investor.
A SHORT PRIMER ON INTERNATIONAL EQUITY INVESTING 139
160
140 Gross returns
120 Net returns
100
80
60
40
20
0
-201998 2000 2001 2003 2004 2006 2007 2008 2010 2011 2013 2014
-40
-60
Fig. 8.1 Cumulative returns on MSCI All Country World Total Return Indices
Note: The figure depicts the cumulative returns on the MSCI All Country World
Total Return Index in US dollars. Net and gross returns are adjusted or unadjusted
for country-specific taxes on dividends, respectively. Values are presented in per-
centage terms. Data sourced from Bloomberg. The study period: January 1998–
June 2015
Table 8.1 Performance of MSCI all country world total return indices
Gross Net
Note: The table reports the statistics of log-returns on the MSCI All Country World Total Return Index
calculated in US dollars. Net and gross returns are adjusted or unadjusted for country-specific taxes on
dividends, respectively. Data are sourced from Bloomberg. The study period: January 1998–June 2015.
Excess returns are calculated over monthly US T-bills’ returns
140 A. ZAREMBA AND J. SHEMER
NOTES
1. See, e.g., Malkiel (2007).
2. We calculate the statistics based on log-returns.
REFERENCES
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Malkiel, B. G. (2007). A random walk down wall street: The time-tested strategy for
successful investing (9 ed.). New York: W. W. Norton.
CHAPTER 9
If value outperforms growth at the stock level and within other asset
classes, then could it be also applied at the country level? The answer is:
yes, it can—in fact—there is plenty of evidence that the value-oriented
country selection really works.
the sample by CAPE and formed portfolios of the cheapest and the most
expensive countries. The equal-weighted quarter portfolio of the countries
with the lowest CAPE delivered a mean yearly return of 13.5 %, while the
most expensive countries earned only 4.3 %. At the same time, the equal-
weighted portfolio of all of the countries in the sample returned 9.4 % per
year. In fact, the low-CAPE markets were also a bit riskier than the rest,
but still, the outperformance in terms of the raw return was remarkable.
Panel A Panel B
0.80 0.80
0.60 0.60
0.40 0.40
0.20 0.20
0.00 0.00
Growth Neutral Value Growth Neutral Value
Panel C Panel D
0.80 0.80
0.60 0.60
0.40 0.40
0.20 0.20
0.00 0.00
Growth Neutral Value Growth Neutral Value
Fig. 9.1 Mean returns on value and growth portfolios formed on equity multi-
ples. Panel A Book-to-market ratio. Panel B Earnings to price ratio. Panel C Cash
flow-to price ratio. Panel D Dividend yield
Note: The figure presents the mean monthly excess returns on the equal-weighted
tertile portfolios from sorts on four characteristics: book-to-market ratio, earn-
ings-to-price ratio, cash flow-to-price ratio and dividend yield. “Growth”,
“Neutral”, and “Value” are portfolios of markets with low, medium, and high
ratios, respectively. Values expressed in percentage terms. Calculations based on
the period 1995–2015; the data are sourced from Bloomberg
slightly negative. Also, the Sharpe ratios of the high-B/M markets score
either similar or below their low-B/M counterparts.
Summing up, the book-to-market ratio—which for a very long time
dominated as the most popular value indicator—was finally dethroned as
the best predictor of future returns of the past two decades. Why? Perhaps,
the B/M-based strategy was so popular that in the end the market became
more efficient? Or it is too closely related to the country-specific charac-
teristics, like the dominating type of industry, for instance? Or, maybe, it
was just a particular period in which the countries with high B/M ratios
ruled? The reason remains to be uncovered.
Table 9.1 Performance of value and growth portfolios formed on equity multiples
Gross returns Net returns
Dividend yield
Mean 0.42 0.68** 0.65** 0.19 −0.05 0.88*** 0.67** 0.58**
145
(continued)
Table 9.1 (continued)
146
The P/E ratio strategy proved superior to the B/M ratio. In the gross
approach equal-weighted portfolios of value markets show mean monthly
return of 0.65 % while the growth countries only 0.35 %. In fact, although
the high earnings-to-price (E/P) ratios also proved riskier in terms of the
standard deviation (6.22 % vs. 5.17 %), the Sharpe ratios performed better
for the value countries.
Perhaps more importantly, the outperformance was even more pro-
nounced in the capitalization-weighted portfolios (Table 9.1, Panel B),
which place more weight on the large and liquid markets, as being more
accessible and better reflecting the standpoint of an average investor.
The mean monthly excess return on the zero-investment strategy, which
assumes long position in the high E/P countries and short position in
the low E/P countries, equaled 0.50 % and 0.93 % in the gross and net
approaches, respectively. In fact, the mean returns on the tertile portfolio
of growth countries selected with the E/P as the discriminator of future
returns, turned even slightly negative. Finally, the mean alpha for the
growth countries ended up substantially negative and falling below −0.44 %
on a monthly basis.
Equally good was the performance of the portfolios of country equity
indices formed on the cash flow-to-price ratios. No matter what particular
weighting scheme or return convention we concentrate on, the high cash
flow-price-ratio (CF/P) countries significantly outperform the low CF/P
markets. Luckily for international investors, the effect was—again—more
pronounced across the capitalization-weighted portfolios. Across both
gross and net return approaches, the value markets outperformed the
growth countries on average by 0.50 % monthly, even having adjusted for
the risk implied by the CAPM. Historically, CF/P seems a very powerful
predictor of future returns.
Finally, the last indicator: dividend yield also seems a reliable basis for
portfolio formation. In the equal–weighted approach (Table 9.1, Panel
A), the countries with high 12-month trailing dividend yields earned an
excess return of over 0.65 % monthly. The returns on the markets with
high dividend yields were visibly higher than in the countries with low
dividend yields—and all this with no higher risk. In the capitalization-
weighting approach, the country-selection strategy based on dividend
yield still delivers, the value markets outperform the growth markets,
and the mean returns on the zero-investment portfolios turn significantly
positive.
VALUE-ORIENTED COUNTRY SELECTION 149
Summing up, the three out of four value indicators we examined (E/P
ratio, CF/P ratio, dividend yield) proved to be useful predictors of future
returns over the past 20 years. Portfolios with value markets chosen based
on these ratios performed far superior to the growth markets. Surprisingly,
the Achilles heel of the value strategies turned out to be the most com-
mon metric: the book-to-market (B/M) ratio. The returns on high-B/M
countries and low-B/M countries remained similar. As a result, over the
last 20 years investors would have been better off focusing on earnings,
cash flows, and dividends, rather than the book value.
One of the weakest points of the cross-country value strategies is their
variability, as in practice their performance is far from stable. Figure 9.2
depicts the cumulative returns on the zero-investment equal-weighted
portfolios formed on various price multiples. Naturally, the performance
varies among different return calculation approaches and weighting
schemes, but the time-series pattern presented in Fig. 9.2 well conveys the
core of the problem.
250
Book-to-market ratio
100
50
0
1995 1996 1998 1999 2001 2002 2004 2005 2007 2008 2010 2011 2013 2014
-50
-100
All the value strategies displayed in Fig. 9.2 were performing well
until mid-2008; but subsequently lost rather than generated profits. In
the post-2007 period the returns on zero-portfolios from sorts on B/M,
CF/P, or earnings yield were negative. Within the period about half of the
entire profits earned in the previous decade was wiped out. The dividend
yield strategy performed slightly better, as it lost no money—but its per-
formance approximated zero.
It is not entirely clear why the performance of value-oriented country
selection strategies performed so disappointingly in recent years. Evidently
the underperformance coincided with the beginning of the market decline
bringing about the global financial crisis. However, the question whether
there is a clear causal link remains unanswered. There are a few possibili-
ties. Some structural changes, which took place in the post-crisis period,
as for example the ultra-loose global monetary policy, lead to the evapo-
ration of cross-country value profits. On the other hand, the last decade
epitomizes volatility of the returns to value strategies. Finally profitability
of value strategies may just have been a random price pattern that lasted
throughout the 1980s and 1990s and is not to be continued. The out-
performance could be linked, for example, with the rise of the emerging
markets.
In practice, regardless of the reason underlying the recent poor returns,
the message for investors is hardly optimistic. Cross-country value invest-
ing might be a very volatile experience: for many years it can consistently
beat the global market, only to subsequently underperform it for almost
a decade. Although this approach proves profitable over the long haul,
it demands a great deal of patience and self-confidence. Furthermore,
implementing it might pose a greater challenge for institutional investors
who need to exercise patience, not only for themselves but also to temper
the emotions of their clients. If clients remain dissatisfied for too long, the
investment management company may even be forced to liquidate
the fund—as John Maynard Keynes used to say: “markets can remain irra-
tional a lot longer than you and I can remain solvent”.4 There is, however,
a bright side to this predicament. If the variability of the value strategies
prevent some investors from exploiting them, perhaps it is one of the rea-
sons the value-based country selection strategies will remain profitable.
So far, we have discussed the performance of strategies based on the
equity multiples. However, as we recall from the earlier discussion, at the
stock level it was the EV multiples (particularly EV/EBITDA) that per-
formed particularly well (Gray and Vogel 2012). Let’s look at the efficiency
VALUE-ORIENTED COUNTRY SELECTION 151
Panel A Panel B
0.80 1.00
0.80
0.60
0.60
0.40 0.40
0.20 0.20
0.00 0.00
Growth Neutral Value Growth Neutral Value
Fig. 9.3 Mean returns on value and growth portfolios formed on enterprise
multiples. Panel A: Sales-to-EV ratio. Panel B: EBITDA-to-EV ratio
Note: The figure presents the mean monthly excess returns on the equal-weighted
tertile portfolios from sorts on two characteristics: sales-to-EV ratio and EBITDA-
to-EV ratio. “Growth”, “Neutral”, and “Value” are portfolios of markets with low,
medium, and high ratios, respectively. Values are expressed in percentage terms,
calculations based on the period I 1995–VI 2015, and the data sourced from
Bloomberg
Table 9.2 Performance of value and growth portfolios formed on enterprise multiples
152
Panel A
Sales-to-EV ratio
Mean return 0.29 0.69** 0.70* 0.37* 0.34 0.54 0.56 0.16
(0.90) (2.00) (1.92) (1.89) (0.99) (1.52) (1.56) (0.78)
Volatility 5.57 5.61 5.56 3.08 5.74 5.65 5.53 3.26
Sharpe ratio 0.18 0.43 0.44 0.41 0.20 0.33 0.35 0.17
Alpha −0.17 0.22 0.24 0.36* −0.05 0.23 0.23 0.22
(−0.77) (1.05) (1.19) (1.89) (−0.30) (0.52) (0.61) (1.12)
A. ZAREMBA AND J. SHEMER
EBITDA-to-EV ratio
Mean return 0.16 0.65* 0.91** 0.73*** −0.10 0.82** 0.79** 0.82***
(0.62) (1.93) (2.26) (3.46) (−0.11) (2.24) (2.01) (3.39)
Volatility 5.45 5.21 6.05 3.23 5.81 5.74 5.88 3.79
Sharpe ratio 0.10 0.43 0.52 0.79 −0.06 0.50 0.47 0.75
Alpha −0.30 0.21 0.42* 0.70*** −0.47* 0.44 0.47 0.87***
(−1.52) (1.11) (1.83) (3.34) (−1.77) (1.33) (1.26) (3.67)
Panel B
Sales-to-EV ratio
Mean return 0.10 0.66** 0.19 −0.07 −0.44 0.58 0.25 0.50*
(0.40) (2.16) (0.64) (−0.29) (−0.78) (1.59) (0.79) (1.67)
Volatility 6.38 5.07 5.22 4.31 6.85 5.67 5.37 4.51
Sharpe ratio 0.05 0.45 0.12 −0.05 −0.22 0.35 0.16 0.39
Alpha −0.41 0.21 −0.25 0.01 −0.74** 0.31 0.03 0.57*
(−1.61) (1.31) (−1.38) (0.05) (−2.41) (0.92) (−0.12) (1.87)
EBITDA-to-EV ratio
Mean return −0.35 0.44 0.85** 1.14*** −0.21 −0.09 0.70* 0.89***
(−0.76) (1.20) (2.32) (5.09) (−0.43) (−0.05) (1.69) (3.60)
Volatility 5.73 5.80 6.00 3.84 5.80 5.90 6.40 3.69
Sharpe ratio −0.21 0.26 0.49 1.03 −0.13 −0.05 0.38 0.83
Alpha −0.82*** 0.00 0.36 1.11*** −0.49** −0.32 0.44 0.89***
(−3.71) (−0.04) (1.48) (4.51) (−2.27) (−1.10) (1.08) (3.52)
Panel A: equal-weighted portfolios. Panel B: capitalization-weighted portfolios
Note: The table presents the mean monthly excess returns on the tertile portfolios from sorts on two characteristics: sales-to-EV ratio and EBITDA-to-EV
ratio. Panel A and B present performance of the equal-weighted and capitalization-weighted portfolios, respectively. “Growth”, “Neutral”, and “Value” are
portfolios of markets with low, medium, and high ratios, respectively. “Mean” is the mean monthly excess return; “Volatility” is the standard deviation of
monthly excess returns while “Alpha” is the Jensen’s alpha based on the CAPM. The Sharpe ratio is presented on an annualized basis. Mean returns, volatili-
ties, and alphas are expressed in percentage terms. Numbers in brackets are t-statistics. Asterisks *, ** and *** indicate values significantly different from zero
at the 10 %, 5 % and 1 % levels, respectively. Calculations are based on the period I 1995–VI 2015, and the data are sourced from Bloomberg
VALUE-ORIENTED COUNTRY SELECTION
153
154 A. ZAREMBA AND J. SHEMER
700
Sales-to-EV ratio
600
400
300
200
100
0
1995 1996 1998 1999 2001 2002 2004 2005 2007 2008 2010 2011 2013 2014
-100
Note: The table presents the mean monthly excess returns on the capitalization-weighted portfolios from
sorts on book-to-market ratio among the markets with below-median total capitalization. “Growth”,
“Neutral”, and “Value” are portfolios of markets with low, medium, and high ratios, respectively. “Mean”
is the mean monthly excess return; “Volatility” is the standard deviation of monthly excess returns while
“Alpha” is the Jensen’s alpha based on the CAPM. The Sharpe ratio is presented on an annualized basis.
Mean returns, volatilities, and alphas are expressed in percentage terms. Numbers in brackets are t-statis-
tics. Asterisks *, ** and *** indicate values significantly different from zero at the 10 %, 5 % and 1 % levels,
respectively. Calculations are based on the period I 1995–VI 2015, and the data are sourced from
Bloomberg
NOTES
1. For example Keppler (1990a, b), Macedo (1995a, c), Asness et al. (1997).
2. See, e.g., Desrosiers et al. (2004, 2007), Blitz and van Vliet (2008), Asness
et al. (2013), Angelidis and Tessaromatis (2014).
158 A. ZAREMBA AND J. SHEMER
3. For practitioners research on CAPE, see, e.g., Tower (2011), Butler et al.
(2012), Faber (2012), Keimling (2014), Golob (2014), and Klement
(2015).
4. As quoted in Lowenstein (2001, p. 123).
5. For momentum: Jegadeesh and Titman (1993), Hong et al. (2000), Zhang
(2006); for B/M ratio: Loughran (1997), Griffin and Lemmon (2002).
6. See, e.g., Zaremba and Konieczka (2015).
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CHAPTER 10
Fig. 10.1 Mean excess returns on basic momentum strategies. Panel A: Short-
term momentum. Panel B: Long-term momentum. Panel C: Intermediate
momentum
Note: The figure presents the mean monthly excess returns on the equal-weighted
tertile portfolios from sorts on cumulative past returns: months t−6 to t−1 (short-
term momentum), months t−12 to t−2 (long-term momentum), and months
t−12 to t−7 (intermediate momentum). “Low”, “Neutral”, and “High” are port-
folios of markets with low, medium, and high past returns, respectively. Values
expressed in percent. Calculations based on the I 1995–VI 2015 period; data
sourced from Bloomberg
Table 10.1 Performance of portfolios based on basic momentum strategies
Gross returns Net returns
Bottom Neutral Top T-B Bottom Neutral Top T-B
Panel A
Short-term momentum
Mean return 0.20 0.65* 0.74** 0.43* 0.10 0.59* 0.70** 0.48*
(0.62) (1.92) (2.08) (1.68) (0.35) (1.76) (1.98) (1.70)
Volatility 6.18 5.34 5.28 3.76 6.15 5.25 5.24 3.86
Sharpe ratio 0.11 0.42 0.49 0.39 0.06 0.39 0.46 0.43
Alpha −0.28 0.21 0.34 0.50** −0.23 0.31 0.42 0.53**
(−1.10) (1.11) (1.61) (2.22) (−0.79) (0.84) (1.36) (2.36)
Long-term momentum
Mean return 0.30 0.51 0.88** 0.48* 0.09 0.46 0.80** 0.59**
(0.87) (1.47) (2.34) (1.75) (0.36) (1.32) (2.24) (2.08)
Volatility 6.18 5.18 5.53 3.66 6.18 5.24 5.38 3.85
Sharpe ratio 0.17 0.34 0.55 0.46 0.05 0.31 0.52 0.53
Alpha −0.15 0.12 0.48** 0.53** −0.19 0.21 0.55* 0.63***
(−0.57) (0.62) (2.21) (2.32) (−0.67) (0.59) (1.66) (2.62)
Intermediate momentum
Mean 0.22 0.55 0.92** 0.63*** 0.13 0.49 0.80** 0.57**
(0.72) (1.58) (2.45) (3.03) (0.48) (1.37) (2.23) (2.35)
Volatility 5.93 5.38 5.45 3.25 5.98 5.46 5.32 3.58
Sharpe ratio 0.13 0.36 0.59 0.67 0.08 0.31 0.52 0.56
Alpha −0.22 0.15 0.53** 0.67*** −0.16 0.23 0.56* 0.61***
(−0.95) (0.78) (2.50) (3.22) (−0.60) (0.64) (1.77) (2.67)
(continued)
MOMENTUM EFFECT ACROSS COUNTRIES
163
Table 10.1 (continued)
164
Long-term momentum
Mean return 0.18 0.21 0.64* 0.22 0.34 0.22 0.28 −0.16
(0.51) (0.70) (1.69) (0.57) (0.93) (0.68) (0.64) (−0.60)
Volatility 7.02 5.49 5.80 5.68 6.24 5.26 6.48 4.54
Sharpe ratio 0.09 0.14 0.38 0.14 0.19 0.14 0.15 −0.12
Alpha −0.28 −0.18 0.21 0.27 0.14 0.04 0.07 −0.16
(−0.96) (−0.88) (0.94) (0.81) (0.68) (0.26) (0.37) (−0.46)
Intermediate momentum
Mean return 0.19 0.23 0.49 0.17 0.48 0.29 0.26 −0.30
(0.68) (0.67) (1.27) (0.46) (1.35) (0.80) (0.63) (−1.08)
Volatility 6.06 5.83 5.77 4.73 5.75 5.60 6.11 4.46
Sharpe ratio 0.11 0.14 0.30 0.12 0.29 0.18 0.15 −0.24
Alpha −0.22 −0.19 0.06 0.16 0.30 0.10 0.05 −0.32
(−0.89) (−0.85) (0.25) (0.56) (1.42) (0.82) (0.33) (−0.97)
Panel A: equal-weighted portfolios. Panel B: capitalization-weighted portfolios
Note: The table presents the performance of equal-weighted and capitalization-weighted tertile portfolios from sorts on cumulative past returns: months t−6 to t−1
(short-term momentum), months t−12 to t−2 (long-term momentum), and months t−12 to t−7 (intermediate momentum). “Low”, “Neutral”, and “High” are port-
folios of markets with low, medium, and high past returns, respectively. “Mean” is the mean monthly excess return; “Volatility” is the standard deviation of monthly excess
returns while “Alpha” is the Jensen’s alpha based on the CAPM. The Sharpe ratio is presented on an annualized basis. Mean returns, volatilities, and alphas are expressed
in percent. Numbers in brackets are t-statistics. Asterisks *, ** and *** indicate values significantly different from zero at the 10 %, 5 % and 1 % levels, respectively. The
calculations are based on the I 1995–VI 2015 period, and the data sourced from Bloomberg
MOMENTUM EFFECT ACROSS COUNTRIES 165
400
Short-term momentum
350
Long-term momentum
300
Intermediate-momentum
250
200
150
100
50
0
1996 1997 1998 2000 2001 2003 2004 2006 2007 2008 2010 2011 2013 2014
-50
past 20 years. In fact, we cannot even see any visible evidence of the severe
momentum crash of 2009, which in other asset classes wiped out the
momentum profits earned over many years.2 Summing up, the momen-
tum profits seem robust and survive the test of time, at least under the
equal-weighted approach.
volatility, markets with high book-to-market ratio, and the liquid markets,
with liquidity measured with turnover ratio. Interestingly, almost none of
the additional sorts seem to visibly improve the profitability of momentum
strategies. Perhaps the momentum effect is driven more by the cross-sec-
tional patterns across the groups rather than within them. The only appar-
ent exception is the size-enhanced momentum, particularly when the
countries are weighted for capitalization. Taking, for instance, the gross
returns on these portfolios, we see that the past winners delivered the
mean monthly excess return of 0.75 %, while the marauders lost on aver-
age 0.46 %. Furthermore, the top momentum portfolios were also safer.
The standard deviation of monthly excess returns of the market winners
amounted to 6.65 %, while the low-momentum portfolios showed the
standard deviation of 8.50 %. In consequence, the zero-investment port-
folios formed on past performance displayed both positive and significant
abnormal returns. The monthly alpha on the dollar-neutral momentum
portfolio reached 0.94 % and departed 2.12 standard deviations from 0
(Table 10.2).
Although the size enhanced momentum displayed sizable returns, its
sensitive spots are risk and instability. Even the safest portfolios from dou-
ble sorts on size and momentum proved riskier than others which did not
rely on the additional sort on size. This variability of returns stands out
clearly in Fig. 10.3, which depicts the cumulative excess returns on the five
zero-investment equal-weighted tertile portfolios derived from enhanced
momentum strategies. Even the performance of the best strategy, i.e. the
size-enhanced momentum, suffered severe losses in the 2009–2011 period.
The substantial drawdown erased then about half of the profits gained over
the previous decade. As a result, the performance of enhanced momentum
strategies hardly gives a promise of future returns. Additionally, it might
prove difficult to implement as small markets are usually illiquid and the
potential capital mobility barriers considerable.
(continued)
Table 10.2 (continued)
170
(−0.15) (−0.09)
Volatility 8.95 7.40 6.41 7.70 8.10 6.21 6.38 5.87
Sharpe ratio −0.09 0.25 0.28 0.13 0.13 0.27 0.33 0.00
Alpha −0.76* 0.04 0.07 0.36 0.08 0.30 0.40* 0.03
(−1.80) (0.04) (0.27) (0.79) (0.23) (1.30) (1.92) (0.15)
Turnover ratio-enhanced momentum
Mean return 0.36 0.24 0.21 −0.26 0.39 0.09 0.03 −0.47*
(1.06) (0.65) (0.56) (−1.24) (1.12) (0.31) (0.17) (−1.87)
Volatility 6.08 5.24 5.57 3.93 6.14 5.31 5.79 4.05
Sharpe ratio 0.21 0.16 0.13 −0.23 0.22 0.06 0.02 −0.40
Alpha 0.18 0.07 0.04 −0.24 0.30 0.01 −0.06 −0.46
(0.00) (0.96) (0.53) (0.28) (0.00) (1.56) (0.06) (−0.31)
Panel A: equal-weighted portfolios. Panel B: capitalization-weighted portfolios
Note: The table presents the performance of equal-weighted and capitalization-weighted tertile portfolios based on the enhanced momentum strategies. The portfolios
are formed from double sorts: first, on additional variables, and second, on the long-term momentum (the cumulative return in months t−12 to t−2). The additional
variables include: size (total stock market-capitalization at t−1), age (time since the first Bloomberg coverage), idiosyncratic volatility (derived from the CAPM, based on
24-month past returns), book-to-market ratio (at t−1), and turnover ratio (total dollar turnover to total stock market capitalization averaged over months t−12 to t−1).
“Low”, “Neutral”, and “High” are portfolios of markets with low, medium, and high past returns, respectively. “Mean” is the mean monthly excess return; “Volatility”
is the standard deviation of monthly excess returns, while “Alpha” is the Jensen’s alpha based on the CAPM. The Sharpe ratio is presented on an annualized basis. Mean
returns, volatilities, and alphas are expressed in percent. Numbers in brackets are t-statistics. Asterisks *, ** and *** indicate values significantly different from zero at the
10 %, 5 % and 1 % levels, respectively. The calculations are based on the I 1995–VI 2015 period, and the data sourced from Bloomberg
MOMENTUM EFFECT ACROSS COUNTRIES 171
250
Size
Age
200
Idiosyncrativ volatility
Book-to-market ratio
150
Turnover ratio
100
50
0
1999 2001 2002 2003 2004 2005 2006 2008 2009 2010 2011 2012 2013 2015
-50
20.0
15.0
%
10.0
12
5.0
dio
9
per
0.0 2
ng
1
rti
2 1
6
So
9
Holding period 12
and the 1-month holding period where the “winner” countries outper-
formed the “loser” countries on average by 17.4 % per year. In their study,
Georgopoulou and Wang (2015) examined the robustness of the time-
series strategy across countries over various periods and subsamples. They
have proved it to work in both developed and emerging markets with
undiminished profitability. Summing up, the time series momentum has
been proven to be a valid and simple strategy for country-asset allocation
which consistently delivered impressive returns.
To add recent evidence to the alternative trend following approaches,
we have tested the simple moving average strategy, which is closely related
to the concept of absolute momentum as it compares the current price to
its past readings. In our strategy, at the beginning of each month we calcu-
lated the ratio of the current price to its trailing moving average. We then
sorted the markets on this ratio. For robustness, we checked two popular
variants of moving averages, based on 10 and 12 months.3 Naturally, the
moving averages might also be utilized in other ways; for instance, by
examining whether the current prices are simply above or below the trail-
ing average, if they exceed some percentage bands or follow other similar
strategies, like the 52-week high strategy (George and Hwang 2004).
MOMENTUM EFFECT ACROSS COUNTRIES 173
The outcomes shown in Fig. 10.5 suggest that moving averages might
constitute a powerful predictor of future returns. The equal-weighted
tertile portfolios formed on the moving average strategies display a clear
cross-sectional pattern: the larger the distance to the moving average,
the better the expected returns. This phenomenon holds true for both
10-month and 12-month trailing average.
The more detailed data from Table 10.3 suggest that the trend fol-
lowing concept of using moving average works very well, but still almost
exclusively within the equal-weighting framework. In this portfolio
weighting scheme, regardless of the moving average we used (10-month
or 12-month) or the method we calculated returns (on the gross basis
or on the net basis), the high momentum portfolio always outperformed
the low momentum ones. Moreover, the past winners were usually also
slightly less risky: the monthly standard deviation was about 1 percentage
point lower. In each of the variants of the equal-weighed portfolios, the
zero-investment portfolios always delivered positive raw and risk-adjusted
returns which were significantly different from 0 and the outperformance
exceeded 0.50 % per month.
Yet again the Achilles’ heel of the trend following strategies seems to
be the alteration of the weighting scheme. When, during the forming of
portfolios, the country equity indices are capitalization weighted, the out-
Panel A Panel B
1.00 1.00
0.80 0.80
0.60 0.60
0.40 0.40
0.20 0.20
0.00 0.00
Low Neutral High Low Neutral High
Fig. 10.5 Mean excess returns on moving average strategies. Panel A: 10-month
moving average. Panel B: 12-month moving average
Note: The figure presents mean monthly excess returns on the equal-weighted
tertile portfolios from sorts on the ratio of current index value to its 10-month
(Panel A) and 12-month (Panel B) moving average. “Low”, “Neutral”, and
“High” are portfolios of markets with low, medium, and high past returns, respec-
tively. The values are expressed in percent, calculations based on the I 1995–VI
2015 period, and the data sourced from Bloomberg
174 A. ZAREMBA AND J. SHEMER
300
10-month moving average
250
12-month moving average
200
150
100
50
0
1995 1997 1998 2000 2001 2003 2004 2005 2007 2008 2010 2011 2012 2014
-50
(continued)
176 A. ZAREMBA AND J. SHEMER
Note: The table presents the mean returns on zero-investment, equal-weighted and capi-
talization-weighted tertile portfolios from sorts on past returns: 1-month return (month
t−1, short-term reversal) and 48-month lagged 12 months (months t−60 to t−13, long-
term reversal). The portfolios have long (short) position in markets with low (high) past
returns. The mean returns are expressed in percent. Numbers in brackets are t-statistics.
Asterisks *, ** and *** indicate values significantly different from zero at the 10 %, 5 %
and 1 % levels, respectively. The calculations are based on the listings of 78 countries
within the I 1995–VI 2015 period. Source: Table 1 in Zaremba (2015a)
178 A. ZAREMBA AND J. SHEMER
NOTES
1. Further evidence on momentum across country equity indices include
Asness et al. (1997), Chan et al. (2000), Vu (2012), Andreu et al. (2013),
Evans and Schmitz (2015), Grobys (2016), Zaremba (2015b), or Guilmin
(2015).
2. For further discussion on the momentum crashes see: Daniel and Moskowitz
(2013), Chabot et al. (2014), and Heidari (2015).
3. Specifically, we follow Jacobs (2015), who tests 200-day and 250-day mov-
ing averages.
4. For behavioral explanations: Shiller (1984), Black (1986), Stiglitz (1989),
Summers and Summers (1989), Subrahmanyam (2005), Da et al. (2014a);
for liquidity considerations and related models: Grossman and Miller
(1988), Campbell et al. (1993), Jegadeesh and Titman (1995a, b), Pastor
and Stambaugh (2003), Avramov et al. (2006); for microstructure issues:
Conrad et al. (1991), Jegadeesh and Titman (1995a, b), Kaniel et al. (2008).
5. For behavioral explanations: Barberis et al. (1998), Daniel et al. (1998),
Hong and Stein (1999), Jegadeesh and Titman (2001); for tax-related
issues: Klein (1999); for data snooping: Conrad et al. (2003); for other
rational explanations: Berk et al. (1999), Lewellen and Shanken (2002),
Brav and Heaton (2002).
6. See: Richards (1997), Balvers and Wu (2006), Malin and Bornholt (2013).
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MOMENTUM EFFECT ACROSS COUNTRIES 179
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CHAPTER 11
Small-Country Effect
Note: The table presents the performance of equal-weighted and capitalization-weighted tertile portfolios
from sorts on the total stock market capitalization. “Large”, “Medium”, and “Small” are portfolios of
markets with low, medium, and high total stock market capitalization, respectively. “S-L” is a zero-invest-
ment portfolio with long (short) position in small (large) markets. “Mean” is the mean monthly excess
return; “Volatility” is the standard deviation of monthly excess returns, while “Alpha” is the Jensen’s alpha
based on the CAPM. The Sharpe ratio is presented on an annualized basis. Mean returns, volatilities, and
alphas are expressed in percentage terms. Numbers in brackets are t-statistics. Asterisks *, ** and ***
indicate values significantly different from zero at the 10 %, 5 % and 1 % levels, respectively. Calculations
are based on the I 1995–VI 2015 period, and the data are sourced from Bloomberg
(1993) or Li and Pritamani (2015), could have been equally a result of the
so-called return on rebalancing (Willenbrock 2011) rather than a conse-
quence of the small country premium. Third, the earlier studies may have
included some computational inaccuracies which inflated the small-cap
premium. For example, a number of researches were based on arithmetic
returns instead of log-returns (or geometric returns), which could have
artificially inflated the returns on smaller markets tending to be more vola-
tile. Finally, the abnormal returns on the tiniest markets could also have
been simply sample- and time-specific.
The last point is well illustrated in Fig. 11.1. The small markets indeed
outperformed the large ones, but only to a specific point in time. The
peak of the cumulative abnormal returns on small markets coincided
186 A. ZAREMBA AND J. SHEMER
100
Equal-weighted portfolios
80
Capitalization-weighted portfolios
60
40
20
0
1995 1996 1998 1999 2001 2002 2004 2005 2007 2008 2010 2011 2013 2014
-20
-40
-60
-80
Fig. 11.1 Cumulative excess returns on strategies based on market size. Note:
The figure presents the cumulative excess return (expressed in percentage terms)
on the zero-investment equal-weighted and capitalization-weighted tertile portfo-
lios from sorts on the total stock market capitalization. The zero-investment port-
folio is long (short) the tertile of the small (large) markets. The calculations are
based on the I 1995–VI 2015 period, and the data sourced from Bloomberg
non-market risk. In other words, the small markets might really deliver
superior returns, but the reason is simple: they are just more risky.
300
250
Turnover Turnover ratio
200
150
100
50
0
1995 1996 1998 1999 2001 2002 2004 2005 2007 2008 2010 2011 2013 2014
-50
-100
NOTE
1. The seminal results of Keppler and Traub were later confirmed by other
authors, for example by Asness et al. (1997) and Angelidis and Tessaromatis
(2014).
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SMALL-COUNTRY EFFECT 191
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effects. Finance Research Letters, 18, 226–233.
CHAPTER 12
0.80
0.60 0.60
0.40 0.40
0.20 0.20
0.00 0.00
Low Medium High Low Medium High
A. ZAREMBA AND J. SHEMER
Panel C Panel D
0.80 0.80
0.60 0.60
0.40 0.40
0.20 0.20
0.00 0.00
Low Medium High Low Medium High
Fig. 12.1 Mean excess returns on portfolios from sorts on price risk. Panel A: Beta. Panel B: Standard deviation. Panel C:
Value at risk. Panel D: Idiosyncratic volatility
Note: The figure presents the mean monthly excess returns on equal-weighted tertile portfolios from sorts on four risk
measures: beta, standard deviation, value at risk, and idiosyncratic volatility. All of the measures are based on 24-month
trailing data as available (min. 12 months). The beta and idiosyncratic volatility is calculated relative to excess returns on the
market portfolio, i.e. the capitalization-weighted portfolio of all the markets in the sample. “Low”, “Medium”, and “High”
are portfolios of markets with low, medium, and high risk, respectively. The values are expressed in percentage terms; the
calculations based on the I 1995–VI 2015 period, and the data sourced from Bloomberg
Table 12.1 Performance of portfolios from sorts on price risk
Gross returns Net returns
Panel A
Beta
Mean return 0.49 0.37 0.33 −0.13 0.61* 0.41 0.43 −0.12
(1.54) (1.03) (0.79) (−0.16) (1.88) (1.11) (0.91) (−0.06)
Volatility 4.89 5.86 7.81 5.49 4.42 5.68 7.54 4.95
Sharpe ratio 0.35 0.22 0.15 −0.08 0.48 0.25 0.20 −0.08
Alpha 0.20 −0.06 −0.20 −0.36 0.48*** 0.21 0.18 −0.23
(0.86) (−0.28) (−0.74) (−1.26) (2.65) (1.57) (0.76) (−0.93)
Standard deviation
Mean return 0.44 0.54 0.68 0.31 0.41 0.54 0.71 0.36
(1.52) (1.47) (1.46) (1.27) (1.46) (1.51) (1.53) (1.41)
Volatility 4.46 5.54 7.05 3.88 4.42 5.49 6.74 3.64
Sharpe ratio 0.34 0.34 0.33 0.27 0.32 0.34 0.36 0.34
Alpha 0.12 0.15 0.19 0.15 0.22 0.30 0.44 0.28
(0.81) (0.71) (0.67) (0.69) (0.74) (0.85) (0.97) (1.16)
Value at risk
Mean return 0.60** 0.58* 0.64 0.11 0.61** 0.62* 0.59 0.04
(2.17) (1.74) (1.63) (0.70) (2.29) (1.88) (1.49) (0.31)
Volatility 4.32 5.28 6.62 3.48 4.26 5.37 6.37 3.39
Sharpe ratio 0.48 0.38 0.34 0.11 0.50 0.40 0.32 0.04
Alpha 0.20 0.09 0.05 −0.08 0.33 0.23 0.18 −0.09
(1.36) (0.45) (0.16) (−0.41) (1.24) (0.64) (0.35) (−0.52)
RISK-BASED COUNTRY ASSET ALLOCATION
(continued)
195
Table 12.1 (continued)
196
Idiosyncratic volatility
Mean return 0.44 0.53 0.68 0.31 0.41 0.53 0.71 0.36
(1.52) (1.46) (1.47) (1.28) (1.47) (1.48) (1.54) (1.41)
Volatility 4.46 5.55 7.05 3.88 4.42 5.49 6.75 3.65
Sharpe ratio 0.34 0.33 0.33 0.28 0.32 0.33 0.36 0.34
Alpha 0.12 0.14 0.20 0.15 0.23 0.28 0.44 0.27
(0.81) (0.68) (0.69) (0.71) (0.77) (0.81) (0.98) (1.15)
A. ZAREMBA AND J. SHEMER
Panel B
Beta
Mean return 0.45 0.36 0.57 0.16 0.21 0.17 0.52 0.37
(1.63) (1.03) (1.29) (0.57) (0.80) (0.51) (1.12) (1.30)
Volatility 4.49 5.50 7.18 4.92 4.33 5.65 7.13 4.56
Sharpe ratio 0.34 0.22 0.27 0.11 0.17 0.10 0.25 0.28
Alpha 0.13 −0.06 0.06 −0.03 0.07 −0.03 0.28 0.27
(0.75) (−0.42) (0.13) (−0.12) (0.54) (−0.22) (1.42) (1.03)
Standard deviation
Mean return 0.38 0.13 0.37 0.08 0.15 0.41 0.55 0.48*
(1.36) (0.40) (0.83) (0.34) (0.60) (0.97) (1.09) (1.75)
Volatility 4.48 6.33 7.99 5.18 4.45 6.37 7.47 4.33
Sharpe ratio 0.29 0.07 0.16 0.05 0.12 0.22 0.25 0.39
Alpha 0.03 −0.28 −0.17 −0.10 −0.01 0.19 0.30 0.40
(0.19) (−1.17) (−0.60) (−0.38) (−0.32) (1.26) (1.31) (1.47)
Value at risk
Mean return 0.51* 0.12 0.37 −0.08 0.19 0.24 0.43 0.32
(1.92) (0.40) (0.97) (−0.11) (0.68) (0.69) (0.93) (1.41)
Volatility 4.43 5.87 7.64 4.93 4.54 5.98 7.36 3.99
Sharpe ratio 0.40 0.07 0.17 −0.05 0.14 0.14 0.20 0.28
Alpha 0.07 −0.40** −0.32 −0.31 0.03 0.03 0.18 0.24
(0.59) (−2.00) (−1.19) (−1.17) (0.43) (0.16) (0.89) (1.03)
Idiosyncratic volatility
Mean return 0.38 0.13 0.36 0.07 0.15 0.40 0.54 0.47*
(1.36) (0.40) (0.82) (0.32) (0.60) (0.95) (1.08) (1.71)
Volatility 4.48 6.32 8.00 5.18 4.45 6.36 7.48 4.34
Sharpe ratio 0.29 0.07 0.16 0.05 0.12 0.22 0.25 0.38
Alpha 0.03 −0.28 −0.17 −0.11 −0.01 0.18 0.29 0.39
(0.21) (−1.18) (−0.62) (−0.41) (−0.26) (1.21) (1.28) (1.43)
Panel A: equal-weighted portfolios. Panel B: capitalization-weighted portfolios
Note: The table presents the performance of equal-weighted and capitalization-weighted tertile portfolios from sorts on four risk measures: beta, standard
deviation, value at risk, and idiosyncratic volatility. All of the measures are based on 24-month trailing data as available (min. 12 months). The beta and
idiosyncratic volatility is calculated relative to excess returns on the market portfolio, i.e. the capitalization-weighted portfolio of all the markets in the sample.
“Low”, “Medium”, and “High” are portfolios of markets with low, medium, and high risk, respectively. “H-L” is a zero-investment portfolio with long
(short) position in risky (safe) markets. “Mean” is the mean monthly excess return; “Volatility” is the standard deviation of monthly excess returns while
“Alpha” is the Jensen’s alpha based on the CAPM. The Sharpe ratio is presented on an annualized basis. Mean returns, volatilities, and alphas are expressed
in percentage terms. Numbers in brackets are t-statistics. Asterisks *, ** and *** indicate values significantly different from zero at the 10 %, 5 % and 1 %
levels, respectively. The calculations based on the I 1995–VI 2015 period, and the data are sourced from Bloomberg
RISK-BASED COUNTRY ASSET ALLOCATION
197
198 A. ZAREMBA AND J. SHEMER
percentage points over the safe markets. Nonetheless, this spread is too
narrow to be statistically different from 0. The outcomes for the idiosyn-
cratic volatility are very similar.
In both cases of capitalization and weighted portfolios, the return
spreads, for standard deviation and idiosyncratic volatility prove slightly
higher—especially for net returns—but the outperformance is still far from
satisfactory with the mean returns on the risky markets scoring almost 0.5
percentage points above the safe markets. Also, these portfolios are con-
siderably more volatile, and the risk-adjusted returns on the zero-invest-
ment portfolios seem no longer abnormal.
Summing up the data for the last 20 years, the risk-return relation-
ship at the country level seems rather vague as we find no relationship
between the systematic risk measured with beta and future returns. The
profitability seems similar across all the types of markets. As for the total
or idiosyncratic volatility, the relationship could be positive at best. We
observe no low-risk anomaly, and the returns in general seem to be slightly
higher for the risky portfolios. Nonetheless, the cross-sectional differences
are so small, that it makes it irrational to draw any statistical inference. In
essence, the price risk appears to be an unreliable discriminator for portfo-
lio formation and country level tactical asset allocation.
Equal-weighted portfolios
Mean 0.40 0.48 0.77* 0.36** 0.28 0.53 0.71* 0.41**
return
(1.20) (1.31) (1.91) (2.21) (0.85) (1.46) (1.78) (2.12)
Volatility 5.45 5.64 5.94 2.56 5.46 5.48 5.83 2.91
Sharpe 0.26 0.29 0.45 0.49 0.17 0.34 0.42 0.49
ratio
Alpha 0.02 0.07 0.34 0.32* 0.05 0.31 0.45 0.38**
(0.14) (0.35) (1.55) (1.86) (0.04) (0.78) (1.26) (1.97)
Capitalization-weighted portfolios
Mean 0.08 0.26 0.78** 0.61** 0.16 0.23 0.50 0.28
return
(0.32) (0.77) (2.27) (2.57) (0.49) (0.70) (1.38) (1.30)
Volatility 5.89 5.78 5.43 3.58 5.71 5.71 5.37 3.20
Sharpe 0.05 0.15 0.50 0.59 0.09 0.14 0.32 0.30
ratio
Alpha −0.33 −0.16 0.37** 0.60*** −0.03 0.04 0.31*** 0.27
(−1.43) (−0.79) (2.22) (2.65) (−0.16) (0.32) (2.77) (1.28)
Note: The table presents the performance of equal-weighted and capitalization-weighted tertile portfolios
from sorts on skewness of the return distribution based on 24-month trailing monthly returns as available
(min. 12 months). “Low”, “Medium”, and “High” are portfolios of markets with low, medium, and high
skewness, respectively. “L-H” is a zero-investment portfolio with long (short) position in the markets of
low (high) skewness. “Mean” is the mean monthly excess return; “Volatility” is the standard deviation of
monthly excess returns while “Alpha” is the Jensen’s alpha based on the CAPM. The Sharpe ratio is pre-
sented on annualized basis. Mean returns, volatilities, and alphas are expressed in percentage terms. The
numbers in brackets are t-statistics. Asterisks *, ** and *** indicate values significantly different from zero
at the 10 %, 5 % and 1 % levels, respectively. The calculations are based on the I 1995–VI 2015 period, and
the data sourced from Bloomberg
350
200
150
100
50
0
1997 1998 1999 2001 2002 2003 2005 2006 2007 2009 2010 2011 2013 2014
-50
NON-MARKET RISKS
So far, we have discussed the measures of risk and related concepts derived
from the price movements. However, as we have already noticed, inter-
national investors also face other types of fundamental risks arising from
for example expropriation, currency devaluation, coups, or regulatory
changes. If they are priced, we should examine how they affected the
expected returns in the recent years.
RISK-BASED COUNTRY ASSET ALLOCATION 201
Equal-weighted portfolios
Mean 0.39 0.75 0.89** 0.48** 0.34 0.68 0.88** 0.53**
(1.08) (1.62) (1.99) (2.1) (0.94) (1.5) (2.03) (2.28)
Volatility 5.39 6.02 6.05 3.2 5.47 5.86 5.98 3.16
SR 0.25 0.43 0.51 0.52 0.21 0.4 0.51 0.58
α 0.13 0.47** 0.63** 0.49** 0.15 0.48** 0.70*** 0.53**
(0.95) (2.36) (2.48) (2.17) (1.07) (2.55) (2.8) (2.42)
Capitalization-weighted portfolios
Mean 0.46 0.59 0.56 0.19 0.38 0.53 0.59 0.29
(1.31) (1.29) (1.04) (0.67) (1.09) (1.19) (1.1) (0.96)
Volatility 4.93 6.3 8.46 5.39 5 6.27 8.2 5.08
SR 0.32 0.32 0.23 0.12 0.26 0.29 0.25 0.2
α 0.22* 0.3 0.2 0.08 0.2 0.33 0.34 0.22
(1.71) (1.42) (0.56) (0.23) (1.59) (1.57) (1.01) (0.68)
Liquidity-weighted portfolios
Mean 0.4 0.54 0.74 0.44 0.33 0.48 0.72 0.49
(1.16) (1.21) (1.25) (1.25) (0.97) (1.08) (1.22) (1.39)
Volatility 5 6.73 8.71 5.46 5.07 6.72 8.75 5.48
SR 0.28 0.28 0.29 0.28 0.23 0.25 0.29 0.31
αCAPM 0.16 0.23 0.38 0.32 0.16 0.25 0.47 0.41
(1.2) (1.08) (0.92) (0.93) (1.16) (1.19) (1.14) (1.18)
Notes: The table presents the performance of equally-weighted, capitalization-weighted, and liquidity-
weighted (based on 12-month trailing turnover) tertile portfolios from sorts on composite country risk.
“Low”, “Medium”, and “High” are portfolios of markets with low, medium, and high country risk,
respectively. H-L is the zero-investment portfolio that includes a long position in the high-risk portfolio
and a short position in the low-risk portfolio. Mean is a mean monthly excess return; Volatility is a stan-
dard deviation of monthly returns; SR is an annualized Sharpe ratio, and α is an intercept from the
country-level CAPM. “Gross” and “net” approaches refer to the adjustment for taxes on dividends. The
means, volatilities, p-values, and intercepts are expressed in percentage terms. The numbers in brackets are
t-statistics based on bootstrap standard errors, and the significance at the 10 % level is given in bold type.
Asterisks (*, **, ***) indicate values significantly different from zero at the 10 %, 5 %, and 1 % levels,
respectively. The data in the table are sourced from Zaremba (2015): Tables 1 and 8
202 A. ZAREMBA AND J. SHEMER
lated by its Country Risk Service (EIU 2015a). The EIU indices continu-
ously monitor the situation in 128 emerging and developed countries and
belong to the most respected and commonly used risk metrics (Hoti and
McAleer 2002, 2005). The EIUs have been computed since 1997 and
are the only recognized risk indices freely available in Bloomberg. This
approach additionally aligns our research with both the perspective and
investment practice of the institutional investor. Based on over 60 various
qualitative and quantitative indicators, the Economist Intelligence Unit
provides a rating for each of the countries on a 100-point scale in 5 dis-
tinct areas (EIU 2015b).
– Sovereign risk measures the risk of a build-up in arrears of princi-
pal or interest on either foreign or local currency debt which is a
direct obligation or guarantee of the sovereign.
– Currency risk measures the risk of devaluation against the refer-
ence currency (usually the US dollar or euro) of 25 % or more in
nominal terms over the next 12-month period.
– Banking sector risk gauges the risk of a systemic crisis whereby
banks holding 10 % or more of total bank assets become insol-
vent and unable to discharge their obligations to depositors or
creditors.
– Political risk evaluates a range of political factors relating to politi-
cal stability and effectiveness that could affect a country’s ability
and commitment to service its debt obligations or cause turbu-
lence in the foreign-exchange market. This rating informs on the
first three.
– Economic structure risk is derived from a series of macroeconomic
variables of a structural (non-cyclical) nature. Consequently, the
rating for economic structure risk tends to be relatively stable,
evolving in line with the structural changes in the economy.
Finally, the Economist Intelligence Unit also calculates the overall
country risk measure, which is a simple score for the sovereign, currency,
and banking sector risk. Table 12.3 details the performance on this com-
posite risk measure, and later on we will also discuss the individual com-
ponent measures.
Let’s first look at the equal-weighted portfolios (the top panel of
Table 12.3). The market behavior in years 1998–2015 indeed suggests
the fundamental risk to be already priced in. The riskiest portfolios have
earned an average monthly excess return of nearly 0.90 % (in both gross
RISK-BASED COUNTRY ASSET ALLOCATION 203
and net approaches), while the safest markets delivered less than 0.40 %.
The return on the zero-investment portfolio amounted to about 0.50 %
monthly and it was significantly higher than 0. Even after adjustment for
the CAPM beta, the risky markets delivered a substantial alpha of approxi-
mately 0.50 %.
Sadly for investors, the abnormal performance has markedly dimin-
ished under the alternative weighting schemes. Taking, for example, the
gross returns once the returns are capitalization-weighted, we see the raw
returns on the dollar-neutral portfolios shrink to 0.19 %, and the CAPM
alpha merely at 0.08 %.
Table 12.3 in its last panel also presents the performance of liquidity-
weighted portfolios, i.e. the portfolios of the stock markets are weighted
according to their average dollar turnover within the trailing 12 months.
Under this approach, the cross-sectional pattern related to the country
risk seems slightly stronger. While the spread in performance between the
tertiles of risky and safe countries (measured with the return on the 0
portfolio) exceeds 0.40 %, the liquidity-weighted portfolios prove more
volatile than the equal-weighted. This is especially significant for the tertile
portfolios of the risky markets where the standard deviation of monthly
returns visibly exceeds 8 %. As a result, the risky–safe spread in profitability
for the liquidity-weighted portfolios is no longer significantly different
than 0.
The aggregate country risk measure is derived from many indicators
reflecting various dimensions of riskiness. Figure 12.3 splits the impact of
the composite risk into five basic risk areas computed by the EIU: sover-
eign risk, currency risk, banking sector risk, political risk, and economic
structure risk. The figure presents mean monthly returns on zero-invest-
ment equal-weighted portfolios formed from sorts on this individual risk
measures. The portfolios go long on the risky countries and short on the
safe ones.
The evidence singles out two types of risk as the best discriminators of
future returns: sovereign risk and banking sector risk. The differential port-
folios based solely on these metrics have returned approximately 0.50 %
per month. At the other end of the spectrum, the currency risk proved to
be the poorest indicator. As international investors seem to care much less
about the dangers of the currency devaluation, the mean monthly return
on the zero-investment portfolio has sunk below 0.30 % per month.
While the fundamental risk truly seems to be priced in the international
valuation, crafting simple portfolios and strategies aimed at capitalizing
204 A. ZAREMBA AND J. SHEMER
0.53 0.55
0.60
0.48 0.54
0.50 0.45
0.39
0.40 0.27 0.43
0.37
0.30 0.23
0.20
0.10
0.00
Net returns
Sovereign risk
Currency risk Gross returns
Banking sector risk Political risk
Economic structure risk
from fundamental risk could prove really cumbersome as the country risk
is strongly concentrated in the smallest markets.
Figure 12.4 shows the mean composite country risk indicators for small
and big markets, i.e. the markets with total capitalization either below or
above the median. The evidence suggests the small markets to be con-
sistently riskier than the large ones. Thus, forming a portfolio of risky
countries would translate into allocating in both small and illiquid markets
while constantly rebalancing, and portfolio reconstruction within these
segments may pose a significant problem and increase costs in illiquid mar-
kets with cross-country capital mobility constraints.
Interestingly, the country risk effects may generate the country-level
size effects which we have already discussed earlier. As the small markets
are inherently riskier, this additional dose of risk may explain the higher
returns in small markets. Furthermore, it would also clarify why the inter-
market size premium performed quite poorly within our sample. We have
shown (2015b) that returns delivered by the risk-based strategies mark-
edly decreased in the post-2007 period, so it could have also dragged
down the profitability of the size strategies.
RISK-BASED COUNTRY ASSET ALLOCATION 205
55
50
45
40
35
30
Small Big
25
20
1997 1998 2000 2001 2003 2004 2006 2008 2009 2011 2012 2014
NOTE
1. The evidence in this section is based on the study by Zaremba (2015) and
presents the strategies formed on 76 country equity markets within the
period 1998–2015.
REFERENCES
EIU. (2015a). Country risk model. The economist intelligence unit. Retrieved
November 20, 2015, from https://www.eiu.com/handlers/PublicDownload.
ashx?mode=m&fi =risk-section/country-risk-model.pdf
EIU. (2015b). Country risk service The economist intelligence unit. Retrieved
November 20, 2015, fromhttps://www.eiu.com/handlers/PublicDownload.
ashx?mode=m&fi =risk-section/country-risk-service.pdf
Hoti, S., & McAleer. (2002). Country risk ratings: An international comparison.
Working paper, Department of Economics University of Western Australia.
Retrieved November 20, 2015, from https://faculty.fuqua.duke.edu/
~charvey/Teaching/CDROM_BA456_2003/Country_risk_ratings.pdf
Hoti, S., & McAleer (2005). Modeling the riskiness in country risk ratings. Bingley:
Emerald Publishing Group.
Zaremba, A. (2015a). Country risk and asset allocation across global equity markets.
Unpublished working paper.
CHAPTER 13
EBITDA-to-debt ratio
Mean return 0.35 0.71** 0.74** 0.38** 0.20 0.57 0.65* 0.43**
(1.12) (1.98) (2.00) (1.99) (0.65) (1.40) (1.74) (2.34)
Volatility 5.36 5.42 5.82 3.10 5.37 6.50 5.77 3.09
Sharpe ratio 0.22 0.45 0.44 0.42 0.13 0.31 0.39 0.48
Alpha −0.10 0.26 0.27 0.35* −0.13 0.15 0.32 0.43**
(−0.51) (1.24) (1.19) (1.79) (−0.58) (0.41) (0.83) (2.19)
Panel B
Equity-to-debt ratio
Mean return 0.31 0.57* 0.29 0.03 −0.12 0.52 0.55 0.67***
(1.18) (1.80) (0.84) (0.30) (−0.21) (1.44) (1.42) (2.80)
Volatility 4.63 5.24 7.28 4.64 5.03 5.76 6.41 3.98
Sharpe ratio 0.23 0.38 0.14 0.03 −0.08 0.31 0.30 0.58
Alpha −0.12 0.18 −0.28 −0.10 −0.34 0.26 0.31 0.66**
(−1.18) (0.70) (−0.95) (−0.38) (−1.51) (0.68) (0.68) (2.52)
EBITDA-to-debt ratio
Mean return −0.07 0.52* 0.62* 0.67*** −0.04 0.29 0.48 0.51**
(−0.08) (1.84) (1.68) (2.87) (0.02) (0.78) (1.26) (2.12)
Volatility 5.40 4.44 6.53 4.12 5.47 5.99 6.66 4.07
Sharpe ratio −0.05 0.41 0.33 0.56 −0.03 0.17 0.25 0.43
Alpha −0.53*** 0.15 0.08 0.59** −0.28 0.00 0.20 0.47*
(−2.83) (0.83) (0.29) (2.30) (−1.12) (−0.09) (0.39) (1.74)
PROFITABILITY
The second type of quality variable we tested is profitability. We sorted
country equity markets by three popular measures: return on assets (i.e.
trailing 4-quarter net income divided by total balance sheet assets), return
on equity (i.e. trailing 4-quarter net income divided by common equity),
and gross margin (i.e. gross return divided by total sales). The perfor-
mance of the tertile portfolio formed on these characteristics is presented
in Table 13.2.
When the portfolios are equally weighted, the performance of the
profitability-based strategies is far from impressive. For the portfolios
COUNTRY SELECTION BASED ON QUALITY 211
200
Equity-to-debt ratio
150
EBITDA-to-debt ratio
100
50
0
1995 1996 1998 1999 2001 2002 2004 2005 2007 2008 2010 2011 2013 2014
-50
-100
formed on return on assets and return on equity, the most profitable mar-
kets only marginally outperformed the least profitable. The mean monthly
returns on the equal-weighted tertile zero-investment portfolios varied
from 0.05 % to 0.25 %, and none of these numbers significantly departed
from 0. Looking at gross returns on the ROA portfolios, the low-ROA
markets earned on average 0.47 % per month, while the high-ROA mar-
kets reached 0.65 % per month. The mean return on the zero-investment
portfolio recorded merely 0.15 % and insignificantly departed from 0.
After adjusting for the CAPM risk, the abnormal return dropped even
further to 0.14 % monthly.
Perhaps the only exception here is the equal-weighted strategy based
on gross margin. In the gross-return approach, the tertile of markets with
the highest gross margin yielded on average as much as 1.04 % per month.
In consequence, the mean monthly return on the zero-investment port-
folio equaled 0.54 % and it was significantly abnormal after adjusting for
the market risk according to the CAPM model. Yet, as soon as the returns
Table 13.2 Performance of portfolios from sorts on profitability
212
Return on equity
Mean return 0.45 0.57* 0.67* 0.15 0.46 0.13 0.59 0.05
(1.32) (1.73) (1.85) (0.51) (1.26) (0.44) (1.64) (0.15)
Volatility 5.67 5.43 5.45 3.34 5.82 6.37 5.57 3.78
Sharpe ratio 0.27 0.36 0.42 0.16 0.27 0.07 0.37 0.04
Alpha −0.01 0.11 0.23 0.18 0.10 −0.25 0.26 0.08
(−0.08) (0.55) (1.05) (0.85) (0.17) (−0.86) (0.69) (0.38)
Gross margin
Mean return 0.44 0.64* 1.04*** 0.54*** 0.51 0.40 0.79* 0.21
(1.29) (1.81) (2.79) (3.28) (1.28) (1.00) (1.89) (0.94)
Volatility 5.87 5.65 5.68 3.11 6.07 5.79 5.74 3.17
Sharpe ratio 0.26 0.39 0.63 0.60 0.29 0.24 0.48 0.23
Alpha −0.03 0.16 0.57*** 0.55*** 0.31* 0.20 0.60*** 0.22
(−0.17) (0.77) (2.79) (2.78) (1.72) (1.44) (3.20) (0.97)
Panel B
Return on assets
Mean return −0.01 0.49* 0.28 0.28 −0.06 0.34 0.64 0.68***
(0.09) (1.65) (0.89) (1.18) (−0.04) (1.17) (1.63) (2.60)
Volatility 5.20 4.88 6.86 4.71 5.40 4.81 6.46 4.00
Sharpe ratio −0.01 0.35 0.14 0.21 −0.04 0.24 0.34 0.59
Alpha −0.44** 0.06 −0.24 0.20 −0.29 0.14 0.36 0.63**
(−2.40) (0.39) (−0.86) (0.71) (−1.18) (0.37) (0.87) (2.47)
Return on equity
Mean return −0.03 0.12 0.65* 0.64*** −0.08 0.11 0.54 0.59**
(−0.01) (0.54) (1.82) (2.65) (−0.11) (0.37) (1.48) (2.39)
Volatility 5.26 6.03 5.80 3.76 5.34 7.00 5.90 3.68
Sharpe ratio −0.02 0.07 0.39 0.59 −0.05 0.06 0.32 0.55
Alpha −0.47** −0.36 0.15 0.58** −0.31 −0.20 0.28 0.56**
(−2.55) (−1.54) (0.67) (2.46) (−1.25) (−0.68) (0.71) (2.31)
Gross margin
Mean return 0.30 0.24 0.46 0.12 0.25 0.42 0.38 0.09
(0.85) (0.66) (1.32) (0.73) (0.73) (1.19) (1.14) (0.60)
Volatility 5.63 6.58 5.77 3.16 5.51 5.13 5.68 3.14
Sharpe ratio 0.19 0.12 0.28 0.13 0.16 0.28 0.23 0.10
Alpha 0.03 −0.05 0.17 0.10 0.06 0.25 0.18 0.08
(0.08) (−0.17) (0.92) (0.44) (0.38) (1.60) (1.36) (0.32)
from zero at 10 %, 5 % and 1 %, respectively. The calculations are based on the I 1995–VI 2015 period, with the data sourced from Bloomberg
213
214 A. ZAREMBA AND J. SHEMER
STOCK ISSUANCE
The last type of quality characteristic we examine is associated with stock
issuance. We aggregated the total value of all initial and secondary public
offerings, for each month calculating the average ratio of share issuance to
the total stock market capitalization. Subsequently, we averaged this ratio
over six months preceding the portfolio formation and used this metric as
the basis for portfolio formation.
COUNTRY SELECTION BASED ON QUALITY 215
300
Return on assets
250 Return on equity
Gross margin
200
150
100
50
0
1995 1996 1998 1999 2001 2002 2004 2005 2007 2008 2010 2011 2013 2014
-50
-100
Equal-weighted portfolios
Mean return 0.32 0.48 0.65 0.27 0.33 0.70* 0.45 0.07
(0.95) (1.40) (1.63) (1.11) (1.01) (1.90) (1.09) (0.22)
Volatility 5.98 5.59 6.17 3.83 5.71 5.56 6.44 4.36
Sharpe ratio 0.19 0.30 0.36 0.25 0.20 0.43 0.24 0.06
Alpha −0.16 0.03 0.21 0.30 0.02 0.38 0.10 0.03
(−0.75) (0.11) (0.72) (1.09) (−0.05) (1.11) (0.21) (0.17)
Capitalization-weighted portfolios
Mean return 0.53* 0.46 0.17 −0.40 0.42 0.35 0.16 −0.30
(1.75) (1.47) (0.55) (−1.50) (1.31) (1.17) (0.52) (−1.11)
Volatility 4.77 5.53 5.80 4.22 4.93 5.39 5.90 4.35
Sharpe ratio 0.39 0.29 0.10 −0.33 0.29 0.23 0.09 −0.24
Alpha 0.15 −0.02 −0.25 −0.43 0.19 0.06 −0.10 −0.33
(0.81) (−0.15) (−1.06) (−1.55) (0.48) (0.06) (−0.47) (−1.13)
Note: The table presents the performance of equal-weighted and capitalization-weighted tertile portfolios from sorts on issuance, i.e. the average relation of
total value of IPOs and SPOs in the market to the total stock market capitalization over trailing 6 months. “Low”, “Medium”, and “High” are portfolios of
markets with low, medium, and high leverage. “H-L” is a zero-investment portfolio with long (short) position in the markets of high (low) profitability.
“Mean” is the mean monthly excess return; “Volatility” is the standard deviation of monthly excess returns, while “Alpha” is the Jensen’s alpha based on the
CAPM. The Sharpe ratio is presented on an annualized basis. Mean returns, volatilities, and alphas are expressed in percentage terms. The numbers in brackets
COUNTRY SELECTION BASED ON QUALITY
are t-statistics. *Asterisks, ** and *** indicate values significantly different from zero at the 10 %, 5 % and 1 %, respectively. The calculations are based on the
I 1995–VI 2015 period, with the data sourced from Bloomberg
217
218 A. ZAREMBA AND J. SHEMER
120
Equal-weighted portfolios
100
80 Capitalization-weighted portfolios
60
40
20
0
1995 1997 1998 2000 2001 2003 2004 2006 2007 2009 2010 2012 2013 2015
-20
-40
-60
-80
Equal-weighted portfolios
Mean return 0.25 0.59 0.76** 0.46** −0.17 0.61 0.58 0.49
(0.85) (1.58) (2.18) (2.27) (−0.24) (1.54) (1.61) (1.37)
Volatility 5.43 6.00 5.34 3.19 7.34 6.07 5.48 5.57
Sharpe ratio 0.16 0.34 0.49 0.49 −0.08 0.35 0.37 0.31
Alpha −0.20 0.07 0.25 0.39* −0.48 0.38 0.34 0.56
(−0.76) (0.19) (1.38) (1.92) (−1.35) (0.91) (1.01) (1.61)
Capitalization-weighted portfolios
Mean return −0.07 0.36 0.44* 0.32 −0.43 0.54 0.30 0.37
(−0.05) (0.90) (1.68) (1.32) (−0.67) (1.22) (1.09) (0.97)
Volatility 6.36 7.54 4.41 4.44 7.80 6.86 4.63 5.74
Sharpe ratio −0.04 0.16 0.35 0.25 −0.19 0.27 0.22 0.22
Alpha −0.53* −0.29 −0.01 0.32 −0.75** 0.28 0.07 0.47
(−1.70) (−0.99) (−0.19) (1.10) (−2.05) (0.56) (0.12) (1.36)
Note: The table presents the performance of equal-weighted and capitalization-weighted tertile portfolios
from sorts on age, i.e. the time since the first coverage in Bloomberg. “Young”, “Medium”, and “Old”
are portfolios of markets with low, medium, and high time since the first coverage, respectively. “O-Y” is
a zero-investment portfolio with long (short) position in the markets of high (low) profitability. “Mean”
is the mean monthly excess return; “Volatility” is the standard deviation of monthly excess returns, while
“Alpha” is the Jensen’s alpha based on the CAPM. The Sharpe ratio is presented on an annualized basis.
Mean returns, volatilities, and alphas are expressed in percentage terms. The numbers in brackets are
t-statistics. Asterisks *, ** and *** indicate values significantly different from zero at 10 %, 5 % and 1 %,
respectively. The calculations are based on the I 1995–VI 2015 period, with the data sourced from
Bloomberg
220 A. ZAREMBA AND J. SHEMER
250
Equal-weighted portfolios
150
100
50
0
1995 1996 1998 1999 2001 2002 2004 2005 2007 2008 2010 2011 2013 2014
Fig. 13.4 Cumulative excess returns on strategies based on ageNote: The figure
presents a cumulative excess return (expressed in percentage terms) on the zero-
investment of equal-weighted and capitalization-weighted tertile portfolios from
sorts on age, i.e. the time since the first coverage in Bloomberg. “Young”,
“Medium”, and “Old” are portfolios of markets with low, medium, and high time
since the first coverage, respectively. “O-Y” is a zero-investment portfolio with
long (short) position in the markets of high (low) profitability. The calculations are
based on the I 1995–VI 2015 period, with the data sourced from Bloomberg
COUNTRY SELECTION BASED ON QUALITY 221
Good luck returned to the mature markets in 2008 and continued till
2015. Summing up, although an investor with a portfolio concentrated
in the old markets would be a winner in the long term, he would have to
have been ready to weather through an entire decade of poor performance
first, which might prove too difficult even for the most patient of stock
market investors.
At our disposal we have a broad range of various quality-based strat-
egies. Although they relate to numerous aspects of a singular business:
payout, profitability, or indebtedness, particular strategies may also prove
useful at the country level. It is worth bearing in mind that low levels of
debt or high profitability may favor good performance in the cross-section
of country returns, and that old markets have historically outperformed
the young markets. These strategies should, nonetheless, be approached
with caution, as the empirical evidence behind them is weaker than for
the cross-country value strategies, and the theoretical motivation appears
more modest than for other strategies.
Despite their weakness, the quality strategies may still prove useful for
international investors. First, they might enhance the standard value strat-
egies, for instance by additional sorting, and perhaps, analogously as at
the stock level, both value and quality can form an effective marriage.2
Individual investors may scour the market for segments where the quality-
based strategies perform better. In fact, if this phenomenon is a behavioral
anomaly, its implementation in less efficient markets might make perfect
sense. In general, quality investing is a broad category offering a range of
interesting strategies that should not be overlooked.
NOTES
1. Zaremba (2015a) provides evidence of outperformance of markets popu-
lated with companies rich in cash and not highly leveraged, the effect mostly
driven by small stocks.
2. Some evidence on the country-level double sorts with the use quality invest-
ing has been provided in Zaremba (2015b).
REFERENCES
Campbell, J. Y., Hilscher, J., & Szilagyi, J. (2008b). In search of distress risk.
Journal of Finance, 63, 2899–2939.
Dorn, D. (2009). Does sentiment drive the retail demand for IPOs? Journal of
Financial and Quantitative Analysis, 44, 85–108.
222 A. ZAREMBA AND J. SHEMER
Jiang, G., Lee, C. M., & Zhang, Y. (2005). Information uncertainty and expected
returns. Review of Accounting Studies, 10, 185–221.
Keppler, M., & Traub, H. D. (1993). The small-country effect: Small markets beat
large markets. Journal of Investing, 2(3), 17–24.
Lee, C. M. C., Shleifer, A., & Thaler, R. H. (1991). Investor sentiment and the
closed-end fund puzzle. Journal of Finance, 46, 75–109.
Lowry, M. (2003). Why does IPO volume fluctuate so much? Journal of Financial
Economics, 67, 3–40.
Zaremba, A. (2015a). The financialization of commodity markets: Investing during
times of transition . New York: Palgrave Macmillan.
Zaremba, A. (2015b). Country selection strategies based on value, size and
momentum. Investment Analyst Journal, 44(3), 171–198.
Zaremba, A., & Okoń, S. (2015). Share issuance and expected returns around the
world. Journal of Investing, forthcoming. Working paper. Retrieved November
22, 2015, from SSRN http://ssrn.com/abstract=2619415 or http://dx.doi.
org/10.2139/ssrn.2619415
CHAPTER 14
Value 0.12
Momentum −0.19 −0.11
Risk −0.09 0.19 −0.02
Note: The table presents correlation coefficients between returns among four fac-
tor portfolios related to cross-country value, momentum, and risk factors, as well
as the market portfolio. The value, momentum, and risk factors are zero-investment
tertile equal-weighted portfolios formed on EBITDA-to-EV ratio, with total
return in months t−12 to t−2, and EIU country risk measure, respectively. The
market portfolio is the excess return on the capitalization-weighted portfolio of all
the markets within the sample. The calculations are based on monthly gross returns
denominated in US dollars in the period from January 1999 to June 2015. The
underlying data are sourced from Bloomberg
PANEL A
300
Market
250 Value
200 Momentum
Risk
150
100
50
0
1998 2000 2001 2003 2004 2006 2007 2008 2010 2011 2013 2014
-50
-100
PANEL B
300
Market
250 Value + momentum
200 Value + risk
Mometum + risk
150
100
50
0
1998 2000 2001 2003 2004 2006 2007 2008 2010 2011 2013 2014
-50
-100
PANEL C
200
Market
100
50
0
1998 2000 2001 2003 2004 2006 2007 2008 2010 2011 2013 2014
-50
-100
Single-strategy portfolios
Market 2.93 15.83 0.18 −54.58 1.00
Value 6.37 9.99 0.64 −23.00 0.07
Momentum 3.29 12.04 0.27 −22.59 −0.14
Risk 6.46 10.71 0.60 −26.58 −0.06
Double-strategy portfolios
Value + 5.17 7.34 0.70 −13.69 −0.03
momentum
Value + risk 6.63 7.96 0.83 −20.56 0.01
Momentum + risk 5.21 7.94 0.66 −14.07 −0.10
Triple-strategy portfolios
Value + 5.77 6.36 0.91 −9.10 −0.04
momentum + risk
Fig. 14.1 (continued) Note: The figure presents cumulative excess returns on
portfolios based on cross-country value, momentum, and risk factors, set against
the market portfolio. Also, the figure shows equal-weighted monthly-rebalance
combinations of these strategies. The value, momentum, and risk factors are zero-
investment tertile equal-weighted portfolios formed on the EBITDA-to-EV ratio,
total return in months t−12 to t−2, and EIU country risk measure, respectively.
The market portfolio is the excess return on the capitalization-weighted portfolio
of all the markets within the sample. The calculations are based on monthly gross
returns denominated in USD with the period from January 1999 to June 2015.
The underlying data are sourced from Bloomberg
228 A. ZAREMBA AND J. SHEMER
7.0
6.0 Risk
Value
Excess return [% ]
5.0
4.0
3.0
Momentum
Market
2.0
4.0 6.0 8.0 10.0 12.0 14.0 16.0 18.0
Volatility [% ]
SEASONAL EFFECTS
The turn-of-the-year effect, or in other words the January effect, is a ten-
dency of stocks to perform particularly well in January. Since its discovery
almost 40 years ago (Rozeff and Kinney 1976), it has been documented
in many international markets.6
WHAT NEXT? COMBINING AND IMPROVING COUNTRY SELECTION STRATEGIES 231
1.5 1.34
0.93
1.0
0.61 0.55
0.5
0.0
Momentum Quality Skewness Value
-0.5 -0.39
-1.0 -0.75
-0.86
High limits to arbitrage
-1.5 -1.37
High sentiment
-2.0
Fig. 14.3 The impact of limits on arbitrage and investor sentiment on the per-
formance of country-level stock-market strategies
Note: The figure presents coefficients from single regressions of composite anom-
aly benchmark-adjusted returns, orthogonalized with respect to global CAPM, in
month t on a dummy variable representing aggregate metrics of limits on arbitrage
and market at the end of month t−1. Net returns on capitalization-weighted port-
folios are used and the precise methodology is described in Zaremba (2015a). The
data are sourced from Zaremba (2015b), Table 6; the sample period is 1995–2015,
and the underlying data come from Bloomberg
The January effect has been explained in many ways, but it appears
that only two hypotheses hold up to serious scrutiny. First, the tax-loss
selling story assumes that at the end of the year investors sell stocks that
have “lost money” to capture the capital loss, resulting in the low or nega-
tive returns, and then buy them back in January, driving the prices up
(Chen and Singal 2004). The second rationale—the window-dressing
hypothesis—links the turn-of-the-year phenomenon to the behavior of
institutional investors, who “clear” their balance sheet before the end of
December when the detailed portfolio composition is reported to inves-
tors (Haugen and Lakonishok 1988; Lakonishok et al. 1991). Thus, they
sell the risky and neglected stocks in December and buy them back at the
beginning of the year.
232 A. ZAREMBA AND J. SHEMER
Both hypotheses have clear implications for some of the most popu-
lar and best documented cross-sectional investment strategies, particu-
larly for value investing. Both explanations based on either tax-loss selling
and window-dressing hypotheses recommend selling risky and neglected
stocks, in effect all value stocks, in December, and subsequently buy
them back in January. Thus, the value strategies should underperform in
December and perform particularly well in the beginning of the year. The
empirical evidence seems to be generally consistent with these hypotheses.
Davis (1994) and Loughran (1997) have found that the stock-level value
premium is particularly high in January.7
In other words, at the stock level, it appears that some seasonal anoma-
lies might potentially help investors to pick the right strategies and suc-
cessfully allocate money across them. Could these time-series patterns be
also used for the country-level strategies?
Presumably, the same arguments stemming from the tax selling and
window dressing explanations could also be applied for the country-level
effects. On the one hand, investment managers might reduce the exposure
to risky countries that would not be well perceived by investors reviewing
the funds’ financial statements. On the other hand, the individual inves-
tors could sell the funds exposed to the “loser countries” to capture the
capital loss. The impact of both effects would be potentially unwound in
January. Summing up, the monthly seasonalities might also be applied to
predict the performance of cross-country value effects.
Figure 14.4 shows the mean returns under various value strategies from
sorts on four different ratios: earnings-to-price ratio, EBITDA-to-EV
ratio, EBITDA-to-price ratio, and sales-to-EV, in various months. The
figure also presents the performance of aggregate value strategy, which is
an equal-weighted monthly-rebalanced portfolio of all of the four strate-
gies. Each strategy is depicted with the gross returns on zero-investment
equal-weighted tertile portfolios.
The time-series patterns in Fig. 14.4 seem to be in line with the hypoth-
esis that the turn-of-the-year effect indeed influences the performance of
value strategies. The mean monthly returns in January were historically
much higher in January than in other months, and particularly low in
December. The mean return on the composite value strategy amounted
to 1.5 % in January, scoring only 0.3 % in December. In the remaining
months, from February to November, the performance stuck somewhere
in the middle and reached 0.7 % on average.
WHAT NEXT? COMBINING AND IMPROVING COUNTRY SELECTION STRATEGIES 233
2.50
2.00
Mean return [%]
1.50
1.00
0.50
January
0.00
Other
December
0.80
Future return [%]
0.60
0.40
0.20
High
Past return
0.00 Medium
3-months Low
6-months
9-months
Sorting period 12-months
gest that selecting strategies with the best performance over the past 6–12
months may improve the performance of a multi-strategy portfolio.
In summary, let us reiterate the key points in this chapter. First and fore-
most, the correlation between country-level strategies derived from dif-
ferent economic mechanisms is usually low. In consequence, combining a
few strategies within a single portfolio leads to a substantial risk reduction.
Second, a few tools appear to be potentially useful to time the cross-country
strategies. On the other hand, the anomalies tend to display higher returns
in periods of good sentiment and low limits on arbitrage. In addition, the
factor strategies display momentum behavior, so the best performing strat-
egies over the recent months tend to continue to beat the market. Finally,
some strategies might also be influenced by some seasonal patterns, for
instance the outperformance of value over growth tend to be particularly
pronounced in January. Using all these concepts and ideas in an interna-
tional portfolio construction could benefit the international investor.
236 A. ZAREMBA AND J. SHEMER
NOTES
1. The issue below is also discussed in Zaremba (2015a).
2. For discussion see Barberis and Thaler (2003), Brav et al. (2010), Szyszka
(2013), Hanson and Sunderan (2014), or Jacobs (2015).
3. (1) The Baker and Wurgler (2006) market-level investor sentiment index is
a monthly index composed of various components reflecting issues such as
IPO volume and discounts, closed-end fund discounts and NYSE turnover.
(2) The State Street Investor Confidence Index measures investor confi-
dence quantitatively by analyzing the actual buying and selling patterns of
institutional investors. The index assigns a meaning to changes in investor
asset allocation; a greater percentage allocation to equities indicates a higher
risk appetite or confidence. SSIC reflects the investor sentiment in North
America, Europe and the Asia-Pacific region. (3) The Sentix Economic
Indices Global Aggregate Overall Index is a survey-based index calculated
based on a market assessment of 5000 registered investors from Europe, the
USA and Japan. (4) The GDP Weighted Manufacturing & Non-
Manufacturing Composite Purchasing Managers’ Index, calculated by
Markit Group, is a real economy-oriented indicator as it is derived from
monthly surveys of private-sector companies. The PMIs are conducted in
over 30 countries worldwide; thus, they mirror global economy-wide confi-
dence well.
4. (1) The Ted spread is calculated as the difference between 3-month US$
Libor and the 3-month US benchmark T-bill rate. The spread usually wid-
ens in times of liquidity problems, mirroring the “flight to liquidity”
(Brunnermeier et al., 2008), and it is a frequently utilized representation of
funding liquidity, e.g. by Moskowitz et al. (2012) and Asness et al. (2013).
(2) The Baa spread (Credit), i.e. the difference between the yield on US
corporate bonds with Baa ratings and the 10-year maturing US Treasury
bond, and (3) the term spread, i.e. the difference between the yields on the
US 10-year and 2-year benchmark Treasury bonds (Engelberg et al. 2008;
Akbas et al. 2014). Both metrics tend to be additional proxies for deteriora-
tion of economic conditions (Estrella and Mishkin 1998). (4) The Chicago
Board Options Exchange Market Volatility Index (VIX) expresses the
implied volatility of short-term index options on the S&P 500 index. As
indicated by Jacobs (2015), increased limits on arbitrage faced by investors
in times of high VIX values may stem from a few dimensions. First, Vayanos
(2004) provides evidence of higher risk aversion and “flight-to-quality”
effects when the VIX is high. Second, several studies demonstrate that that
periods of levered expected volatility lead to tighter funding constraints for
investors, difficulties in raising or borrowing money, or even money with-
drawal by investors leading to forced position unwinding or even a “fire
WHAT NEXT? COMBINING AND IMPROVING COUNTRY SELECTION STRATEGIES 237
sale” (Shleifer and Vishny 1997; Brunnermeier and Pedersen 2009; Gromb
and Vayanos 2010). Finally, Ang et al. (2011) and Ben-David et al. (2012)
indicate that hedge funds may face the necessity to reduce leverage and
manage cash out-flows during high-Vix periods.
5. In order to test the robustness, the study examined the impact of sentiment
and limits on arbitrage in many ways. The outcomes were not qualitatively
different, so as an example we present results of a simple regression with the
use of dummy variables based on net returns on portfolios of capitalization-
weighted country-level strategies.
6. See: Ho (1990), Haugen and Jorion (1996), Tonchev and Kim (2004),
Rosenberg (2004), Haug and Hirschey (2006), Zhang and Jacobsen
(2012).
7. The January effect might also have implication for other strategies. For
example, Yao (2012) and Novy-Marx (2012b) indicate, that momentum
returns are highest in December and lowest in January.
8. For detailed discussion and evidence, see the chapter on momentum.
9. Furthermore, Chan and Docherty (2015) use the Jegadeesh and Titman
(1995a, b) decomposition to show that the factor momentum is predomi-
nantly explained by positive autocorrelation.
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market efficiency and arbitrage efficacy. AFA 2013 San Diego Meetings Paper.
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of Financial Economics, 102, 102–126. Retrieved November 27, 2015
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everywhere. Journal of Finance, 68(3), 929–985.
Baker, M., & Wurgler, J. (2006). Investor sentiment and the cross-section of stock
returns. Journal of Finance, 61(4), 1645–1680.
Barberis, N., & Thaler, R. H. (2003). A survey of behavioral finance. In G. M.
Constantinides, M. Harris, & R. Stulz (eds.), Handbook of the economics of
finance (1 ed., Vol. 1, Chap. 18), 1053–1128. Elsevier.
Ben-David, I., Franzoni, F., & Moussawi, R. (2012). Hedge fund stock trading in
the financial crisis of 2007–2009. Review of Financial Studies, 25, 1–54.
Brav, A., Heton, J., & Li, S. (2010). The limits of the limits of arbitrage. Review
of Finance, 14, 157–187.
Brunnermeier, M. K., Nagel, S., & Pedersen, L. H. (2008). Carry trades and cur-
rency crashes. NBER Macroeconomics Annual, 23, 313–347.
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Brunnermeier, M. K., & Pedersen, L. H. (2009). Market liquidity and funding
liquidity. Review of Financial Studies, 22, 2201–2238.
Chan, H., & Docherty, P. (2015). Momentum in Australian style portfolios: risk or
inefficiency? Accounting & Finance, 56(2), 333–361.
Chen, H. S., & De Bondt, W. (2004). Style momentum within the S&P-500
index. Journal of Empirical Finance, 11, 483–507.
Chen, H., & Singal, V. (2004). All things considered, taxes drive the January
effect. Journal of Financial Research, 27(3), 351–372.
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Davis, J. (1994). The cross-section of realized stock returns: The pre-COMPUSTAT
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Hanson, S. G., & Sunderan, A. (2014). The growth and limits of arbitrage:
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Haug, M., & Hirschey, M. (2006). The January effect. Financial Analyst Journal,
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Haugen, R., & Jorion, P. (1996). The January effect: Still there after all these
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WHAT NEXT? COMBINING AND IMPROVING COUNTRY SELECTION STRATEGIES 239
Conclusions
The recent rapid development of Exchange Traded Funds and similar pas-
sive investment products has offered investors unprecedented access to
international equity markets. Yet so far the number of quantitative tools
helping investors analyze and select particular country markets has been
fairly limited. In this book we have reviewed and tested a series of strate-
gies that could be employed for global equity markets.
The first category—the value-based strategies—rely on buying in
markets with low valuation ratios and shorting those with high valua-
tion ratios. While this strategy performed well and provided reasonable
returns over the past two decades, in recent years its profitability has vis-
ibly declined. Among all the valuation ratios we have tested, sorting the
markets on EBITDA-to-EV ratio has delivered superior returns whereas
the performance of portfolios based on the most popular ratio, book-to-
market, proved unsatisfactory.
The momentum approach is a cross asset phenomenon. This strat-
egy assumes past winners to outperform, and past losers to deliver poor
returns. The momentum strategies have performed very well for the coun-
try equity indices, but their soft spot has been revealed. The overpefor-
mance was strongest for equal-weighted portfolios, so once the returns
were weighted for capitalization, the abnormal return melted away.
The biggest controversies surround the size effect, with the questions
about its real existence outside the world of data mining. A number of
studies have already hinted that it also applies at the country level, i.e.
that buying small markets may markedly improve the returns. To date,
however, we have found no strong evidence supporting the validity of
this strategy; neither have analogous liquidity-based strategies proved very
robust.
The low-volatility anomaly—a counter-intuitive paradox—implies that
low-volatility assets outperform assets of high volatility. Although it could
be approached using various risk measures––for example, total volatility,
idiosyncratic volatility, beta–– and the anomaly works across numerous
asset classes, including stocks or corporate bonds, the recent evidence
seems to indicate the risk-return relationship across international markets
leans more towards positive rather than negative results. Having tested
this relationship at the country level, we found the link between returns
and volatility rather weak and unreliable. It appears that some alternative
risk or quasi-risk measures, like country fundamental risk or the skewness
of past returns, prove more useful as a predictor of future returns at the
country level.
Finally, the comprehensive concept of quality investing assumes high-
quality stocks to outperform the stocks of low-quality. The sole notion of
quality could be defined in many ways, referring, for example, to payout,
profitability, or indebtedness. Interestingly enough, some of them may
prove useful across various country markets. For example, low levels of
debt or high profitability may favor satisfactory performance in the cross-
section of country returns. However, these strategies should be treated
with caution, as the empirical evidence is weaker than for the cross-coun-
try value strategies.
All these strategies might be further implemented in a portfolio to
improve performance. The correlation between various country-level
strategies discussed in this book is often low. Thus, combining a few strat-
egies in a single portfolio leads to a substantial risk reduction. In addition,
a few of the tools appear to be useful to time the cross-country strate-
gies: cross-country anomalies tend to deliver higher returns in periods of
good sentiment and low limits on arbitrage; the factor strategies display
momentum behavior, so the best performing strategies over the recent
months tend to continue to outperform. Finally, some strategies might
also be influenced by seasonal patterns, for instance the outperformance
of value over growth tends to be particularly pronounced in January.
Incorporating these concepts when constructing an international portfo-
lio could benefit international investors.
CONCLUSIONS 243
This book offers lessons for, first of all, asset allocators, individual
investors, fund pickers and portfolio managers with a global investment
mandate. We show that the country-specific non-market risks relate to
future returns. The presented strategies and concepts provide new insights
into country-level asset pricing that could be employed within the cross-
sectional asset pricing model for either assessing investment performance
or determining the cost of capital.
Our book does not conclude the discussion on country-level strate-
gies. The research still can and should be pursued in several directions to
continue to provide further clues for international investors. First, one
limitation of this book is the lack of accounting for transaction costs and
cross-country capital mobility constraints. Considering these issues could
yield some further insights into the practical aspects of the risk-based strat-
egies. Second, many of the strategies presented in this book could be fur-
ther improved. Additional sortings and concentration of specific market
segments might even enhance the risk adjusted performance. Finally, our
framework could be easily replicated for other asset classes, for example
real estate (via REITs) or sovereign bonds. A few studies, e.g. Asness et al.
(2013) or Frazzini and Pedersen (2014), suggested that many cross-sec-
tional return patterns are phenomena that perform well across many assets
and asset classes. Expanding the portfolio to other investments, even of
an alternative nature, would surely improve its risk-return profile even
further.
REFERENCES
Asness, C. S., Moskowitz, T. J., & Pedersen, L. H. (2013). Value and momentum
everywhere. Journal of Finance, 68(3), 929–985.
Frazzini, A., & Pedersen, L. H. (2014). Betting against beta. Journal of Financial
Economics, 111, 1–25.
APPENDIX A: LIST OF COUNTRIES
INVESTIGATED IN THE STUDY
No. Country Index Bloomberg Mean total Bloomerg Start date End date Mean Monthly Bloomerg Start date End date Mean Monthly
provider ticker capital- ticker [y/m/d] [y/m/d] monthly volatility ticker [y/m/d] [y/m/d] monthly volatility
ization return [%] return [%]
[bn US$] [%] [%]
1 Argentina MSCI MXAR 18.1 GDUESAG 12/31/1998 6/30/2015 0.44 10.85 NDEUSAG 12/31/1998 6/30/2015 0.42 10.85
2 Australia MSCI MXAU 727.3 GDDUAS 1/31/1995 6/30/2015 0.77 6.16 NDDUAS 12/31/1998 6/30/2015 0.59 5.80
3 Austria MSCI MXAT 60.7 GDDUAT 1/31/1995 6/30/2015 0.20 7.84 NDDUAT 12/31/1998 6/30/2015 0.13 7.44
4 Bahrain MSCI MXBH 5.4 MGCUBHG 1/31/2006 6/30/2015 −0.73 5.09 MGCUBHN 1/31/2006 6/30/2015 −0.73 5.09
5 Bangladesh MSCI MXBD 8.0 MSEIBDUG 11/30/2009 6/30/2015 0.04 4.37 MSEIBDUN 11/30/2009 6/30/2015 0.03 4.37
6 Belgium MSCI MXBE 192.6 GDDUBE 1/31/1995 6/30/2015 0.62 6.51 NDDUBE 12/31/1998 6/30/2015 0.14 6.27
7 Brazil MSCI MXBR 567.5 GDUEBRAF 12/31/1998 6/30/2015 0.72 9.71 NDUEBRAF 12/29/2000 6/30/2015 0.54 8.81
8 Bulgaria MSCI MXBU 0.6 MSEIBGUG 5/31/2005 6/30/2015 −0.57 7.86 MSEIBGUN 5/31/2005 6/30/2015 −0.58 7.86
9 Canada MSCI MXCA 1019.9 GDDUCA 1/31/1995 6/30/2015 0.83 6.03 NDDUCA 12/31/1998 6/30/2015 0.57 5.54
10 Chile MSCI MXCL 79.6 GDUESCH 12/31/1998 6/30/2015 0.60 5.76 NDEUSCH 12/31/1998 6/30/2015 0.55 5.76
11 China MSCI MXCN 607.8 GDUETCF 1/31/1995 6/30/2015 0.30 9.72 NDEUCHF 12/31/1998 6/30/2015 0.54 7.83
12 Colombia MSCI MXCO 63.0 GDUESCO 12/31/1998 6/30/2015 1.07 8.29 NDEUSCO 12/31/1998 6/30/2015 1.06 8.29
13 Croatia MSCI MXCR 11.5 MSEICRUG 5/31/2002 6/30/2015 0.25 6.35 MSEICRUN 5/31/2002 6/30/2015 0.24 6.35
14 Cyprus Dow CYSM- 5.3 DWCYDT 12/31/2004 6/30/2015 −1.74 16.08 DWCYNDT 12/31/2004 6/30/2015 −1.74 16.08
Jones MAPA
15 Czech MSCI MXCZ 30.3 GDUESCZ 12/31/1998 6/30/2015 0.91 7.42 NDEUSCZ 12/31/1998 6/30/2015 0.84 7.43
Republic
16 Denmark MSCI MXDK 132.7 GDDUDE 1/31/1995 6/30/2015 1.05 5.89 NDDUDE 12/31/1998 6/30/2015 0.71 5.55
17 Egypt MSCI MXEG 21.4 GDUESEG 1/31/1995 6/30/2015 1.17 9.21 NDEUSEG 12/31/1998 6/30/2015 0.96 8.63
18 Estonia MSCI MXEST 1.0 MSEIESUG 5/31/2002 6/30/2015 0.50 7.53 MSEIESUN 5/31/2002 6/30/2015 0.49 7.53
19 Finland MSCI MXFI 158.3 GDDUFI 1/31/1995 6/30/2015 0.81 9.44 NDDUFI 12/31/1998 6/30/2015 0.20 8.59
20 France MSCI MXFR 1321.9 GDDUFR 1/31/1995 6/30/2015 0.63 6.03 NDDUFR 2/28/1995 6/30/2015 0.57 6.03
21 Germany MSCI MXDE 992.4 GDDUGR 1/31/1995 6/30/2015 0.63 6.83 NDDUGR 12/31/1998 6/30/2015 0.27 6.47
22 Greece MSCI MXGR 62.1 GDUESGE 1/31/1995 6/30/2015 −0.32 10.60 NDDUGRE 12/31/1998 6/30/2015 −0.79 9.74
23 Hong Kong MSCI MXHK 347.5 GDDUHK 1/31/1995 6/30/2015 0.72 7.17 NDDUHK 12/31/1998 6/30/2015 0.59 5.75
24 Hungary MSCI MXHU 19.9 GDUESHG 12/31/1998 6/30/2015 0.28 9.50 NDEUSHG 12/31/1998 6/30/2015 0.27 9.50
Basic data Gross returns Net returns
No. Country Index Bloomberg Mean total Bloomerg Start date End date Mean Monthly Bloomerg Start date End date Mean Monthly
provider ticker capital- ticker [y/m/d] [y/m/d] monthly volatility ticker [y/m/d] [y/m/d] monthly volatility
ization return [%] return [%]
[bn US$] [%] [%]
25 Iceland Dow ICEXI 3.0 DWISDT 1/31/2007 6/30/2015 −0.86 14.96 DWISNDT 1/31/2007 6/30/2015 −0.87 14.96
Jones
26 India MSCI MXIN 357.3 GDUESIA 1/31/1995 6/30/2015 0.67 8.71 NDEUSIA 12/31/1998 6/30/2015 0.85 7.96
27 Indonesia MSCI MXID 93.8 GDUESINF 12/31/1998 6/30/2015 0.96 9.67 NDEUINF 12/31/1998 6/30/2015 0.92 9.67
28 Ireland MSCI MXIE 59.6 GDDUIE 1/31/1995 6/30/2015 0.22 6.68 NDDUIE 12/31/1998 6/30/2015 −0.18 6.39
29 Israel MSCI MXIL 65.7 GDUESIS 12/31/1998 6/30/2015 0.54 6.10 NDEUIS 12/31/1998 6/30/2015 0.50 6.10
30 Italy MSCI MXIT 502.1 GDDUIT 1/31/1995 6/30/2015 0.38 7.01 NDDUIT 12/31/1998 6/30/2015 −0.01 6.26
31 Japan MSCI MXJP 2545.3 GDDUJN 1/31/1995 6/30/2015 0.09 5.22 NDDUJN 2/28/1995 6/30/2015 0.09 5.21
32 Jordan MSCI MXJO 12.2 GDUESJO 12/31/1998 6/30/2015 0.25 5.19 NDEUJOR 12/31/1998 6/30/2015 0.25 5.65
33 Kazakhstan MSCI MXKA 12.1 MSEIKZUG 11/30/2005 6/30/2015 0.31 8.55 MSEIKZUN 11/30/2005 6/30/2015 0.29 8.55
34 Kenya MSCI MXKE 9.2 MSEIKYUG 5/31/2002 6/30/2015 1.24 6.63 MSEIKYUN 5/31/2002 6/30/2015 1.22 6.63
35 Kuwait MSCI MXKW 74.8 MGCUKWG 1/31/2006 6/30/2015 −0.11 4.67 MGCUKWN 1/31/2006 6/30/2015 −0.12 4.67
36 Latvia STOXX RIGSE 1.4 TCLVGV 2/28/2011 6/30/2015 −0.10 2.90 TCLVV 2/28/2011 6/30/2015 −0.10 2.90
37 Lebanon MSCI MXLB 7.5 MSEILBUG 5/31/2002 6/30/2015 0.47 6.67 MSEILBUN 5/31/2002 6/30/2015 0.46 6.67
38 Lithuania MSCI MXLT 0.9 MSEILIUG 5/30/2008 6/30/2015 0.15 4.83 MSEILIUN 5/30/2008 6/30/2015 0.11 4.82
39 Luxemburg STOXX LUXXX 87.6 TCLUGV 2/28/2011 6/30/2015 −0.12 3.48 TCLUV 2/28/2011 6/30/2015 −0.13 3.49
40 Malaysia MSCI MXMY 159.7 GDDUMAF 12/31/1998 6/30/2015 0.78 5.50 NDDUMAF 12/31/1998 6/30/2015 0.78 5.50
41 Malta Dow DWML- 2.1 DWMLDT 12/31/2004 6/30/2015 0.25 4.47 DWMLNDT 12/31/2004 6/30/2015 0.18 4.46
Jones NDT
42 Mexico MSCI MXMX 199.8 GDUETMXF 1/31/1995 6/30/2015 0.93 8.14 NDEUMXF 12/31/1998 6/30/2015 0.84 6.43
43 Morocco MSCI MXMA 24.3 GDUESMO 12/31/1998 6/30/2015 0.26 4.95 NDEUSMO 12/31/1998 6/30/2015 0.23 4.96
44 Mauritius MSCI MXMR 2.5 MSEIMTUG 5/31/2002 6/30/2015 0.98 5.69 MSEIMTUN 5/31/2002 6/30/2015 0.98 5.69
45 Netherlands MSCI MXNL 381.0 GDDUNE 1/31/1995 6/30/2015 0.65 6.06 NDDUNE 12/31/1998 6/30/2015 0.24 5.69
46 New MSCI MXNZ 17.0 GDDUNZ 1/31/1995 6/30/2015 0.49 6.39 NDDUNZ 12/31/1998 6/30/2015 0.43 5.82
Zealand
47 Nigeria MSCI MXNI 37.5 MSEUNIGG 9/30/2009 6/30/2015 0.17 3.59 MSEUNIGN 5/31/2002 6/30/2015 0.56 7.83
48 Norway MSCI MXNO 148.2 GDDUNO 1/31/1995 6/30/2015 0.64 7.99 NDDUNO 12/31/1998 6/30/2015 0.57 7.37
Continued
Table A1 (Continued)
Basic data Gross returns Net returns
No. Country Index Bloomberg Mean total Bloomerg Start date End date Mean Monthly Bloomerg Start date End date Mean Monthly
provider ticker capital- ticker [y/m/d] [y/m/d] monthly volatility ticker [y/m/d] [y/m/d] monthly volatility
ization return [%] return [%]
[bn US$] [%] [%]
49 Oman MSCI MXOM 10.2 MSEIOMUG 5/31/2005 6/30/2015 0.02 4.25 MGCUOMN 1/31/2006 6/30/2015 0.05 4.53
50 Pakistan MSCI MXPK 16.7 MSEIPKUG 5/31/2002 6/30/2015 0.90 7.65 MSEIPKUN 5/31/2002 6/30/2015 0.85 7.64
51 Peru MSCI MXPE 27.9 GDUESPR 12/31/1998 6/30/2015 1.06 7.63 NDEUSPR 12/31/1998 6/30/2015 1.05 7.63
52 Philippines MSCI MXPH 45.9 GDUESPHF 12/31/1998 6/30/2015 0.51 6.67 NDEUPHF 6/28/1996 6/30/2015 −0.09 8.60
53 Poland MSCI MXPL 74.5 GDUESPO 12/31/1998 6/30/2015 0.44 8.92 NDEUSPO 12/31/1998 6/30/2015 0.40 8.91
54 Portugal MSCI MXPT 54.8 GDDUPT 1/31/1995 6/30/2015 0.29 6.67 NDDUPT 12/31/1998 6/30/2015 −0.19 6.09
55 Qatar MSCI MXQA 81.9 MGCUQAG 1/31/2006 6/30/2015 0.18 5.62 MGCUQAN 1/31/2006 6/30/2015 0.18 5.62
56 Romania MSCI MXRO 10.9 MSEIROUG 11/30/2005 6/30/2015 0.04 8.72 MSEIROUN 11/30/2005 6/30/2015 0.02 8.72
57 Russia MSCI MXRU 414.7 GDUESRUS 12/31/1998 6/30/2015 0.99 10.46 NDEUSRU 12/31/1998 6/30/2015 0.97 10.47
58 Serbia MSCI MXRS 1.3 MSEISBUG 5/30/2008 6/30/2015 −0.66 9.01 MSEISBUN 5/30/2008 6/30/2015 −0.68 9.00
59 Saudi MSCI MXSAD 320.7 MGCUSAG 1/31/2006 5/30/2008 −0.26 4.22 MGCUSAN 1/31/2006 5/30/2008 −0.26 4.23
Arabia
60 Singapore MSCI MXSG 171.8 GDDUSG 1/31/1995 6/30/2015 0.43 7.43 NDDUSG 12/31/1998 6/30/2015 0.61 6.23
61 Slovenia MSCI MXSL 5.4 MSEISVUG 5/31/2002 6/30/2015 0.29 5.53 MSEISVUN 5/31/2002 6/30/2015 0.27 5.53
62 South Africa MSCI MXZA 232.6 GDUESSA 12/31/1998 6/30/2015 0.81 6.74 NDEUSSA 12/31/1998 6/30/2015 0.81 6.74
63 South MSCI MXKR 423.7 GDUESKO 12/31/1998 6/30/2015 0.74 8.19 NDEUSKO 12/31/1998 6/30/2015 0.71 8.19
Korea
64 Spain MSCI MXES 460.3 GDDUSP 1/31/1995 6/30/2015 0.83 7.14 NDDUSP 12/31/1998 6/30/2015 0.27 6.49
65 Sri Lanka MSCI MXLK 2.3 MSEISLUG 5/31/2002 6/30/2015 0.72 7.38 MSEISLUN 5/31/2002 6/30/2015 0.70 7.38
66 Sweden MSCI MXSE 329.1 GDDUSW 1/31/1995 6/30/2015 0.91 7.54 NDDUSW 12/31/1998 6/30/2015 0.50 7.04
67 Switzerland MSCI MXCH 844.3 GDDUSZ 1/31/1995 6/30/2015 0.82 4.88 NDDUSZ 12/31/1998 6/30/2015 0.36 4.20
68 Taiwan MSCI TAMSCI 336.8 GDUESTW 12/31/1998 6/30/2015 0.33 6.91 NDEUSTW 12/31/1998 6/30/2015 0.29 6.91
69 Thailand MSCI MXTH 106.0 GDUESTHF 12/31/1998 6/30/2015 0.79 8.46 NDEUSTW 12/31/1998 6/30/2015 0.29 6.91
70 Trinidad MSCI MXTT 3.3 MSEITTUG 11/28/2008 6/30/2015 0.19 1.68 MSEITTUN 11/28/2008 6/30/2015 0.17 1.67
and Tobago
71 Tunisia MSCI MXTN 2.2 MSEITNUG 5/31/2004 6/30/2015 0.38 3.75 MSEITNUN 5/31/2004 6/30/2015 0.38 3.75
Basic data Gross returns Net returns
No. Country Index Bloomberg Mean total Bloomerg Start date End date Mean Monthly Bloomerg Start date End date Mean Monthly
provider ticker capital- ticker [y/m/d] [y/m/d] monthly volatility ticker [y/m/d] [y/m/d] monthly volatility
ization return [%] return [%]
[bn US$] [%] [%]
72 Turkey MSCI MXTR 85.6 GDUESTK 12/31/1998 6/30/2015 0.65 12.96 NDEUTUR 12/31/1998 6/30/2015 0.63 12.96
73 Ukraine MSCI MXUK 5.2 MSEIUKUG 5/31/2006 6/30/2015 −1.08 9.10 MSEIUKUN 5/31/2006 6/30/2015 −1.09 9.09
74 United MSCI MXAE 72.3 MSTRUAGR 5/31/2005 6/30/2015 −0.05 7.75 MGCUAEN 1/31/2006 6/30/2015 −0.18 7.18
Arab
Emirates
75 United MSCI MXGB 1967.5 GDDUUK 1/31/1995 6/30/2015 0.58 4.62 NDDUUK 2/28/1995 6/30/2015 0.58 4.62
Kingdom
76 USA MSCI MXUS 10,464.1 GDDUUS 1/31/1995 6/30/2015 0.77 4.42 NDDUUS 2/28/1995 6/30/2015 0.71 4.42
77 Venezuela MSCI MXVE 9.7 GDUESVZF 12/31/1998 12/31/2007 0.42 8.67 NDEUSVZF 12/29/2000 12/31/2007 0.37 7.73
78 Vietnam MSCI MXVI 17.2 MSEIVTUG 11/30/2006 6/30/2015 −0.04 7.46 MSEIVTUN 11/30/2006 6/30/2015 −0.04 7.46
Note: The authors’ own elaboration based on the data sourced from Bloomberg
APPENDIX B: MAJOR CROSS-SECTIONAL
PATTERNS WITH THEIR EXPLANATIONS
Distress risk X
Production risk X
Option models X
Divergence of X
opinions
Country risk X
Overreaction X
Underreaction X X
Over-optimism X X
Extrapolation bias X
Agency effects X
Mental accounting X
Loss aversion X
Survivorship bias X X
Data mining X X
Non-market risks X X X X
Anchoring X
Disposition effect X
Herd behavior X
Feedback trading X
Confirmation bias X
Representativeness X X
Order flow X
(Continued)
Table B1 (Continued)
Value Momentum Size Low-risk Profitability Distress risk Issuance
investing effects effect effect and leverage
Central banks’ X
behavior
Risk management X
practices
Chaos theory X
Trading costs X
Liquidity risk X
Information risk X
Preference for X
lotteries
Overconfidence X
Greed and envy X
Attention X
grabbing
Leverage X
constraints
Short-selling X
constraints
Regulatory X
constraints
Information X X X
processing
constraints
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INDEX
A C
absolute momentum, 40, 53, 174, 175 CAPE. See cyclically adjusted
accounting quality, 110 price-to-earnings ratio (CAPE)
accruals, 106, 113, 114, 116, Capital Asset Pricing Model (CAPM),
117n12, 117n13 73, 81, 82, 84, 86, 91, 93, 127–9,
analysts coverage, 53 130n2, 131n10, 147, 148, 153,
anchoring, 47–8, 54n9 157, 165, 166, 173, 174, 178,
AQR Capital Management, 109 187, 191, 199, 201, 203–5,
asset turnover, 109 211–13, 215, 219, 221, 233
attention grabbing, 93–4 CAPM. See Capital Asset Pricing
Model (CAPM)
cash flow, 14, 70, 109, 114,
B 117n12, 143
BCG matrix, 108 cash flow-to-price ratio, 13–14,
behavioral mispricing, 21–3 143–5, 147–9, 155, 156
beta, 73, 81–5, 90, 91, 93–5, 96n6, change in dividends, 16
106, 128, 129, 132n11, commodity trading advisors, 42, 44
195–200, 204, 229, 244 confirmation bias, 49–51, 54n12
betting against beta, 84, 85 country asset allocation, 3, 67, 161,
book-to-market ratio, 13, 15, 25, 53, 175, 195–208
125, 141, 143–9, 156, 157, 168, country risk, 21, 202–7, 220, 226,
173, 174 227, 229, 231
book value, 13, 17, 19, 109, 148 credit rating, 53, 105, 111
Buffet’s alpha, 108 cyclically adjusted price-to-earnings
Buffet, Warren, 9, 107, 108 ratio (CAPE), 142, 143, 157n3
N
J net income, 10, 13, 109, 213
January effect, 52, 55n16, 69, net payout, 110, 112
233, 239n7 noise traders, 45
Jensen’s alpha, 127–9, 131n11, 147, non-market risk, 20, 188, 202–7,
153, 157, 165, 173, 178, 187, 227, 244
191, 199, 201, 211, 215, 219, 221
judgmental bias, 21
O
operating cash flow, 14
L operating income, 10, 109
leverage, 17, 19, 94, 106, 108–111, oscillators, 44
116n3, 209–13, 215, 219, 239n4 outliers, 72–3
leverage constraints, 94 overconfidence, 92–3
limits to arbitrage, 91, 233
liquidity, 4, 46, 71, 73, 95, 105, 109,
116n3, 168, 180, 182n4, 190–2, P
209, 222, 238n4, 244 passive screens, 10
liquidity premium, 73, 189–92 P/E ratio, 10–13, 16–18, 107,
liquidity risk, 73, 189 125, 144
long-term reversal, 50, 180, 181 preference for lotteries, 91–2
loss aversion, 22, 28n19 price channels, 44
low-beta anomalies, 83 price-to-earnings ratio, 10–12, 21,
low-volatility anomalies, 81–97 107, 142
price-to-sales ratio, 17, 27n11
profitability, 12, 13, 21, 24, 25, 27n7,
M 44, 45, 50, 83, 96n6 105, 106,
margins, 94, 105, 108–111, 213–16 108–111, 115, 150, 156, 168,
mental accounting, 22, 28n19 175, 200, 205, 206, 209, 213–17,
micro-cap effect, 70 219, 221–3, 243, 244
microcaps, 70, 75n4 P/S ratio, 17, 18, 27n10
262 INDEX
S
sales-to-price ratio, 17 T
seasonal effects, 233–5 take-profit orders, 50
seasonality, 4, 68–9, 225 taxes on dividends, 15, 138, 139,
Seykota, Ed, 41, 42 203, 213
Sharpe ratio, 73, 127, 131n8, 139, technical analysis, 3, 40, 44, 45, 54n7
143–7, 151–4, 156–7, 163–5, time series momentum, 40, 44, 175
169–73, 177, 178, 186, 187, timing country-level strategies, 4, 5,
190, 191, 197–9, 201, 203, 123, 142, 206, 225–7, 230–4,
210, 211, 214, 215, 219, 221, 236, 237, 239n5, 244, 245
227, 229, 230 trading costs, 71–2, 75n7
short-selling constraints, 94–5 Treasury bills, 125, 137, 217
short-term reversal effect, 51, 180 trend following, 40, 41, 44, 46, 48,
size effect, 67–75, 186, 188, 189, 53, 166, 174–6, 178–80
206, 222, 243 turn-of-the-year effect, 233, 234
size premium, 67, 68, 70–4, 185, 206 Turtle Traders, 41
skewness, 89–90, 92, 96n14–15,
97n19 127, 200–2, 207, 232,
233, 244 V
small-cap effect, 68, 70, 74 value at risk, 81, 82, 88–9, 195–9
small-cap investing, 67, 70 value investing, 4, 9, 26n1, 106, 150,
small-cap premium, 55n16, 68–71, 155, 180, 234
73, 74, 187 value premium, 19–26, 28n15, 28n20
small-country effect, 71, 72, 74, 185–92 115, 141, 227, 234