Country Asset Allocation Quantitative Country Selection Strategies in Global Factor Investing

COUNTRY ASSET ALLOCATION
Quantitative Country Selection

Strategies in Global Factor Investing
ADAM ZAREMBA AND JACOB SHEMER

Country Asset Allocation
Adam Zaremba • Jacob Shemer
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
ISBN 978-1-137-59190-6 ISBN 978-1-137-59191-3 (eBook)

DOI 10.1057/978-1-137-59191-3
Library of Congress Control Number: 2016956112
© The Editor(s) (if applicable) and The Author(s) 2017

This work is subject to copyright. All rights are solely and exclusively licensed by the
Publisher, whether the whole or part of the material is concerned, specifically the rights of
translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on
microfilms or in any other physical way, and transmission or information storage and retrieval,
electronic adaptation, computer software, or by similar or dissimilar methodology now
known or hereafter developed.
The use of general descriptive names, registered names, trademarks, service marks, etc. in this
publication does not imply, even in the absence of a specific statement, that such names are
exempt from the relevant protective laws and regulations and therefore free for general use.
The publisher, the authors and the editors are safe to assume that the advice and information
in this book are believed to be true and accurate at the date of publication. Neither the
publisher nor the authors or the editors give a warranty, express or implied, with respect to
the material contained herein or for any errors or omissions that may have been made.
Cover image © JamieB / Getty Images
Printed on acid-free paper
This Palgrave Macmillan imprint is published by Springer Nature

The registered company is Nature America Inc., US
FOREWORD
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
PRAISE FOR COUNTRY ASSET ALLOCATION: QUANTITATIVE

COUNTRY SELECTION STRATEGIES IN GLOBAL FACTOR
INVESTING
“Zaremba and Shemer provide a nice perspective on the important topic
of how to allocate investment portfolios across country markets. Their
book offers a non-technical discussion that nicely summarizes the exist-
ing academic literature on international portfolio choice with an eye on
the practical investment implications. I highly recommend the book to
practitioners, as well as academics who want to stay informed of the latest
developments in international portfolio choice.”
—Ronald Balvers, Professor, McMaster University, Canada
“Zaremba and Shemer provide a clear and accessible discussion of country
allocation strategies. They review how recent research has extended the
firm-level evidence on equity factor premia to the country level. Their
book is timely because investment managers now have access to a wide
range of low-cost and liquid products replicating country indices, so that
practitioners can implement country allocation strategies with ease.”
—Felix Goltz, Head of Applied Research, EDHEC-Risk Institute,
France
“The authors review the quantitative signals that forecast relative stock
returns within a country, and investigate whether the same signals work
in forecasting stock returns across country indices. Zaremba and Shemer
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
We thank Professor Waldemar Fra ̨ckowiak from the Poznan University

of Economics who provided inspiration, insight and comments that
greatly assisted this research. Special thanks to Bartłomiej Dzięciołowski,
Przemysław Konieczka, and Andrzej Nowak, who also contributed to
the development of this book. The research presented in this book was
a part of project no. 2014/15/D/HS4/01235 financed by the National
Science Centre of Poland. The views expressed in this book are those of
the authors and not necessarily those of any affiliated institution.
xi
CONTENTS
1 Introduction 1
Part I 7
2 Value Versus Growth: Is Buying Cheap Always a Bargain? 9
3 Trend Is Your Friend: Momentum Investing 39
4 Is Small Beautiful? Size Effect in Stock Markets 67
5 Is Risk Always Rewarded? Low-Volatility Anomalies 81
6 Is Good Company a Good Investment? Quality Investing 105
xiii
xiv CONTENTS
Part II 121
7 Testing the Country Allocation Strategies 123
8 A Short Primer on International Equity Investing 137
9 Value-Oriented Country Selection 141
10 Momentum Effect Across Countries 161
11 Small-Country Effect 183
12 Risk-Based Country Asset Allocation 193
13 Country Selection Based on Quality 207
14 What Next? Combining and Improving Country

Selection Strategies 223
15 Conclusions 241
Appendix A 245
Appendix B 251
References 253
Index 259
LIST OF FIGURES
Fig. 3.1 Life cycle of a trend 47

Fig. 4.1 Long-term performance of small and large firms in the
US stock market 69
Fig. 5.1 The performance of the betting-against-beta portfolio [%] 85
Fig. 5.2 Performance country portfolios from sorts on idiosyncratic
volatility and size 87
Fig. 5.3 Skewness of return distributions. Panel A left skewed
distribution. Panel B right skewed distribution 89
Fig. 6.1 Performance of MSCI Quality Gross Index in the
1975–2015 period 110
Fig. 8.1 Cumulative returns on MSCI All Country
World Total Return Indices 139
Fig. 9.1 Mean returns on value and growth portfolios formed
on equity multiples. Panel A Book-to-market ratio.
Panel B Earnings to price ratio. Panel C Cash flow-to
price ratio. Panel D Dividend yield 144
Fig. 9.2 Cumulative outperformance of value countries
over growth countries 149
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 151
Fig. 9.4 Cumulative performance of country-selection
strategies based on enterprise value multiples 155
Fig. 10.1 Mean excess returns on basic momentum strategies.
Panel A: Short-term momentum. Panel B: Long-term
momentum. Panel C: Intermediate momentum 162
Fig. 10.2 Cumulative excess returns on basic momentum strategies 166
xv
xvi LIST OF FIGURES
Fig. 10.3 Cumulative excess returns on enhanced momentum strategies 171

Fig. 10.4 Performance of time-series momentum strategies across
equity markets 172
Fig. 10.5 Mean excess returns on moving average strategies.
Panel A: 10-month moving average. Panel B: 12-month
moving average 173
Fig. 10.6 Cumulative excess returns on strategies based on
moving average. 174
Fig. 11.1 Cumulative excess returns on strategies based on market size 186
Fig. 11.2 Cumulative excess returns on strategies based on market size 192
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 196
Fig. 12.2 Cumulative excess returns on strategies based on skewness 200
Fig. 12.3 Performance of equal-weighted tertile portfolios
from sorts on five components of the country risk 204
Fig. 12.4 Country risk within subgroups classified by market size 205
Fig. 13.1 Cumulative excess returns on strategies based on leverage 211
Fig. 13.2 Cumulative excess returns on strategies based on profitability 215
Fig. 13.3 Cumulative excess returns on strategies based on issuance 218
Fig. 13.4 Cumulative excess returns on strategies based on age 220
Fig. 14.1 Cumulative excess returns on country-level factor portfolios.
Panel A: single-strategy portfolios. Panel B:
double-strategy portfolios. Panel C: triple-strategy portfolios 226
Fig. 14.2 Performance of portfolios of country-level factor strategies 238
Fig. 14.3 The impact of limits on arbitrage and investor sentiment on the
performance of country-level stock-market strategies 231
Fig. 14.4 Mean monthly returns on country-level value strategies
during various months. 233
Fig. 14.5 Momentum across country-level stock market anomalies 235
LIST OF TABLES
Table 3.1 Studies of momentum in international stock markets 43

Table 4.1 Size premium around the world in early studies 68
Table 8.1 Performance of MSCI all country world total return indices 139
Table 9.1 Performance of value and growth portfolios formed on
equity multiples 145
Table 9.2 Performance of value and growth portfolios formed
on enterprise multiples 152
Table 9.3 Performance of capitalization-weighted portfolios formed
on B/M among the small countries 157
Table 10.1 Performance of portfolios based on basic
momentum strategies 163
Table 10.2 Performance of portfolios based on enhanced
momentum strategies 168
Table 10.3 Performance of portfolios based on moving averages 175
Table 10.4 The performance of zero-investment country
equity indices based on short-term and long-term
reversal anomalies 177
Table 11.1 Performance of portfolios from sorts on total capitalization 185
Table 11.2 Performance of portfolios from sorts on liquidity 188
Table 12.1 Performance of portfolios from sorts on price risk 195
Table 12.2 Performance of portfolios from sorts on skewness 199
Table 12.3 Performance of portfolios from sorts on country
fundamental risk 201
Table 13.1 Performance of portfolios from sorts on financial leverage 208
Table 13.2 Performance of portfolios from sorts on profitability 212
Table 13.3 Performance of portfolios from sorts on issuance 217
Table 13.4 Performance of portfolios from sorts on age 219
xvii
xviii LIST OF TABLES
Table 14.1 Correlation across the country-level strategies 225

Table 14.2 Performance of portfolios of country-level factor strategies 227
Table A1 Research sample 246
Table B1 Major stock market anomalies with their explanations 251
CHAPTER 1
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 Author(s) 2017 1

A. Zaremba, J. Shemer, Country Asset Allocation,
DOI 10.1057/978-1-137-59191-3_1
2 A. ZAREMBA AND J. SHEMER
in the USA with combined assets of $2.1 trillion (Investment Company

Institute 2015) and the global ETF market is still expected to rise even as
fast as 10–30 % annually over the coming years (EY 2015).
Still, these changes have their dark side: similar trading behavior by
investors from all over the world led to rising correlations between the
stock market returns in individual countries.2 As a result, the benefits
of the diversification of international investments have fallen markedly.
According to Goetzmann et al. (2005), the risk reduction achievable by
sending money abroad has fallen from 90 percent in the 1950s to 65
percent at the end of the twentieth century, and the cross-country correla-
tions are constantly rising (Authers 2010).
Diminishing diversification opportunities have had an evident implica-
tion for market practitioners. A few decades ago sending money abroad
was enough to reap the benefits of international investments. Today, how-
ever, it no longer guarantees any improvement in portfolio performance
and so we need to be all the more careful when selecting the place to allo-
cate our capital. In essence, the recent trend of rising correlations amplify
the importance of using country selection strategies as part of the invest-
ment process.3
Choosing the right countries to invest in is by no means an easy feat.
It demands a long and in-depth analysis of particular countries, spend-
ing much time poring over large amounts of data, as well as taking many
discretionary investment decisions that can never be free from behavioral
biases. Ultimately, it can all lead to wrong conclusions as the final turn
of the markets might prove very counterintuitive. For instance, as popu-
lar belief has it, the growth of the local economy should favor perfor-
mance of the local stock markets. Nevertheless, the evidence suggests that
this could not be further from the truth: in his influential paper of 2012,
Jay R. Ritter, a professor at the University of Florida, found that across
19 countries with continuously operating stock markets since 1900, the
cross-sectional correlation between the returns and growth rate of GDP
per capita is negative and the correlation coefficient reaches −0.39. The
results for 15 emerging markets during the 24-year period from 1988 to
2011 are a remarkably similar: the correlation coefficient equals −0.41. In
other words, apparently we were better off investing in the countries with
low rather than high GDP growth.4
In this book, we would like to explain the efficiency of quantitative
investing, capturing a huge amount of data very quickly, relative to the
traditional approach that not only has a limited scope but is also vulnerable
INTRODUCTION 3
to behavioral errors. The work under the traditional approach is immense,

especially given the limited attention capacities. This, however, can be
overcome with the help of a new paradigm of quantitative investment at
the country level. Efficient cross-country asset allocation can be accom-
plished using quantitative investing insights that have been proliferating
in the academic literature, which identify numerous anomalies and regular
patterns in asset prices.
Taking into account the wealth of opportunities and the large size of
the global ETF market, the investment tools available for ETF investors
still appear relatively modest. Stock-level investors have ample literature at
their disposal, dealing with both cross-sectional and time-series patterns.
Recent research papers contain dozens, if not hundreds, of cross-sectional
stock-level effects.5 Against this background, only a small number of
return patterns and predictive signals have been so far transposed at the
country level. For both passive ETFs and index products, there are still
plenty of tools still waiting to be developed.
The variety of the stock-level return patterns and phenomena identi-
fied in the research papers has been employed in numerous quantitative
easy-to-implement investment strategies. These methods are utilized not
only by progressive hedge fund managers but are also described in numer-
ous books available to individual investors. Stock-level concepts such as
value and growth strategies, momentum effect and technical analysis or
quality and low-volatility strategies are strewn across hundreds of books.
On the other hand, there are very few (or no) publications available for
either institutional managers or individual investors that explain and pres-
ent quantitative country-level parallels of these investment strategies.
Hence, the primary goal of this book is to bridge these gaps. We aim to
present various country-level global investment strategies, and thus equip
investors with the appropriate tools for investing in ETFs, index funds or
futures markets.
The book includes both theoretical and empirical content. On the one
hand, it sets the existing empirical research against the theoretical back-
ground of the presented strategies, reviewing and systematizing the exist-
ing studies on the country-level investment strategies. On the other hand,
the book lays out empirical examination of all these global approaches. We
demonstrate how investors can profit from applying these state-of-the-art
strategies. Our investigations are based on the performance of nearly
80 country equity markets for the years 1995–2015. Our approach is
based on simple sorting: for each month we rank markets according to
a certain characteristic; for example, the valuation ratios, capitalization,

or past returns. Then, we form practical tertile portfolios (composed of
1/3 of the markets in the sample), which are then weighted either equally
or by capitalization. For each month, we rebalance the portfolios, to
keep the allocation to the tertiles indicative of the given characteristics.
Subsequently, we calculate the portfolio returns and assess the risk–return
profile using simple measures as, for instance, the ratios. Finally, we test
the performance on both gross and net basis, i.e. recognizing, or not,
any dividend taxes, which may differ from country to country. We detail
both our methods and the data used in the methods section and in the
Appendix. Readers can easily access this section for details when we refer
to the performance of country-level strategies.
The book is divided into two major parts. The first part describes the
existing quantitative stock market strategies, while the second part shows
their implementation for cross-country asset allocation.
In Part 1, we review the most popular return patterns in equity mar-
kets. Chapters 2, 3, 4, 5, and 6 describe the five grand categories of quan-
titative investment strategies. They include: value investing, momentum
investing, capturing size and liquidity premia, risk-related phenomena,
and quality investing. For each strategy, we explain both the underlying
concept and the theoretical grounding. We also present existing empirical
evidence on the stock selection based on this strategies.
In Part 2 we examine whether these stock-level strategies could be
employed for successful country selection and international asset alloca-
tion. In Chap. 7, we start with the description of our research methods
and data. There we outline our research methods, freeing the body of the
book from these technical details. We continue with a short primer on
international equity investing (Chap. 8). Next, in Chaps. 9, 10, 11, 12,
and 13 we present how country-level value, momentum, size, risk, and
quality strategies performed using real data over the last 20 years.
In conclusion, Chap. 14 focuses on the implementation of the country-
level strategies within an investment portfolio. We present some basic
ideas on how to further improve the quantitative approach to country
selection and blend different approaches within a single portfolio. We start
by presenting benefits of diversifying across various anomalies and then
move on to phenomena useful for allocating assets across these strategies,
i.e. the behavior during various market states, as well as seasonality and
momentum effect within the strategies.
INTRODUCTION 5
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
Investment Company Institute. (2015). Exchange-traded funds: October 2015. ICI

Research & Statistics. Retrieved November 29, 2015, from https://www.ici.
org/research/stats/etf/etfs_10_15
Jacobs, H. (2015). What explains the dynamics of 100 anomalies? Journal of
Banking & Finance, 57, 65–86.
MSCI. (2010). Is there a link between GDP growth and equity returns? MSCI Barra
Research Bulletin. Retrieved November 29, 2015, from https://www.msci.
com/documents/10199/a134c5d5-dca0-420d-875d-06adb948f578
Quinn, D. P., & Voth, H. J. (2008). Century of stock market correlations and
international financial openness. American Economic Review, 98, 529–534.
PART I
CHAPTER 2
Value Versus Growth: Is Buying Cheap

Always a Bargain?
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.

DOI 10.1057/978-1-137-59191-3_2
IMPLEMENTATION AND TESTS OF VALUE STRATEGIES

The value strategy may be implemented in various forms. The quantitative
investment techniques, however, capitalize on its simplest variant—the
passive screens. Under this approach, stocks are sorted by quantitative
characteristics related to the company fundamental ratios, and subse-
quently grouped into portfolios. The portfolios of assets displaying attrac-
tive characteristics are deemed good investments, while the others are
quite the opposite.1
Value screens may be based on a large number of ratios. All of them,
however, share a similar design: they relate to a fundamental item from the
company’s balance sheet compared to its market value. In general, there
are two types of ratios used:
– Equity multiples. These metrics compare various accounting
items to the market value of the company’s equity. As these mul-
tiples focus on the common stock, the fundamental values must
relate to the shareholders’ earnings. A flagship example of equity
multiples is the price-to-earnings ratio (the P/E ratio), which
compares net income—usually aggregated over the previous four
quarters—to the stock market capitalization of the company.
– Enterprise multiples. One of the shortcomings of the equity
multiples is that they largely ignore the company’s indebtedness.
The antidote is to use enterprise multiples which compare fun-
damental figures to the market value of the enterprise, i.e. the
total market value of both equity and debt. By their nature, these
measures use fundamentals related to the income generated for
all the crediting parties; for example, shareholders, bondhold-
ers, or banks. The EV-to-EBITDA ratio (enterprise value/earn-
ings before interest, taxes, and amortization) can serve as a classic
example of the enterprise multiple as it divides enterprise value by
the company’s EBITDA, i.e. operating income plus depreciation
and amortization.
When investors evaluate stock companies, they usually rely on ratios,
with the market value of the company as the numerator and the funda-
mental as the denominator. This approach might not always prove use-
ful for passive screens, as it is inapplicable in companies with negative
fundamentals. In other words, it is difficult to implement such ratios for
stocks with losses and/or negative book values. Secondly, these types of
VALUE VERSUS GROWTH: IS BUYING CHEAP ALWAYS A BARGAIN? 11
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”
(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.
Although these defects by no means disqualify the usefulness of the

P/E ratio as a valuation tool and a sorting technique—after all, its effi-
ciency has been demonstrated across many studies—these deficiencies
push investors to seek and try alternative value indicators.
Book-to-market ratio. The book-to-market ratio (and its reciprocal:
the price-to-book ratio) sets the accounting value of equity against its
market value. The book value of equity comprises total assets less total
liabilities, and ensures much more stability than, for example, the P/E
ratio. This ratio does not rely on any highly variable item from the finan-
cial statements, but on the latest balance sheet data. The company book
value changes in no way so rapidly as its profitability, and is less prone to
various manipulations (even if it can be).
The book-to-market ratio (B/M ratio) provides a foundation for vari-
ous strategies, either basic or sophisticated. Probably the first widespread
scientific evidence asserting that the book-to-market ratio can predict
future returns in the cross section was delivered by Rosenberg, Reid, and
Lanstein in 1985. The authors examined how successful the picking of
stocks would have been, based on the B/M ratios in the USA in years
1973–1984. They discovered that the investment in the low price-to-
book stocks had beaten the US equity market on a risk-adjusted basis by
over 4 percentage points year in, year out.
The use of book-to-market ratio was subsequently popularized by
Eugene Fama, later Nobel laureate, and his frequent co-author Kenneth
French. In their study of 1992, they investigated a much longer period
analyzing the performance of US stocks within the years 1963–1990.
They examined the returns of 12 portfolios from sorts by the book-to-
market ratio, and identified that the top B/M ratio companies delivered
the average annual return of over 24.3 %, while the firms with the lowest
B/M metric yielded merely 3.7 %.
The profitability of the book-to-market ratio-based strategies is not
restricted to the USA. It was also documented in various markets across
the world (Chan et al. 1991; Capaul et al. 1993; Fama and French 1998;
Griffin 2002; Hou et al. 2011; Asness et al. 2013; Bali et al. 2013).4 The
recent years have seen a few broad international studies that examined the
book-to-market effects across the large number of markets; in developed
markets, for instance, Fama and French 2012, Chattopadhyay et al. 2015,
or in emerging markets: Cakici et al. 2013 and Hanauer and Linhart 2015.
Finally, De Groot et al. (2012) demonstrated the importance of the book-
to-market ratio in exotic frontier markets such as Bangladesh or Lebanon.
Cash flow-to-price ratio. This measure represents another attempt to

correct the shortcomings of the P/E ratio. It stems from the philosophy
that in the financial statements changes in cash are much more reliable
than net income, which is much more susceptible to subtle decision-mak-
ing of accountants and financial officers. The ratio usually ignores total
cash flow, which is the sum of cash flows from operating, investing, and
financing activities, and focuses solely on operating cash flow. Cash flow
from financing activities, which reflects debt issuance and repayments, is
highly volatile, and more detached from the intrinsic value than cash flow
from operating activities, and only cash flow from investing activities gets
sometimes included in the calculations.
Early studies of cash flow-to-price ratio (CF/P) yielded very promising
results. Lakonishok et al. (1994) found that the strategies based on cash
flow-to-price perform better than other value strategies that employ, for
example, book-to-market or earnings-to-price ratios. Later, other studies
confirmed the effectiveness of the CF/P ratio (Desai et al. 2004; Chan
and Lakonishok 2004; Kimlyk 2014; Brandes Institute 2015) pointing to
the outperformance of cash flow yield-based strategies in various regions
across the globe. For example, Brouwer et al. (1996) adopting the data
from years 1982–1993 examined the performance of value strategies
within stocks listed in France, Germany, the Netherlands, and the United
Kingdom. The team found that the difference in returns between the quin-
tiles of stock with the highest and the lowest CF/P ratios amounted to
20.8 % annually, greatly exceeding analogous results for sorts on book-to-
market, earnings-to-price, or dividend yield. In another study, Hou et al.
(2011) tested the CF/P strategy within a huge sample of 29,000 indi-
vidual securities from 49 countries over the 1981–2003 period. They, in
turn, identified that the equal-weighted zero-investment portfolios from
sorts by CF/P earned an average monthly return of 0.92 % with a stan-
dard deviation of 2.26 %. In consequence, this approach to stock selection
proved to be more profitable and less risky than any other value strategy
examined by the authors. Subsequently, Desai et al. (2004) identified that
CF/P can be used to explain fully the performance of other value strate-
gies: that is, when we sort stock on cash flow-to-price ratio, it makes no
sense to sort them additionally on other value metrics.
The cash flow used when calculating the CF/P ratio is sometimes sim-
plified as the sum of net profit, depreciation and amortization. Thus, this
measure effectively matches the EBITDA-to-price ratio. This approach is
sometimes used by market practitioners (for example, Mesale 2008b), but

it is not widely discussed in the academic literature.
Dividend yield. The use of dividend yields as a basis for sorting stocks
is not as popular as the P/E or B/M ratio; this practice offers, however,
certain advantages. First of all, this is the ultimate indicator of the reward
given to investors for holding the stocks, and, in fact, the only real money
they receive. On the other hand, the measure ignores all the cash gener-
ated and withheld by the company to generate future profits.
The predictive ability of dividend yield was investigated by a wide range
of studies in both time series and cross section.5 Preliminary studies were
based on a time-series analysis for aggregated indices and demonstrated
its impact on future stock returns in many developed markets over various
time horizons (Fama and French 1988; Campbell and Shiller 1988a, b;
Cochrane et al. 1993). In the cross section of equity returns, the validity
of stock-picking strategy based on dividend was also proven in the USA
and other developed and emerging markets (Mei 1992; Claessens et al.
1998; Lewellen 2004; Lyn and Zyowicsch 2004; Maio and Santa Clara
2015). Hou et al. (2011) in their large cross-sectional study of 29,000
stocks revealed that the capitalization-weighted quintile of stocks with the
highest dividend yield outperformed the companies with the lowest divi-
dend yields in the period from 1981 to 2003 by 0.69 % monthly, which
equals over 8 % per annum. Przemysław Konieczka and I examined the
importance of dividend yields across Central and Eastern Europe and in
our study identified the profits on the dividend strategy to outperform
even the popular strategies based on book-to-market ratio, momentum,
and size (capitalization).6
The predictive power of dividends is also supported by some anecdotal
evidence. The popular investment strategy “Dogs of the Dow” is a classic
example. Under this approach you invest in 10 stocks from the Dow Jones
Industrial Average (DJIA) with the highest dividend yield. The strategy
was popularized by O’Higgins and Downes (1991) in their famous book
Beating the Dow.7 Further on, Clemens (2012) calculated that this simple
strategy over the years 1961–1998 delivered an average annual geometric
return amounting to 14 % while DJIA earned only 11.4 % per year. Parallel
strategies were proven successful also for stock picking from market indi-
ces in other countries, including even some exotic markets, like Peru (Da
Silva 2001) or Pakistan (Soomro and Haroon 2015).8 The more recent
studies on the Dog of the Dow strategy are no longer that optimistic.
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
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.
1. Sales-to-price ratio, i.e. the reciprocal of the price-to-sales ratio (P/S

ratio). The ratio is calculated as the value of revenue divided by the
total stock market capitalization of a given company. Although it is
very popular, this metric faces an important problem of leverage. If
a firm incurred a significant amount of debt, it is perfectly possible
that it will be traded at a low multiple of sales, as its operations are
not financed with equity, but debt. In consequence, when we pick
stocks based on the P/S ratio, we are likely to arrive at a portfolio of
highly indebted companies.
2. Revenue-to-EV ratio, i.e. the reciprocal of the EV-to-revenue ratio
(EV/sales, EV/S ratio).9 This measure compares sales to the entire
enterprise value, namely the market value of debt and equity
together, instead of focusing only on debt. This eliminates the bias
towards the highly leveraged companies.
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
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.
1. EBITDA-to-EV ratio, i.e. the reciprocal of the EV-to-EBITDA

ratio. It relates the company’s EBITDA to its enterprise value.
2. EBITDA-to-price ratio, i.e. the reciprocal of the price-to-EBITDA
ratio. This measure is probably even more popular than the previous
one, due to its calculation simplicity. However, as it takes no account
of debt, it shares the shortcomings of the price-tosales ratio.
Therefore portfolios formed on the EBITDA-to-price ratio are
biased towards highly leveraged companies.
Although the EBITDA multiples are not as popular as the metrics

based on earnings or book value, the evidence supporting their useful-
ness is astonishingly robust. The EV-to-EBITDA (EV/EBITDA) ratio
was notably investigated in 2012 by Loughran and Wellman when the
authors examined the returns on the US stocks from 1963 to 2009 and
concluded that the quintile of low EV/EBITDA stocks outperformed the
high EV/E stocks by an economically meaningful 5.28 % annually, which
remained significant even after considering other popular value, size, and
momentum strategies.
In another paper published the same year, Gray and Vogel compared
the investment performance of various valuation measures in the USA in
years 1971–2010. They found that across all of the examined metrics, the
EV/EBITDA performed the best. The equal-weighted quintile portfolios
of low EV/EBITDA stocks outperformed the high EV/EBITDA stocks
by 9.69 % a year. In comparison, the analogous number for the B/M ratio
was only 5.83 %. The EV/EBITDA was a clearly superior predictor of
future winners over all the other ratios. Further on, Wesley R. Gray, one
the authors of this analysis, advocated the use of the EBITDA multiples in
his popular book Quantitative value Gray and Carliste (2012).12
WHY DOES VALUE OUTPERFORM GROWTH?

While most academics generally agree that we have value premiums in the
market, the reason why they arise is still hotly debated. Two important
theories dominate the literature: that concerning risk and that of behavior.
Both theories have their strengths and weaknesses, so the debate between
the two warring camps continues. In addition, there are a few minor
explanations about some side phenomena that may shed some light on the
value premium. Let us first look more carefully at the two most popular
explanations referring to risk and behavioral biases.
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
Another interpretation of the non-market risk was offered by Doukas

et al. (2004), who suggested that the risk could arise from the divergence
of opinions on the company’s future among market participants. If the
investors substantially disagree about the company’s prospects, the invest-
ment may seem riskier than in the case of a universal market consensus. In
time, however, this idea was challenged by Shon and Zhou (2010), who
used the dispersion among analysts’ forecasts as the proxy for testing the
divergence of opinions. Surprisingly, they found firms with greater expo-
sure to divergent opinions earning no higher excess, and historically, earn-
ing even slightly lower returns. These findings challenge the initial claim
that divergence of opinions might really help explain the value premium.
The risk story sends ripples also at the country level. Undoubtedly,
international investors face numerous risks of expropriation, currency
devaluation, coups, or regulatory changes (Bekaert et al. 1996; Dahlquist
and Bansal 2002) which—due to their nature—are not fully reflected in
the volatility of returns. A solid block of academic evidence suggests that
these risks are, in fact, priced in. The markets considered riskier in terms
of political risk, country risk, or economic risk are indeed associated with
higher returns.18 Exploring it further, Erb et al. (1996b) confirmed that
riskier countries display lower price-to-book and price-to-earnings ratios,
and higher dividend yields.
Behavioral mispricing. The behavioral justification of the value pre-
mium came forward as an alternative explanation almost at the same time
when the risk story was advancing (Lakonishok et al. 1994). In essence,
the theory indicates that the abnormal returns on value and growth stocks
result from behavioral mispricing and investor irrationality. This mispric-
ing is a consequence of a series of behavioral biases of market participants,
the most important of which is probably the so-called judgmental bias.
This relates to overreaction of investors who too optimistically (or pes-
simistically) extrapolate either the past sales or earnings growth when pre-
dicting the future. Under this theory, growth companies with the highest
past growth rates should be overpriced, as investors expect them to grow
very fast, and the overpricing should be reflected in the inflated valua-
tion ratios. Consequently, the firms with the lowest past growth should
be undervalued with underestimated valuation ratios. Lakonishok et al.
(1994) identified certain data patterns that generally confirm the behav-
ioral hypothesis: growth stocks display higher growth rates, yet they tend
to revert to the mean within a few years. Analogously, while value stocks
grow more slowly, the growth stocks quickly accelerate. Summing up,
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.
The behavioral explanation of stock market anomalies brings another

implication: the value premium should be particularly high in the periods
of levered investor irrationality, i.e. following the times of high investor
sentiment. This was proven by Baker and Wurgler in 2006 and subse-
quently an analogous pattern was identified by me at the country level
(Zaremba 2015a): there too returns on the markets with low valuation
multiples score particularly high in comparison to the “growth countries”
in months when the investor sentiment is high.
Finally, an interesting experiment was also performed by Du (2011),
who tested jointly the two competing explanations of the value premium:
the risk compensation hypothesis and the investor sentiment story. He
found that while the value premium displays correlation with the investor
sentiment, it is loosely related to the state of the economy. Consequently,
Du concluded that it is difficult to argue that the value premium results
from risk.20
The risk hypothesis seems very convincing, well-grounded and hardly
argued against (Ling and Koo 2012). It has, nonetheless, its critics. Fama
and French (1996) argue that although the growth stocks exhibit higher
past growth rates, this does not necessarily determine the value premium.
In other words, the value strategy can work equally well no matter if the
investor uses the information about the past growth rates or not. Also,
some studies challenge the notion that investors systematically extrapolate
the past growth rates. For example, when we look at the analysts’ forecasts
for the growth and value stocks, in fact no overly optimistic nor pessimistic
estimation is visible (Doukas et al. 2002). Blitz et al. (2014b) tested the
impact on returns of jointly overreaction indicators and the B/M ratio to
conclude that once the B/M ratio is considered, the overreaction indica-
tors prove irrelevant. These findings cast some doubt on the behavioral
explanations of the value premium.
Survivorship bias. Survivorship bias is the distortion in results occur-
ring when only the surviving companies are investigated. It is, in fact, a
common problem in testing investment strategies as investors look only
at the strategies that exist and ignore the ones that are no longer present
in the market (due to, for example, delisting or bankruptcy). If this is the
case, it may significantly contribute to the alleged overperformance of the
value stocks. How? Let us assume that a company is undergoing serious
financial problems. Its standing deteriorates, the stock prices plunge, and
the bankruptcy seems to be looming ahead. The company is priced at a
ridiculously low valuation ratio, because no one wants to pay more for
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
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
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.
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”.
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.
REFERENCES
Alles, L., & Shen, Y. T. (2008). Dogs of the Dow’ down under. Finsia Journal of
Applied Finance, 3, 30–38.
Andersson, M., Hall, E., & Örn, P. (2010). The dividend effect: A study of the
OMXS30. Bachelor Thesis, School of Economics and Management, Lund
University. Retrieved October 10, 2015, from http://www.lunduniversity.
lu.se/lup/publication/1627607
Andrade, S. C. (2009). A model of asset pricing under country risk. Journal of
International Money and Finance, 28(4), 671–695.
Andrikopoulos, P., Daynes, A., Latimer, D., & Pagas, P. (2006). The value pre-
mium and methodological biases: Evidence from the UK equity market.
Investment Management and Financial Innovation, 3(1), 40–59.
Ang, A., & Bekaert, G. (2007). Stock return predictability: Is it there? Review of
Financial Studies, 20, 651–707.
Anghel, A., Dumitrescu, D., & Tudor, C. (2015). Modeling portfolio returns on
Bucharest Stock exchange using the Fama-French multifactor model.
Romanian Journal of Economic Forecasting, 17(1), 22–46.
Asness, C. S., Moskowitz, T. J., & Pedersen, L. H. (2013). Value and momentum
everywhere. Journal of Finance, 68(3), 929–985.
Avramov, D., Chordia, T., Jostova, G., & Philipov, A. (2013). Anomalies and
financial distress. Journal of Financial Economics, 108(1), 139–159.
Baker, M., & Wurgler, J. (2006). Investor sentiment and the cross-section of stock
returns. Journal of Finance, 61(4), 1645–1680.
Bali, T. G., Cakici, N., & Fabozzi, F. J. (2013). Book-to-market and the cross-
section of expected returns in international stock markets. Journal of Portfolio
Management, 39(2), 101–115.
Banz, R., & Breen, W. (1986). Sample dependent results using accounting and
market data: Some evidence. Journal of Finance, 41(4), 779–793.
Barbee Jr., W. C., Jeong, J.-G., & Mukherji, S. (2008). Relations between portfo-
lio returns and market multiples. Global Finance Journal, 19(1), 1–10.
Barbee, W. C., Mukherji, S., & Raines, G. A. (1996). Do sales-price and debt-
equity explain stock returns better than book-market and firm size? Financial
Analysts Journal, 52(2), 56–60.
Barberis, N., & Huang, M. (2001). Mental accounting, loss aversion, and indi-
vidual stock returns. Journal of Finance, 56(4), 1247–1292.
Basu, S. (1975). The Information content of price-earnings ratios. Financial
Management, 4(2), 53–64.
Basu, S. (1977). Investment performance of common stocks in relation to their
price-earnings ratios: A test of the efficient market hypothesis. Journal of
Finance, 32, 663–682.
Basu, S. (1983). The relationship between earnings yield, market value and return
for NYSE common stocks: Further evidence. Journal of Financial Economics,
12, 129–156.
Bekaert, G., Erb, C. B., Harvey, C. R., & Viskanta, T. E. (1996). The cross-sectional
determinants of emerging equity market returns. Retrieved September 21, 2015,
from https://www0.gsb.columbia.edu/faculty/gbekaert/PDF_Papers/The_
cross-sectional_determinants.pdf
Bekaert, G., Erb, C. B., Harvey, C. R., & Viskanta, T. E. (1997). The cross-sec-
tional determinants of emerging market equity returns. In P. Carman (Ed.),
Quantitative investing for the global markets (pp. 221–272). New York:
Routledge.
Berk, J. B., Green, R. C., & Naik, V. (1999). Optimal investment, growth options
and security returns. Journal of Finance, 54, 1153–1607.
Berk, J. B., Green, R. C., & Naik, V. (2004). Valuation and return dynamics of
new ventures. Review of Financial Studies, 17, 1–35.
Bhushan, R. (1989). Firm characteristics and analyst following. Journal of
Accounting and Economics, 11(2–3), 255–274.
Boehme, R. D., & Sorescu, S. M. (2002). The long-run performance following
dividend initiations and resumptions: Underreaction or product of chance?
Journal of Finance, 57, 871–900.
Brandes Institute. (2015). Value vs. growth: A long-term worldwide perspective.
Retrieved October 9, 2015, from http://www.brandes.com/docs/default-
source/brandes-institute/value-vs-glamour-worldwide-perspective.pdf
Brouwer, I., van der Put, J., & Veld, C. (1996). Contrarian investment strategies
in the European context. Working paper. Retrieved October 9, 2015, from SRN:
http://ssrn.com/abstract=41003 or http://dx.doi.org/10.2139/ssrn.41003
Bryant, P. S., & Eleswaparu, V. R. (1997). Cross-sectional determinants of New
Zealand share market returns. Accounting and Finance, 37, 181–205.
Brzeszczynski, J., Archibald, K., Gajdka, J., & Brzeszczynska, J. (2008). Dividend
yield strategy in the British stock market 1994–2007. Retrieved October 10,
2015, from SSRN: http://ssrn.com/abstract=1100623 or http://dx.doi.
org/10.2139/ssrn.1100623
Brzeszczynski, J., & Gajdka, J. (2008). Performance of high dividend yield invest-
ment strategy on the Polish Stock Market 1997–2007. Investment Management
and Financial Innovations, 5(2), 86–92.
Cakici, N., Fabozzi, F. J., & Tan, S. (2013). Size, value, and momentum in emerg-
ing market stock returns. Emerging Markets Review, 16, 46–65.
Campbell, J. Y., Hilscher, J., & Szilagyi, J. (2008b). In search of distress risk.
Campbell, J. Y., & Shiller, R. J. (1988a). Stock prices, earnings, and expected divi-
dends. Journal of Finance, 43(3), 661–676.
Campbell, J. Y., & Shiller, R. J. (1988b). The dividend-price ratio and expecta-
tions of future dividends and discount factors. Review of Financial Studies,
1(3), 195–227.
Campbell, J. Y., & Thompson, S. (2008). Predicting the equity premium out of
sample: Can anything beat the historical average? Review of Financial Studies,
21(4), 1509–1531.
Campbell, J. Y., & Yogo, M. (2006). Efficient tests of stock return predictability.
Journal of Financial Economics, 81(1), 27–60.
Cao, V. N. (2015). What explains the value premium? The case of adjustment
costs, operating leverage and financial leverage. Journal of Banking & Finance,
59, 350–366.
Capaul, C., Rowley, I., & Sharpe, W. F. (1993). International value and growth
stock returns. Financial Analyst Journal, 49, 27–36.
Carlson, M., Fisher, A., & Giammarino, R. (2004). Corporate investment and
asset price dynamics: Implications for the cross section of returns. Journal of
Finance, 59(6), 2577–2603.
Chan, L. K. C., Hamao, Y., & Lakonishok, J. (1991). Fundamentals and stock
returns in Japan. Journal of Finance, 46, 1739–1764.
Chan, L. K. C., Jegadeesh, N., & Lakonishok, J. (1995). Evaluating the perfor-
mance of value versus glamour stocks: The impact of selection bias. Journal of
Financial Economics, 38(3), 269–296.
Chan, L. K. C., & Lakonishok, J. (2004). Value and growth investing: Review and
update. Financial Analysts Journal, 60(1), 71–86.
Chattopadhyay, A., Lyle, M. R., & Wang, C. C. Y. (2015). Accounting Data,
Market Values, and the Cross Section of Expected Returns Worldwide. Harvard
Business School Accounting & Management Unit Working Paper No. 15-092.
Retrieved October 9, 2015, from SSRN: http://ssrn.com/abstract=2613366
or http://dx.doi.org/10.2139/ssrn.2613366
Chaves, D. B., Hsu, J. C. Kalesnik, V., & Shim, Y. (2012). What drives the value
effect? Risk versus mispricing: Evidence from international markets. Working
paper. Retrieved October 13, 2015, from SSRN: http://ssrn.com/
abstract=1940504 or http://dx.doi.org/10.2139/ssrn.1940504
Choi, J. (2013). What drives the value premium? The role of asset risk and lever-
age. Review of Financial Studies, forthcoming.
Chou, S. R., & Johnson, K. (1990). An empirical analysis of stock market anoma-
lies: Evidence from the Republic of China in Taiwan. In S. G. Rhee & R. P.
Chang (Eds.), Pacific-basin capital markets research. Amsterdam: North
Holland.
Chui, A. C. W., Wei, J. K. C., & Xie, F. (2013). Explaining the value premium
around the world: Risk or mispricing? Working paper. Retrieved October 13,
2015, from http://repository.ust.hk/ir/Record/1783.1-66583
Claessens, S., Dasgupta, S., & Glen, J. (1998). The cross section of stock returns:
Evidence from emerging markets. Emerging Markets Quarterly, 2, 4–13.
Clemens, M. (2012). Dividend investing: Strategy for long-term outperformance.
Working paper. Retrieved October 10, 2015, from SSRN: http://ssrn.com/
Cochrane, J. H. (1991). Production-based asset pricing and the link between
stock returns and economic fluctuations. Journal of Finance, 46, 209–237.
Cochrane, J. H. (1992). Explaining the variance of price-dividend ratios. Review
of Financial Studies, 5, 243–280.
Cochrane, J. H. (1996). A cross-sectional test of an investment-based asset pricing
model. Journal of Political Economy, 104, 572–621.
Cochrane, S. J., DeFina, R. H., & Mills, L. O. (1993). International evidence on
the predictability of stock Returns. Financial Review, 28(2), 159–180.
Cooper, I. (2006). Asset pricing implications of non-convex adjustment costs and

irreversibility of investment. Journal of Finance, 61(1), 139–170.
Czapkiewicz, A., & Wojtowicz, T. (2014). The four-factor asset pricing model on
the Polish stock market. Economic Research, 27(1), 771–783.
Da Silva, A. L. C. (2001). Empirical tests of the Dogs of the Dow strategy in Latin
American stock markets. International Review of Financial Analysis, 10(2),
187–199.
Dahlquist, M., & Bansal, R. (2002). Expropriation risk and return in global equity
markets. EFA 2002 Berlin Meetings Presented Paper. Retrieved September 21,
org/10.2139/ssrn.298180
Dahlstedt, J., & Engellau, O. (2006). High dividend yield as investment strategy.
Stockholm School of Economics, Mater Thesis in Finance. Retrieved October
10, 2015, from http://arc.hhs.se/download.aspx?MediumId=128
Damodaran, A. (2012a). Investment philosophies: Successful strategies and the inves-
tors who made them work. Hoboken, NJ: Wiley.
Damodaran, A. (2012b). Investment valuation: Tools and techniques for determin-
ing the value of any asset (3 ed.). New York: Wiley.
Daniel, K., & Titman, S. (1997). Evidence of the characteristics of cross sectional
variation in stock returns. Journal of Finance, 52, 1–33.
Daniel, K., Titman, S., & Wei, J. (2001). Explaining the cross-section of stock
returns in Japan: Factors or characteristics. Journal of Finance, 56, 743–767.
De Bondt, W. F. M., & Thaler, R. (1985). Does the stock market overreact?
Journal of Finance, 40(3), 793–805.
de Groot, W., & Huij, J. (2011). Are the Fama-French factors really compensations
for distress risk? Working paper. Retrieved October 12, 2015, from SSRN: http://
ssrn.com/abstract=1840551 or http://dx.doi.org/10.2139/ssrn.1840551
de Groot, W., Pang, J., & Swinkels, L. A. P. (2012). The cross-section of stock
returns in frontier emerging markets. Journal of Empirical Finance, 19(5),
796–818.
Desai, H., Rajgopal, S., & Venkatachalam, M. (2004). Value-glamour and accruals
mispricing: One anomaly or two? Accounting Review, 79(2), 355–385.
Dhatt, M. S., Kim, Y. H., & Mukherji, S. (2001). The efficiency of individual and
composite measures for identifying value stocks. Working paper. Retrieved
October 11, 2015, SSRN: http://ssrn.com/abstract=285200 or http://
dx.doi.org/10.2139/ssrn.285200
Dichev, I. D. (1998). Is the risk of bankruptcy a systematic risk? Journal of Finance,
53(3), 1131–1147.
Dimson, E., & Marsh, P. (1999). Murphy’s law and market anomalies. Journal of
Portfolio Management, 25(2), 53–69.
Domain, D. L., Louton, D. A., & Mossman, C. E. (1998). The rise and fall of the
“Dogs of the Dow”. Financial Services Review, 7, 145–159.
Dorfman, J. R. (1988, August 11). Study of industrial averages finds stocks with
high dividends are big winners. Wall Street Journal.
Doukas, J. A., Kim, C. F., & Pantzalis, C. (2002). A test of the errors-in-expecta-
tions explanation of the value/glamour stock returns performance: Evidence
from analysts’ forecasts. Journal of Finance, 57, 2143–2165.
Doukas, J. A., Kim, C., & Pantzalis, C. (2004). Divergent opinions and the per-
formance of value stocks. Financial Analyst Journal, 60(6), 55–64.
Doyle, J. T., Lundholm, R. J., & Soliman, M. T. (2006). The extreme future stock
returns following I/B/E/S earnings surprises. Journal of Accounting Research,
44, 859–887.
Du, D. (2011). Value premium and investor sentiment. Advances in Behavioral
Finance & Economics: The Journal of the Academy of Behavioral Finance, 1(2),
87–101.
Elgammal, M. M., & McMillan, D. G. (2014). Value premium and default risk.
Journal of Asset Management, 15, 48–61.
Erb, C. B., Harvey, C. R., & Viskanta, T. E. (1995). Country risk and global
equity selection. Journal of Portfolio Management, 21(2), 74–83.
Faff, R. (2001). An examination of the Fama and French three-factor model using
commercially available factors. Australian Journal of Management, 26, 1–17.
Fama, E. F., & French, K. R. (1988). Dividend yields and expected stock returns.
Journal of Financial Economics, 22, 3–25.
Fama, E. F., & French, K. R. (1992). The cross-section of expected returns.
Fama, E. F., & French, K. R. (1993). Common risk factors in the returns on stocks
and bonds. Journal of Financial Economics, 33, 3–56.
Fama, E. F., & French, K. R. (1996). Multifactor explanations of asset pricing
anomalies. Journal of Finance, 51(1), 55–84.
Fama, E. F., & French, K. R. (1998). Value versus growth: The international evi-
dence. Journal of Finance, 53(6), 1975–1999.
Fama, E. F., & French, K. R. (2012). Size, value, and momentum in international
stock returns. Journal of Financial Economics, 105(3), 457–472.
Fama, E. F., & French, K. R. (2015). A five-factor asset pricing model. Journal of
Ferson, W. E., & Harvey, C. R. (1997). Fundamental determinants of national
equity market returns: A perspective on conditional asset pricing. Journal of
Banking and Finance, 21, 1625–1665.
Fisher, P. A. (1996). Common stocks and uncommon profits and other writings.
Hoboken, NJ: Wiley.
Fisher, K. (2007). Super stocks. New York: McGraw-Hill.
Garlappi, L., & Song, Z. (2013). Can investment shocks explain value premium
and momentum profits? Working paper. Retrieved October 13, 2015, from
http://finance.sauder.ubc.ca/~garlappi/Papers/IShockReturn_Dec_10.pdf
Gaunt, C. (2004). Size and book to market effects and the Fama French three
factor asset pricing model: Evidence from the Australian Stock Market.
Accounting and Finance, 44, 27–44.
Gharghori, P., Stryjkowski, S., & Veeraraghavan, M. (2013). Value versus growth:
Australian evidence. Accounting & Finance, 53(2), 393–417.
Goetzmann, W. N., & Jorion, P. (1995). A longer look at dividend yields. Journal
of Business, 68, 483–508.
Gomes, J., Kogan, L., & Zhang, I. (2003). Equilibrium cross-section of returns.
Journal of Political Economy, 111, 693–732.
Goyal, A., & Welch, I. (2003). The myth of predictability: Does the dividend yield
forecast the equity premium? Management Science, 49(5), 39–654.
Goyal, A., & Welch, I. (2008). A comprehensive look at the empirical perfor-
mance of equity premium prediction. Review of Financial Studies, 21(4),
1455–1508.
Graham, B. (2006). The intelligent investor: The definitive book on value investing.
A book of practical counsel. New York: HarperBusiness.
Graham, B. (2008). Security analysis (6 ed.). New York: McGraw-Hill Education.
Graham, B., & Dodd, D. (1940). Security analysis: Principles and techniques.
New York: McGraw-Hill Book Company.
Griffin, J. M. (2002). Are the Fama and French factors global or country specific?
Review of Financial Studies, 15, 783–803.
Griffin, J. M., & Lemmon, M. L. (2002). Book-to-market equity, distress risk, and
stock returns. Journal of Finance, 57, 2317–2336.
Halliwell, J., Heaney, J., & Sawicki, J. (1999). Size and book to market effects in
Australian share markets: A time series analysis. Accounting Research Journal,
12, 122–137.
Hanauer, M. X., & Linhart, M. (2015). Size, value, and momentum in emerging
market stock returns: International or segment pricing? Asia-Pacific Journal of
Financial Studies, 44(2), 175–214.
Hansson, B. (2004). Human capital and stock returns: Is the value premium an
approximation for return on human capital? Journal of Business Finance &
Accounting, 31(3–4), 333–358.
Harvey, C. R. (2004). Country risk components, the cost of capital, and returns in
emerging markets. In S. Wilkin (Ed.), Country and political risk: Practical
insights for global finance (pp. 71–102). London: Risk Books. Retrieved
September 21, 2015, from SSRN: http://ssrn.com/abstract=620710 or
http://dx.doi.org/10.2139/ssrn.620710
Hirschey, M. (2000). The Dogs of the Dow myth. Financial Review, 35, 1–15.
Hirshleifer, D., Lim, S. S., & Teoh, S. H. (2009). Driven to distraction: Extraneous
events and underreaction to earnings news. Journal of Finance, 64, 2289–2325.
Hou, K., Karolyi, G. A., & Kho, B. C. (2011). What factors drive global stock
returns? Review of Financial Studies, 24(8), 2527–2574.
Israel, R., & Moskowitz, T. J. (2013). The role of shorting, firm size, and time on
market anomalies. Journal of Financial Economics, 108(2), 275–301.
Jacobs, B. I., & Levy, K. N. (1988a). Disentangling equity return irregularities:
New insights and investment opportunities. Financial Analysts Journal, 44,
18–44.
Jacobs, B. I., & Levy, K. N. (1988b). On the value of “value”. Financial Analysts
Journal, 44, 47–62.
Jank, S. (2014). Specialized human capital, unemployment risk, and the value pre-
mium. Working paper. Retrieved October 15, 2015, from SSRN: http://ssrn.
com/abstract=2526119 or http://dx.doi.org/10.2139/ssrn.2526119
Janssen, L. (2014). The effect of credit risk on stock returns. Retrieved October 15,
2015, from http://arno.uvt.nl/show.cgi?fid=135567
Jegadeesh, N., Kim, J., Krische, S., & Lee, C. M. C. (2004). Analyzing the ana-
lysts: When do recommendations add value? Journal of Finance, 59(3),
1083–1124.
Jensen, G. R., Johnson, R. R., & Mercer, J. M. (1998). The inconsistency of
small-firm and value stock premiums. Journal of Portfolio Management, 24(2),
27–36.
Kang, C. O., & Kang, H. G. (2009). The effect of credit risk on stock returns.
Journal of Economic Research, 14, 49–67.
Kayaçetin, N. V., & Güner, Z. N. (2007). A note on the cross-section of stock
returns on the Istanbul Stock Exchange. Bogazici Journal of Economics and
Administrative Sciences, 21, 93–105.
Kim, Y. G., Chung, K. H., & Pyun, C. S. (1992). Size, price-earnings ratio and
seasonal anomalies in the Korean stock market. In S. G. Rhee & R. P. Chang
(Eds.), Pacific-Basin Capital Markets Research. Amsterdam: North Holland.
Kimlyk, T. (2014). Cash flow indicators as predictors of publicly listed companies’
market value. A thesis presented to the Faculty of ISM University of
Management and Economics in Partial Fulfillment of the Requirements for the
Degree of Master of Financial Economics .Retrieved October 9, 2015, from
http://archive.ism.lt/bitstream/handle/1/385/ETD2014-51_Tatjana%20
Kimlyk_MD.pdf
Knowles, H. C., & Petty, D. (1992). The dividend investor: A safe and sure way to
beat the market with high-yield dividend stocks. Chicago: Irwin Professional
Publishing.
Kothari, S. P., Shanken, J., & Sloan, R. (1995). Another look at the cross-section
of expected stock returns. Journal of Finance, 50(1), 185–224.
Kottkamp, S., & Otte, M. (2001). Die langfristige performance von DAX-
dividendenstrategien. Kredit und Kapital, 3, 393–417.
La Porta, R. (1996). Expectations and the cross-section of stock returns. Journal
of Finance, 51(5), 1715–1742.
La Porta, R., Lakonishok, J., Shleifer, A., & Vishny, R. (1997). Good news for
value stocks: Further evidence on market efficiency. Journal of Finance, 52(2),
859–874.
Lakonishok, J., Schleifer, A., & Vishny, R. W. (1994). Contrarian investment,
extrapolation, and risk. Journal of Finance, 49(5), 1541–1578.
Lam, K. S. K. (2002). The relationship between size, book-to-market equity ratio,
earnings-price ratio, and return for the Hong Kong stock market. Global
Finance Journal, 13, 163–179.
Lamont, O. (1998). Earnings and expected returns. Journal of Finance, 53,
1563–1587.
Leibowitz, M. L. (1997). Sales driven franchise value. Charlottesvile, VA: The
Research Foundation of the Institute of Chartered Financial Analysis.
Levis, M. (1989). Market size, PE ratios, dividend yield and share prices: The UK
evidence. A Reappraisal of the Efficiency of Financial Markets, 54, 165–196.
Lewellen, J. (2004). Predicting returns with financial ratios. Journal of Financial
Economics, 74, 209–235.
Lewellen, J. (2015). The cross section of expected stock returns. Critical Finance
Review, 4, 1–44.
Ling, C. F., & Koo, S. G. M. (2012). On value premium, Part II: The explana-
tions. Journal of Mathematical Finance, 2, 66–74.
Livnat, J., & Mendenhall, R. R. (2006). Comparing the post-earnings announce-
ment drift for surprises calculated from analyst and time series forecasts. Journal
of Accounting Research, 44, 177–2005.
Lo, A. W., & MacKinlay, A. C. (1990). Data-snooping biases in tests of financial
asset pricing models. Review of FInancial Studies, 3(3), 431–467.
Lyn, E. O., & Zyowicsch, E. G. (2004). Predicting stock returns in the developing
markets of Eastern Europe. Journal of Investing, 13(2), 63–71.
Ma, T., & Chow, T. Y. (1990). The relationships between market value, PE ratio,
trading volume and the stock return of Taiwan Stock Exchange. In S. G. Rhee
& R. P. Chang (Eds.), Pacific-Basin capital markets research. Amsterdam:
North Holland.
Maio, P., & Santa-Clara, P. (2015). Dividend yields, dividend growth, and return
predictability in the cross-section of stocks. Journal of Financial and
Quantitative Analysis, 50(1–2), 33–60.
McLean, D. R., & Pontiff, J. (2016). Does academic research destroy stock return
predictability? Journal of Finance, 71(1), 5–32.
McQueen, G., Shields, K., & Thorley, S. R. (1997). Does the Dow-10 investment
strategy beat the Dow statistically and economically? Financial Analyst Journal,
53(4), 66–72.
Mei, J. (1992). Explaining the cross-section of returns via a multi-factor APT
model. Journal of Financial and Quantitative Analysis, 28(3), 331–345.
Michaely, R., Thaler, R. H., & Womack, K. L. (1995). Price reactions to dividend
initiations and omissions: Overreaction or drift. Journal of Finance, 50,
563–608.
Nicholson, F. (1960). Equilibrium in capital asset market. Econometrica, 34,
768–783.
Nilsson, E. (2011). Empirisk studie av investeringsstrategin Dogs of the Dow på den
tyska aktiemarknaden. Lund University, Master Thesis in Economics. Retrieved
October 10, 2015, from http://lup.lub.lu.se/luur/download?func=download
File&recordOId=2224656&fileOId=2224660
O’Higgins, M., & Downes, J. (1991). Beating the Dow. New York: Harper Collins.
Ozdagli, A. K. (2012). Financial leverage, corporate investment, and stock returns.
Pätäri, E., & Leivo, T. (2009). Performance of the value strategies in the Finnish
stock markets. Journal of Money, Investment and Banking, 8, 5–24.
Patel, S. (1998). Cross-sectional variation in emerging markets equity returns:
January 1988-March 1997. Emerging Markets Quarterly, 2, 57–70.
Phalippou, L. (2004). What drives the value premium. INSEAD working paper.
Retrieved October 13, 2015, from http://www3.nd.edu/~pschultz/
Phalippou.pdf
Piotroski, J. D. (2000). Value investing: The use of historical financial statement
information to separate winners from losers. Journal of Accounting Research,
38, 1–52.
Polk, C., Thompson, S., & Vuolteenaho, T. (2006). Cross-sectional forecasts of
the equity premium. Journal of Financial Economics, 81, 101–141.
Rinne, E., & Vähämaa, S. (2001). The ‘Dogs of the Dow’ strategy revisited:
Finnish evidence. European Journal of Finance, 17(5–6), 451–469.
Rouwenhorst, G. K. (1999). Local return factors and turnover in emerging stock
Santos, T., & Veronesi, P. (2006). Labor income and predictable stock returns.
Review of Financial Studies, 19(1), 1–44.
Senchack Jr., A. J., & Martin, J. D. (1987). The relative performance of the psr
and per investment strategies. Financial Analysts Journal, 43, 46–56.
Serra, A. P. (2003). The cross-sectional determinants of returns: Evidence from
emerging markets’ stocks. Journal of Emerging Market Finance, 2, 123–162.
Shleifer, A., & Vishny, R. W. (1997). The limits of arbitrage. Journal of Finance,
52(1), 35–55.
Shon, J., & Zhou, P. (2010). Do divergent opinions explain the value premium?
Journal of Investing, 19(2), 53–62.
Smit, H., & van Vliet, P. (2002). Growth options and the value-size puzzle. Working
paper. Retrieved October 12, 2015, from http://www.realoptions.org/
papers2002/VlietSmit.pdf
Soomro, N., & Haroon, M. A. (2015). Comparison of Dog’s of the Dow Strategy.
Universal Journal of Management, 3(3), 127–130.
Strong, N., & Xu, X. G. (1997). Explaining the cross-section of UK expected
stock returns. British Accounting Review, 29(1), 1–23.
Sylvain, S. (2014). Does human capital risk explain the value premium puzzle?
Working paper. Retrieved October 15, 2015, from SSRN: http://ssrn.com/
Szyszka, A. (2013). Behavioral finance and capital markets: How psychology influ-
ences investors and corporation. New York: Palgrave Macmillan.
Toniato, J., Lee, K., & Jose, D. (2013). Value for money. Barclays Equity Valuation
Academy. Retrieved October 11, 2015, from http://www.adamsoderlund.
com/wp-content/uploads/2014/01/Barcap-ValueInvesting-may13.pdf
van der Hart, J., Slagter, J., & van Dijk, D. (2003). Stock selection strategies in
emerging markets. Journal of Empirical Finance, 10, 105–132.
Visscher, S., & Filbeck, G. (2003). Dividend-yield strategies in the Canadian stock
market. Financial Analyst Journal, 59(1), 99–106.
Vos, E., & Pepper, B. (1997). The size and book to market effects in New Zealand.
New Zealand Investment Analysis, 18, 35–45.
Vruwink, D. R., Quirin, J. J., & O’Bryan, D. (2007). A modified price-sales ratio:
A useful tool for investors? Journal of Business & Economics Research, 5(12),
31–40.
Wang, C., Larsen, J. E., Ainina, M. F., Akhbari, M. L., & Gressis, N. (2011). The
Dogs of the Dow in China. International Journal of Business and Social Science,
2(18), 70–80.
Waszczuk, A. (2013). A risk-based explanation of return patterns—Evidence from
the Polish stock market. Emerging Markets Review, 15, 186–210.
Wolf, M. (2000). Stock returns and dividend yields revisited: A new way to look at
an old problem. Journal of Business and Economic Statistics, 18(1), 18–30.
Wong, K. A., & Lye, M. S. (1990). Market value, earnings yields and stock returns.
Journal of Banking and Finance, 14, 311–326.
Zaremba, A. (2015a). Investor sentiment, limits on arbitrage, and the perfor-
mance of cross-country market anomalies. Journal of Behavioral and
Experimental Finance, forthcoming.
Zaremba, A. (2015b). Value, size, momentum, and unique role of microcaps in
CEE market stock returns. Eastern European Economics, 53(3), 221–241.
Zaremba, A. (2015c). Country risk and asset allocation across global equity markets.
Unpublished working paper.
Zaremba, A., & Konieczka, P. (2015). Do quantitative country selection strategies
really work? Jounal of Investment Strategies, 5(2), 1–33.
CHAPTER 3
Trend Is Your Friend: Momentum Investing
Momentum investing is well-poised to be the holy grail of the financial

markets––the ideal investment strategy for any investor. It combines the
two most desirable traits of investment strategies: robustness and sim-
plicity. On the one hand, the evidence for momentum is probably more
pervasive and timeless than for any other investment technique. On the
other hand, its implementation is astonishingly straightforward, requir-
ing neither complex data nor sophisticated skills. All these traits make the
momentum strategy accessible to virtually any investor in the financial
markets.
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.

DOI 10.1057/978-1-137-59191-3_3
The first type is relative momentum, or simply momentum—a clas-

sic strategy most frequently attributed to Jegadeesh and Titman (1993).
Under this strategy, past performance of a given security is evaluated in
relation to the performance of other securities in the market. In other
words, the strategy favors stocks with the highest past returns over the
companies with the lowest track record. In their seminal paper, Jegadeesh
and Titman (1993) showed that over the span of 3–12 months the win-
ners tend to outperform the losers.
Another category: time series momentum, sometimes also called abso-
lute momentum, has been attracting particular interest in recent years,
most likely sparked by the groundbreaking study of Moskowitz et al.
(2012) entitled “Time series momentum”. Contrary to relative momen-
tum, time series momentum measures directly the price change relative to
its past values, largely ignoring the performance of other assets. In prac-
tice, the indicators used for relative momentum may vary. For example,
Moskowitz et al. (2012) examined rules that generated a buy signal when
the price outperformed its historical, say, 200-day record. On the other
hand, Antonacci (2013, 2015) checked whether the excess return in a past
period was either positive or negative, hinging all trading rules upon this
observation. All time series momentum strategies in their construction
closely correspond with various technical analysis tools based on similar
underlying intuition. For example, the strategies formed upon moving
averages can be considered a strain of time series momentum techniques as
these two approaches are empirically and theoretically closely intertwined.
In fact, as argued by Levine and Pedersen (2016) they are equivalent rep-
resentations in their most general forms, also capturing many other types
of technical indicators.
Although both types of momentum strategies follow similar underly-
ing economic intuition, their behavior is far from identical. In practice,
to improve the risk-return profile they could be applied simultaneously
(Antonacci 2015).
DOES MOMENTUM WORK?

The evidence on momentum is abundant, including both academic
and anecdotal proof.1 The latter could be traced back to David Ricardo
(Antonacci 2015), the respected classical economist who probably coined
the famous adage: “Cut your profits, let your profits run”, laying the
TREND IS YOUR FRIEND: MOMENTUM INVESTING 41
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
trend-following system based on 5-day and 20-day moving averages. This

work inspired legendary traders Richard Dennis and Ed Seykota to train a
group of investors, called later Turtle Traders. Many of them later became
extremely successful commodity trading advisors with Seykota alone men-
toring, among others, Michael Marcus and David Druz.2
While the anecdotal evidence is very compelling, it should not put away
investors’ demand for rigid scientific evidence. The first computer-based
study was probably conducted by Levy in 1967, who coined the phrase
“relative strength” that was later renamed by academics “momentum”.
Although Levy’s initial study falls short of any contemporary academic
standards, as it covered only 625 stocks, and ignored transaction costs and
risk factors, the conclusion was clear: top stock market performers yielded
significantly higher returns over the following six months than any mar-
ket laggards.3 The spread between the top and bottom deciles amounted
to 6.7 percentage points. The next years confirmed the results even hav-
ing accounted for transaction costs and within slightly different samples,
engulfing various American industry groups (as researched by Akermann
and Keller (1977), Bohan (1981), Brush and Bowles (1983)).
Despite this early evidence, the true interest in momentum didn’t pro-
liferate among academics until the 1990s when the arrival of behavioral
finance offered a coherent and logical explanation for the momentum
phenomenon. The groundbreaking work on momentum was the publi-
cation of “Returns to buying winners and selling losers: Implications for
stock market efficiency” by Narasimhan Jegadeesh and Sheridan Titman in
1993. Even today, this is probably the most often cited work on momen-
tum ever written. Jegadeesh and Titman (1993) employed a rule-based
approach, which relied on buying (selling) a quantile of stocks that deliv-
ered the highest (lowest) returns in the past and holding it for a period
of time. The authors examined data from NYSE and AMEX for the years
1965–1989 and discovered that the stocks winning over the previous 6–12
months continue to outperform the losing stocks on a risk-adjusted basis
by about 1 % monthly over the following 6–12 months. A decade later,
Jegadeesh and Titman (2001) replicated their study to examine whether
the momentum persisted. In the 1990–1998 period past winners still dis-
played the same outperformance over losers.
The discoveries of Jegadeesh and Titman triggered an extraordinary
proliferation of momentum studies. The momentum phenomenon is cur-
rently probably the most intensively researched topic in finance. The Nobel
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
Table 3.1 Studies of momentum in international stock markets

Paper Research period Number of examined countries
Griffin et al. (2003) 1926–2000 39

Chui et al. (2010) 1980–2003 55
Park and Kim (2013) 1990–2010 14
Fan et al. (2015) 1989–2009 43
Li and Wei (2015) 1988–2013 36
Schmidt et al. (2015) 1986–2012 21
Note: Own elaboration
and demonstrated that momentum has been at work in the US equity

market since 1800. Given all the evidence, it is difficult to suspect that
momentum is merely a data-mining accident.
All this, however, is still only a part of the story. One of the most surpris-
ing momentum characteristics is the fact that it can be found within every
possible asset class. Apart from individual equities, convincing evidence
has been found across stocks in entire industries as well as in other asset
classes: treasury bonds, corporate bonds, commodities, currencies, real
estate, real estate investment trusts (REITs), and interest rates.4 Moreover,
the momentum effect has been identified not only within individual assets
but also throughout entire strategies and investment styles.5 It truly seems
to be a ubiquitous phenomenon.
Beside the direct evidence, the validity of momentum anomaly is also
indirectly supported by technical analysis. In fact, most of the technical
trading systems used by, for example, professional Commodity Trading
Advisors (Fung and Hsieh 1997; Lhabitant 2008) are based on trend-
following, a concept closely related to time-series momentum. Over the
last decades profitability of the technical analysis has been explored in
numerous papers. Let’s take a closer look at one such study—the research
of Lukac et al. from 1988. The authors examined an array of trading sys-
tems, including the so-called price channels, moving averages, oscillators,
filters, stop-loss orders, and the combinations of the above strategies where
most of them stemmed from the trend-following philosophy. The authors
took good care of the robustness of their results, taking into account vari-
ous levels of transaction costs and optimization methods, applying their
trading systems in various commodity markets and adjusting the resulting
returns for risk. Finally, 7 of the 12 systems proved to provide significant
and positive abnormal returns. In other words, the validity of technical
analysis was, at least partly, confirmed.
Today, the examinations made by Lukac et al. (1988) may appear
relatively simple, as later studies have markedly gained in sophistication.
In 2005, for example, Roberts (2005) used a fairly complicated genetic
algorithm to test the performance of 20,000 random investment rules.
In a recent study, Park and Irwin (2007) made a Herculean effort and
reviewed 95 various studies of technical analysis classifying them as “early”
and “modern” studies according to quality characteristics of the testing
procedures. The “early” studies proved technical trading strategies prof-
itable in both foreign exchange markets and futures markets but not in
stock markets. The “modern” studies, on the other hand, showed that
technical trading strategies generate consistent economic profits in a vari-

ety of speculative markets. Among all the studies reviewed by Park and
Irwin, 59 % yielded positive results of technical trading strategies, 20 %
proved negative while 19 % of the studies produced mixed results.
WHY DOES MOMENTUM WORK?

While technical analysis has been always very appealing to investors, the
academic community has been rather reserved, which probably resulted
from two key issues (Irwin and Park 2008). Firstly, the formal research
attempts to verify the usefulness of technical trading strategies were not
particularly successful.6 Secondly, the profitability of the technical analysis
stood in stark opposition to the efficient market hypothesis (EMH), which
largely dominated the thinking in the 1960s and 1970s. The term EMH
was coined by Harry Roberts (1967), who made the distinction between a
weak and a strong form of efficiency, which later became the classic taxon-
omy in Fama’s research (1970). The EMH assumes that when the market
is informationally efficient, then the prices always fully reflect all the avail-
able information—particularly, if the market is efficient in the weak form,
then all the information on past prices are discounted. Why? Because if
thousands of investors make their best efforts to exploit technical oppor-
tunities, then any possible profits quickly dry up. In other words, there is
no place for any abnormal returns to be generated by technical analysis.
As Samuelson (1965, p. 44) concluded in one of his studies: “[…] There
is no way of making an expected profit by extrapolating past changes in
the future price, by chart or any other esoteric devices of magic or math-
ematics. The market quotation […] already contains in itself all that can
be known about the future and in that sense has discounted future con-
tingencies as much as it is humanly possible.” How firmly the community
believed in the EMH is well expressed in another quote by Michael Jensen
(1978) who famously wrote “I believe there is no other proposition in
economics which has more solid empirical evidence supporting it than the
Efficient Market Hypothesis”.
Despite the very categorical and rigid approach implied by the EMH,
some later models were slightly more generous towards the technical
analysis. Specifically, Grossman and Stiglitz (1976, 1980) have found an
intriguing paradox in reasoning that if markets are truly efficient, investors
have no incentive to either perform any analyses or implement any strate-
gies in particular, associated with costs relating to time and money. In a
nutshell, some investors may deliberately choose not to invest based on a

technical analysis, because they do not want to put their time and money
into something that simply does not work in efficient markets. In other
words, these so-called noise traders do not fully use the information on the
past prices from the markets, creating thus opportunities for someone who
does! The higher the costs of examining and implementing investment
strategies, the more investors intentionally restrain from using technical
tools, making thus these strategies more effective. To sum up, there is
some hope for trend following.7
At that point, further explanations of the momentum phenomenon
were quick to follow. As a result, calling momentum an anomaly seemed
legitimate two or three decades ago, but now such a statement could ring
a little insolent. Although the jury on the sources of momentum is still
out, the academic literature offers a number of reasonable explanations.
As in many cases, the key opposite camps in this dispute are the supporters
of either neoclassical (rational) or behavioral finance.
The risk-based explanations of momentum were brought to life by
Conrad and Kaul (1998), who saw the momentum source in the cross-
sectional variation in expected returns on individual securities. In other
words, some companies simply systematically deliver higher returns than
others. If we put the outperforming companies in our portfolio, it is likely
to continue to outperform in the future, as it comprises outperforming
stocks. Plain and simple. Unfortunately, later studies refuted this theory
and clearly indicated that momentum is driven by rotating companies
and new stocks systematically entering the winners and losers portfolios
(Jegadeesh and Titman 2001; Grundy and Martin 2001).
A number of studies argue that momentum profits may also be asso-
ciated with some countrywide risk factors, related for instance to mac-
roeconomy or liquidity fluctuations. These factors include business cycle
(Chordia and Shivakumar 2002), economic growth shocks (Ahn et al.
2003), aggregate liquidity (Pastor and Stambaugh 2003), consumption
(Bansal et al. 2005), and industrial production (Liu and Zhang 2008).
Furthermore, a paper by Sagi and Seasholes (2007) has linked momentum
profits with firm-specific characteristics, like revenue volatility or costs of
goods sold. Nonetheless, these concepts seem at least partly controversial.
On the one hand, they are challenged by contradictory evidence (e.g.,
Griffin et al. (2003), Avramov and Chordia (2006)); on the other hand,
when examining a large number of factors, the pitfalls of overfitting bias
and data mining create a significant risk. In effect, behavioral advocates

seem to be winning the argument.
Behavioral explanations attribute momentum to a series of psychologi-
cal biases and frictions that affect the market price and lead to a situation
in which a trend in the market substitute an immediate adjustment to the
new information. To better explain this concept, let’s take a look at the
example depicted in Fig. 3.1.8
Let’s assume that an unexpected positive information surprises the mar-
ket. An earnings report exceeded analysts’ estimates or a newly launched
product proved successful. How should investors react in the ideally effi-
cient world? They should immediately recalculate the valuation of the
company and start trading at the new level. On the one hand, no one
would be ready to sell the stocks at the previous price, as the company is
worth more; on the other hand, the buyers would accept a higher price for
the same reason. In other words, the price would be immediately adjusted
to the new information and subsequently would remain relatively stable
until the arrival of the next shocking information.
In the real world, however, with human investors affected by a number
of behavioral biases, the situation may look quite different. Firstly, inves-
tors are likely to underreact to new information. Thus we see more of a
trend-like price movement instead of an instant price increase. This under-
reaction stems from two key tendencies.
Anchoring. The term “anchoring” refers to a psychological bias in
which investors (and other individuals) stick to some arbitrary reference
point or initial value. An excellent example of this bias was presented by
3. The trend continues
Market price
Intrinsic value
4. The trend ends
2. The trend begins

1. New infomation arrives.
Fig. 3.1 Life cycle of a trend

Source: Own elaboration
Kahneman and Tversky in their article of 1974. In their experiment the

authors spun a wheel containing numbers from 1 to 100, asking the sub-
jects to estimate the percentage of African countries in the United Nations.
Unsurprisingly, not many participants knew the answer. Their guesses,
however, strangely correlated with the random numbers prompted by the
wheel. If the wheel landed on 10, the average estimate given by the par-
ticipants was 25 %. If the number was 60, the mean estimate increased to
45 %. The subjects unconsciously “anchored” their answer to a random
number, even if it in no way related to the question.
The anchoring effect isn’t merely an experimental curiosity. It impacts
real decisions in various markets. In another study, real estate agents were
asked to estimate the value of a certain property placed on the market
(Northcraft and Neale 1987). All the agents were given identical informa-
tion with the only exception of a listing price which ranged from $119,900
to $149,900. While the real estate agents denied their valuations to be
influenced by the listing price, the outcomes were evident. In the cases
where the listing price was $119,900, the mean appraisal value equaled
$116,833; while with the higher listing price of $149,900, the average
appraisal value surged to $144,454.
Analogously, the anchoring effect may affect stock market investors. If
the investors stick to the past price without any reasonable justification, in
consequence the price may underreact to any new information.9
Disposition effect. Although the fundamental piece of advice for every
trader employing trend following strategies teaches to “cut your losses and
let your profits run”, most investors find it hard to follow. In practice, they
tend to sell appreciating stocks too early and hold on to losing stocks for
too long, as they prefer cashing in gains to owning up to losses.
This so-called disposition effects is one of the best documented phe-
nomena of behavioral finance. In 1998 Odean analyzed transactions from
10,000 accounts of one US discount broker in the 1987–1993 period,
particularly examining the investors’ behavior following the appreciation
depreciation of the stock prices within their portfolios. As he found, inves-
tors were roughly 50 % more likely to sell stocks after gains than after
losses. The disposition effect impacts all types of stock market investors:
households, corporations, government institutions, non-profit organi-
zations, and even the sophisticated financial institutions (Grinblatt and
Keloharju 2000a). Furthermore, the differences in magnitude of the dis-
position effect between households and professionals are astonishingly
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
any contradictory evidence. As a result, the perception of the company in

the investor’s mind may be significantly biased.12
Indeed, according to the academic evidence, investors do tend to be
affected by the confirmation bias (Wason 1960; Tversky and Kahneman
1974) and the effect is further amplified by the impact of representative-
ness, a heuristic generating an array of biases. One of them—base rate
neglect—is skillfully encapsulated by Tversky and Kahneman (1974) in the
following description of Linda.
“Linda is 31 years old, single, outspoken, and very bright. She majored
in philosophy. As a student, she was deeply concerned with issues of dis-
crimination and social justice, and also participated in anti-nuclear demon-
strations” (Tversky and Kahneman 1974).
Most participants when asked about the probability of “Linda being a
bank teller” or “Linda being a bank teller and active in the feminist move-
ment” chose the latter statement. Even though the second statement is
clearly less probable as the population of bank tellers who are simulta-
neously feminist activists belongs to the broader population of the bank
tellers.
Another manifestation of the representativeness heuristic is a bias called
sample size neglect. People usually fail to properly account for the sam-
ple size when trying to evaluate a probability of some future event. This
can generate the so-called “hot hand” phenomenon, whereby sports fans
believe that a basketball player who has made three shots in a row is on
a hot streak and, therefore, he will score again. In practice, there is no
evidence in the data to support the hot hand phenomenon (Gilovich et al.
1985). The small size neglect may equally lead stock market investors to
see a trend when it does not really exist.13
Summing up, market participants seek out information confirming
their existing beliefs, and can often perceive past price appreciation as rep-
resentative of future price movements. As a result, they would eagerly
invest additional money into stocks that had risen, while withdrawing
capital from companies that had just fallen. Both situations may reinforce
the trend, eventually leading to overvaluation (Daniel et al. 1998; Barberis
et al. 1998).
Finally, all of the biases and heuristics described above lead to overvalu-
ation. In consequence, the overvalued stock will subsequently underper-
form, moving back to its intrinsic value resulting in a long-term reversal,
which leads to systematical poor performance of the companies that per-
formed very well in the past few years.14
Although the tensions between behavioral and risk-based explanations

of the momentum phenomenon dominate the current academic discussion,
there are also other attempts to explain it. For instance, a separate set of mod-
els focuses on the market microstructure, like the flow of orders (Osler 2000).
The stop-loss and take-profit orders tend to concentrate on the market tops
and bottoms, and round price numbers. Thus, their simultaneous activation
may result in either a significant increase or decrease in prices, becoming a self-
fulfilling prophesy of the momentum in the market. These price fluctuations
may justify the profitability of, for example, short-term breakout systems.
Furthermore, some authors also point out that various institutions
may contribute to the trend formation. For example, Silber (1994) partly
blames central banks, which, being focused on their own goals, may
sometimes hinder an immediate and full discounting of the fundamental
information on the currency exchange markets, leading thus to the trend
formation of trends. Meanwhile, Garleanu and Pedersen (2007) see one
of the causes of trend formation in risk management practices of finan-
cial institutions where most of the risk measures are backward-looking.
Consequently, if there is a sharp decline in security prices, the rising risk
indicators may force the financial institution to sell a part of these securi-
ties, leading to further price declines.
Although other theories include for instance the chaos theory (Clyde
and Osler 1997), they are much less discussed.
Although the discussion on the sources of momentum still continues,
the academic community is now light years away from the time when the
EMH dominated the minds of researchers and market practitioners. Today,
momentum is not only well-documented empirically but also attempted
to be fully explained. It appears to be a healthy and reliable return pattern
based on solid fundaments, both in theoretical and empirical terms.15
IMPROVING MOMENTUM STRATEGIES

Basic relative momentum strategies advocate sorting stocks against their
past performance. As always though, the devil is in the detail as even the
most basic momentum technique could be approached in multiple ways
impacting momentum. Let’s take a closer look at the momentum forma-
tion approaches.
Classical. The standard momentum strategy might be derived from the
seminal paper of Jegadeesh and Titman (1993). The authors sorted stocks
on raw past returns of 3–12 months and proved that stocks with high past
returns tended to outperform in the future.
Improving return measurement methods. One line of improvement

to the relative momentum strategies is optimizing the past return mea-
surement period. Perhaps the most common approach is to sort stocks on
their 12-month performance skipping the most recent month (cumulative
return in months t-12 to t-2). The reasons to use this method are three-
fold. First, stock prices tend to exhibit a short-term reversal effect, i.e. the
price movements over the very recent period, for example a month, tend
to partly revert in the next month (Lehmann 1990; Jegadeesh 1990; Da
et al. 2014a). Skipping the last month allows for disentanglement of this
effect from momentum. Second, the momentum efficiency varies when
different sorting periods are used. Historically, the 12-month period has
proved appropriate. The third issue is related to the seasonal anoma-
lies in the stock market, specifically to the so-called January effect. The
January effect is a calendar anomaly implying that small-cap stock deliv-
ers especially strong returns in January (Keim 1983a, b). Academically,
the anomaly has been well-investigated and repeatedly documented.
This effect is most commonly explained by behavior of individual inves-
tors who remain income tax-sensitive and hold disproportionately big-
ger number of small stocks, making them prone to selling stocks for tax
reasons at year end and reinvesting during the first month of the year.16
What is then the role of the January effect? It implies that different types
of stocks have different expected returns in different months. Thus, if the
sorting period is shorter than a full calendar year, the resulting selection
of stocks will be a consequence of the particular months included within
this period. If the period included January, the selection would gravitate
to small stocks while otherwise it would lean towards large companies. A
simple way to overcome this problem is to include a full calendar year in
the ranking period.
Another variation of momentum was introduced by Novy-Marx
(2012a), who proposed the so-called “intermediate momentum”, relying
on sorting on a 6-month return lagged six months (i.e. months t-12 to
t-6). This approach, sometimes also called the “echo”, turned out to be a
powerful predictor of returns.
Finally, we should also consider the volatility of returns. Relatively often,
very volatile stocks fall into the category of either past winners or past los-
ers, simply due to chance or levered volatility. A simple way to overcome
this issue is to divide the past cumulative returns by their standard devia-
tion. This simple tweak allows for the improvement the performance of
the momentum strategy (Ilmanen 2011).
Seeking for inefficiencies. The behavioral finance approach to

momentum, in general, implies it is driven by psychological biases which
cannot be easily arbitraged away. Thus, momentum should appear the
strongest in the market segments comparably less efficient. This supposi-
tion was confirmed by a number of papers adopting different approaches.
The remaining question is how to identify the less efficient markets and
market segments. The basic method adopted in financial studies is first
to sort stocks initially on some characteristic that could be a proxy of
levered market inefficiency, and subsequently to run the momentum
strategy among the less efficient securities. The additional sorting met-
ric can include company capitalization (as momentum appears stronger
among small companies), age (as it is stronger among young companies),
book-to-market ratio (stronger among “value” companies), credit rating
(stronger among firms with low credit rating), analysts coverage (stronger
among the companies not followed by analysts), idiosyncratic risk (stron-
ger among volatile firms), and mutual fund ownership (stronger among
firms with large changes in mutual fund ownership).17 For all these charac-
teristics, the more neglected the company, the higher momentum profits.18
Nonetheless, investors should be very cautious when implementing such
optimized strategies as momentum’s behavior may sometimes be counter-
intuitive. For instance, Lee and Swaminathan (2000) found momentum
stronger among liquid companies, i.e. firms with a high turnover ratio.
Combining trend following signals. The relative momentum is only
one of many popular strategies related to trend following. Other examples
include absolute momentum and breakout strategies. Interestingly, com-
bining them can visibly enhance the strength of momentum signals. For
example, George and Hwang (2004) examined a simple strategy of buying
securities approaching their 52-week high. Mixing this strategy with stan-
dard momentum can have a positive influence on its performance. Some
alternative improvements may include focusing of firms showing more
extreme returns in the formation period (Bandarchuk and Hilscher 2013),
more consistent returns in the formation period (Grinblatt and Moskowitz
2004), or directly enhancing the strategy with absolute momentum.
***
Beside value, momentum is another very powerful concept. It is theoretically
well-motivated and strongly supported by plenty of evidence. Moreover, it
could be potentially furthered to better exploit it potential. Summing up, it
seems to be an ideal candidate for equity country selection strategy.
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).
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.
REFERENCES
Accominotti, O., & Chambers, D. (2014). Out-of-sample evidence on the returns
to currency trading. Retrieved October 21, 2015, from SSRN: http://ssrn.
com/abstract=2293684
Ahn, D.-H., Conrad, J., & Dittmar, R. (2003). Risk adjustment and trading strat-
egies. Review of Financial Studies, 16(2), 459–485.
Akermann, C. A., & Keller, W. E. (1977). Relative strength does persist! Journal
of Portfolio Management, 4(1), 38–45.
Alwathainani, A. M. (2012). Consistent winners and losers. International Review
of Economics and Finance, 21, 210–220.
Amen, S. (2013). Beta’em up: What is market beta in FX? Retrieved October 21,
org/10.2139/ssrn.2439854
Andreu, L., Swinkels, L., & Tjong-A-Tjoe, L. (2013). Can exchange traded funds
be used to exploit industry and country momentum? Financial Markets and
Antonacci, G. (2013). Absolute momentum: A simple rule-based strategy and uni-
versal trend-following overlay. Research paper. Retrieved October 18, 2015,
from SSRN: http://ssrn.com/abstract=2244633 or http://dx.doi.
org/10.2139/ssrn.2244633
Antonacci, G. (2015). Dual momentum investing: An innovative strategy for higher
returns with lower risk. New York: McGraw Hill Education.
Asness, C. S. (1997). The interaction of value and momentum strategies. Financial
Analysts Journal, 61, 29–36.
Avramov, D., & Chordia, T. (2006). Asset pricing models and financial market
anomalies. Review of Financial Studies, 19(3), 1001–1040.
Avramov, D., Chordia, T., Jostova, G., & Philipov, A. (2007). Momentum and
credit rating. Journal of Finance, 62, 2503–2520.
Bae, J. W., & Elkamhi, R. (2015). Global equity correlation in FX carry and
momentum trades. Retrieved October 21, 2015, from SSRN: http://ssrn.
Bandarchuk, P., & Hilscher, J. (2013). Sources of momentum profits: Evidence on
the irrelevance of characteristics. Review of Finance, 17, 809–845.
Bange, M. M. (2000). Do the portfolios of small investors reflect positive feedback
trading? Journal of Financial and Quantitative Analysis, 35, 239–255.
Bansal, R., Dittmar, R. F., & Lundblad, C. T. (2005). Consumption, dividends,
and cross section of equity returns. Journal of Finance, 60(4), 1639–1672.
Barber, B. M., & Odean, T. (2000). Trading is hazardous to your wealth: The
common stock investment performance of individual investors. Journal of
Finance, 55(2), 773–806.
Barber, B. M., & Odean, T. (2004). Are individual investors tax savvy? Evidence
from retail and discount brokerage accounts. Journal of Public Economics,
88(1–2), 419–442.
Barberis, N., Shleifer, A., & Vishny, R. (1998). A model of investor sentiment.
Barberis, N., & Xiong, W. (2009). What drives the disposition effect? An analysis
of a long-standing preference-based explanation. Journal of Finance, 64(2),
751–784.
Beracha, E., & Skiba, H. (2011). Momentum in residential real estate. Journal of
Real Estate Finance and Economics, 43(3), 299–320.
Bianchi, R. J., Drew, M. E., & Polichronis, J. (2005). A test of momentum trading
strategies in foreign exchange markets: Evidence from the G7. Global Business
and Economic Review, 7(2/3), 155–179.
Bikhchandani, S., Hirshleifer, D., & Welch, I. (1992). A theory of fads, fashion,
custom, and cultural change as informational cascades. Journal of Political
Economy, 100(5), 992–1026.
Blitz, D. C., & van Vliet, P. (2008). Global tactical cross-asset allocation: Applying
value and momentum across asset classes. Journal of Portfolio Management,
35(1), 23–38.
Blume, L., Easley, D., & O’Hara, M. (1994). Market statistics and technical analy-
sis: The role of volume. Journal of Finance, 49, 153–181.
Bohan, J. (1981). Relative strength: Further positive evidence. Journal of Portfolio
Bowden, M. P. (2015). A model of information flows and confirmatory bias in
financial markets. Decisions in Economics and Finance, 38(2), 197–215.
Brown, D. P., & Jennings, R. H. (1989). On technical analysis. Review of Financial
Studies, 2, 527–551.
Brush, J. S., & Bowles, K. E. (1983). The predictive power in relative strength and
CAPM. Journal of Portfolio Management, 9(4), 20–23.
Burnside, A. C., Eichenbaum, M., & Rebelo, S. T. (2011). Carry trade and
momentum in currency markets. Annual Review of Financial Economics, 3,
511–535.
Chan, L. K. C., Jegadeesh, N., & Lakonishok, J. (2012). Momentum strategies.
Chen, H. S., & De Bondt, W. (2004). Style momentum within the S&P-500
index. Journal of Empirical Finance, 11, 483–507.
Chen, J., Hong, H., & Stein, J. C. (2002). Breadth of ownership and stock
returns. Journal of Financial Economics, 66, 171–205.
Chestnutt, G. A. (1961). Stock market analysis: Facts and principles. Larchmont:
American Investors Service.
Chordia, T., & Shivakumar, L. (2002). Momentum, business cycle, and time vary-
ing expected returns. Journal of Finance, 57(2), 985–1019.
Chui, A. C. W., Titman, S., & Wei, J. K. C. (2010). Individualism and momentum
around the world. Journal of Finance, 65(1), 361–392.
Clare, A., Sapuric, S., & Todorovic, N. (2010). Quantitative or momentum-based
multi-style rotation? UK experience. Journal of Asset Management, 10,
370–381.
Clyde, W. C., & Osler, C. L. (1997). Charting: Chaos theory in disguise? Journal
of Futures Markets, 17, 489–514.
Conrad, J., & Kaul, G. (1998). A anatomy of trading strategies. Review of Financial
Studies, 11(3), 489–519.
Covel, M. W. (2007). The complete turtle trader: How 23 novice investors became
overnight millionaires. New York: HarperCollins Publishers.
Covel, M. W. (2009). Trend following: Learn to make millions in up or down mar-
kets. London: FT Press.
Cowles III, A., & Jones, H. E. (1937). Some a posteriori probabilities in stock
market criteria. Econometrica, 5(3), 280–294.
Cutler, D. M., Poterba, J. M., & Summers, L. H. (1990). Speculative dynamics
and the role of feedback traders. American Economic Review, 80, 63–68.
Da, Z., Gurun, U., & Warachka, M. (2014a). Frog in the pan: Continuous infor-
mation and momentum. Review of Financial Studies, 27, 2171–2218.
Daniel, K., Hirshleifer, D., & Subrahmanyam, A. (1998). A theory of overconfi-
dence, selfattribution, and security market under- and over-reactions. Journal
of Finance, 53, 1839–1885.
Daniel, K., & Titman, S. (1999). Market efficiency in an irrational world. Financial
Analysts Journal, 55, 28–40.
Darvas, N. (1960). How I made $2,000,000 in the stock market. Larchmont:
American Research Council.
De Bondt, W. E. M. (1993). Betting on trends: Intuitive forecasts of financial risk
and return. International Journal of Forecasting, 9, 355–371.
De Bondt, W. F. M., & Thaler, R. (1985). Does the stock market overreact?
de Groot, W., Karstansje, D., & Zhou, W. (2014). Exploiting commodity momen-
tum along the futures curves. Journal of Banking & Finance, 48, 79–93.
796–818.
De Long, B. J., Shleifer, A., Summers, L. H., & Waldmann, R. J. (1990a). Noise
trader risk in financial markets. Journal of Political Economy, 98, 703–738.
De Long, J. B., Shleifer, A., Summers, L. H., & Waldmann, R. J. (1990b). Positive
feedback investment strategies and destabilizing rational speculation. Journal of
Finance, 45(2), 379–395.
Durham, J. B. (2013). Momentum and the term structure of interest rates. FRB of
New York Staff Report No. 657. Retrieved October 20, 2015, from SSRN: http://
Duyvesteyn, J., & Martens, M. (2014). Emerging government bond market tim-
ing. Journal of Fixed Income, 23(3), 36–49.
Easterday, K. E., Sen, P. K., & Stephan, J. A. (2009). The persistence of the small
firm/January effect: Is it consistent with investors’ learning and arbitrage
efforts? Quarterly Review of Economics and Finance, 49(3), 1172–1193.
Faber, M. T. (2010). Relative strength strategies for investing. Retrieved October
21, 2015, from SSRN: http://ssrn.com/abstract=1585517 or http://dx.doi.
org/10.2139/ssrn.1585517
Fama, E. F., & Blume, M. E. (1966). Filter rules and stock market trading. Journal
of Business, 39(1), 226–241.
Fama, E. F. (1970). Efficient capital markets: A review of theory and empirical
work. Journal of Finance, 25(2), 383–417.
Fama, E. F., & French, K. R. (2008). Dissecting anomalies. Journal of Finance,
63(4), 1653–1678.
Fan, S., Opsal, S., & Yu, L. (2015). Equity anomalies and idiosyncratic risk around
the world. Multinational Finance Journal, 19(1), 33–75.
Feng, Z., Price, S. M., & Sirmans, C. F. (2014). The relation between momentum
and drift: Industry-level evidence from equity Real Estate Investment Trusts
(REITs). Journal of Real Estate Research, 36(3), 407.
Filippou, I., Gozluklu, A. E., & Taylor, M. P. (2015). Global political risk and cur-
rency momentum. Retrieved October 21, 2015, from SSRN: http://ssrn.
Forsythe, R., Nelson, F., Neumann, G., & Wright, J. (1992). Anatomy of an
experimental stock market. American Economic Review, 82, 1142–1161.
Frazzini, A. (2006). The disposition effect and underreaction to news. Journal of
Finance, 61(4), 2017–2046.
Frieder, L. (2008). Investor and price response to patterns in earnings surprises.
Journal of Financial Markets, 11, 259–283.
Fuertes, A. M., Miffre, J., & Fernández-Pérez, A. (2015). Commodity strategies
based on momentum, term structure and idiosyncratic volatility. Journal of
Futures Markets, 35(3), 274–297.
Fuertes, A. M., Miffre, J., & Rallis, G. (2010). Tactical allocation in commodity
futures markets: combining momentum and term structure signals. Journal of
Fung, W., & Hsieh, D. A. (1997). Survivorship bias and investment style in the
returns of CTAs. Journal of Portfolio Management, 24(1), 30–41.
Garleanu, N., & Pedersen, L. H. (2007). Liquidity and risk management.
American Economic Review, 97, 193–197.
Gartley, H. M. (1935). Profits in the stock market. Pomeroy, WA: Lambert Gann
Publishing.
Gartley, H. M. (1945). Relative velocity statistics: Their application in portfolio
analysis. Financial Analyst Journal, 51(1), 18–20.
Gebhardt, W. R., Hvidkjaer, S., & Swaminathan, B. (2005). Stock and bond mar-
ket interaction: Does momentum spill over? Journal of Financial Economics,
75(3), 651–690.
Geczy, C., & Samonov, M. (2015). 215 Years of global multi-asset momentum:
1800-2014 (equities, sectors, currencies, bonds, commodities and stocks). Retrieved
October 20, 2015, from SSRN: http://ssrn.com/abstract=2607730 or
George, T. J., & Hwang, C.-Y. (2004). The 52-week high and momentum invest-
ing. Journal of Finance, 59, 2145–2176.
Gilovich, T., Vallone, R., & Tversky, A. (1985). The hot hand in basketball: On
the misperception of random sequences. Cognitive Psychology, 17, 295–314.
Goebel, P. R., Harrison, D. M., Mercer, J. M., & Whitby, R. J. (2012). REIT
momentum and characteristic-related REIT Returns. Journal of Real Estate
Finance and Economics, 47(3), 564–581.
Gorton, G. B., Hayashi, F., & Rouwenhorst, K. G. (2013). The fundamentals of
commodity futures returns. Review of Finance, 17, 35–105.
Graham, J. R. (1999). Herding among investment newsletters: Theory and evi-
dence. Journal of Finance, 54(1), 237–268.
Griffin, J. M., Ji, X., & Martin, S. J. (2003). Momentum investing and business
cycle risk: Evidence from pole to pole. Journal of Finance, 58(6), 2515–2547.
Griffin, J., Ji, X., & Martin, S. J. (2005). Global momentum strategies: A portfolio
perspective. Journal of Portfolio Management, 31(2), 23–39.
Grinblatt, M., & Moskowitz, T. M. (2004). Predicting stock price movements
from past returns: The role of consistency and tax-loss selling. Journal of
Financial Economics, 71, 541–579.
Grobys, K., Heinonen, J.-P., & Kolari, J. W. (2015). Is currency momentum driven
by global economic risk? Retrieved October 21, 2015, from SSRN: http://ssrn.
Grossman, S. J., & Stiglitz, J. E. (1976). Information and competitive price sys-
tems. American Economic Review, 66, 246–253.
Grossman, S. J., & Stiglitz, J. E. (1980). On the impossibility of informationally
efficient markets. American Economic Review, 70, 393–408.
Grundy, B. D., & Martin, J. S. (2001). Understanding the nature of the risks and
the sources of the rewards to momentum investing. Review of Financial Studies,
14(1), 29–78.
Haller, G. (1965). The Haller theory of stock market trends. West Palm Beach, FL:
Gilber Haller.
Hambusch, G., Hong, K. J., & Webster, E. (2015). Enhancing risk-adjusted
return using time series momentum in sovereign bonds. Journal of Fixed
Income, 25(1), 96–111.
Haug, M., & Hirschey, M. (2006). The January effect. Financial Analyst Journal,
62(5), 78–88.
Heisler, J. (1994). Loss aversion in a futures market: An empirical test. Review of
Hellwig, M. (1982). Rational expectations equilibrium with conditioning on past
prices: A mean-variance example. Journal of Economic Theory, 26, 279–312.
Hong, H., Lim, T., & Stein, J. C. (2000). Bad news travels slowly: Size, analyst
coverage, and the profitability of momentum strategies. Journal of Finance,
55(1), 265–295.
Hong, H., & Stein, J. (1999). A unified theory of underreaction, momentum
trading, and overreaction in asset markets. Journal of Finance, 54(6),
2143–2184.
Hung, K., & Glascock, J. L. (2010). Volatilities and momentum returns in real
estate investment trusts. InJournal of Real Estate Finance and Economics, 41(2).
Retrieved October 21, 2015, from: SSRN http://ssrn.com/abstract=1584716.
Hurst, B. K., Ooi, Y. H., & Pedersen, L. H. (2013). Demystifying managed
futures. Journal of Investment Management, 11(3), 42–58.
Ilmanen, A. (2011). Expected returns: An investor’s guide to harvesting market
rewards. Hoboken, NJ: Wiley.
Irwin, S. H., & Park, C. H. (2008). The profitability of technical analysis in com-
modity markets. In F. J. Fabozzi, R. Fus, & D. G. Kaiser (Eds.), The Handbook
of Commodity Investing. Hoboken, NJ: Wiley.
Ivkovic, Z., & Weisbenner, S. (2009). Individual investor mutual fund flows.
Jaffarian, E. (2009). Managed futures. In K. Wilkens-Christopher (Ed.), CAIA
Level II. Advanced core topics in alternative investments. Hoboken, NJ: Wiley.
Jegadeesh, N. (1990). Evidence of predictable behavior of security returns. Journal
of Finance, 45, 881–898.
Jegadeesh, N., & Titman, S. (2001). Profitability of momentum strategies: An
evaluation of alternative explanations. Journal of Finance, 56(2), 599–720.
Jensen, M. C. (1978). Some anomalous evidence regarding market efficiency.
Journal of Financial Economics, 6(2–3), 95–101.
Jensen, M. C., & Benington, G. A. (1970). Random walks and technical theories:
Some additional evidence. Journal of Finance, 25(2), 469–482.
Jiang, G., Lee, C. M., & Zhang, Y. (2005). Information uncertainty and expected
returns. Review of Accounting Studies, 10, 185–221.
Jostova, G., Nikolova, S., Philipov, A., & Stahel, C. W. (2013). Momentum in
corporate bond returns. Review of Financial Studies, 26(7), 1649–1693.
Kaestner, M. (2006). Anomalous price behaviour following earnings surprises:
Does representativeness cause overreaction? Revue de l’Association Francaise de
Finance, 27, 5–31.
Kahneman, D., & Tversky, A. (1972). Subjective probability: A judgment of rep-
resentativeness. Cognitive Psychology, 3, 430–454.
Kaustia, M. (2010). Disposition effect. In H.K. Baker & J.R. Nofsinger (eds.),
Behavioral finance, Chap. 10. Hoboken, NJ: Wiley.
Kessler, S., & Scherer, B. (2010). Macro momentum and the economy. Working
paper. Retrieved October 21, 2015, from https://workspace.imperial.ac.uk/
business-school/Public/research/annadvanceshedgefunds5/12_Kessler.pdf
Kim, D. (2012). Cross-asset style momentum. Asia-Pacific Journal of Financial
Studies, 41(5), 610–636.
Kim, H., Arvind, M., & Petkevich, A. (2012). Sources of momentum in bonds.
Mays Business School Research Paper No. 2012-40. Retrieved October 20,
org/10.2139/ssrn.2054711
Kroencke, T. A., Schindler, F., & Schrimpf, A. (2013). International diversification
benefits with foreign exchange investment styles. Review of Finance, 18(5),
1847–1883.
Lee, C. M., & Swaminathan, B. (2000). Price momentum and trading volume.
Lehmann, B. N. (1990). Fads, martingales and market efficiency. Quartarly
Journal of Economics, 105, 1–28.
Levine, A., & Pedersen, L. H. (2016). Which trend is your friend? Financial
Analysts Journal, 72(3), 51–66.
Levy, R. A. (1968). The relative strength concept of common stock price forecasting.
Larchmont, NY: Investors Intelligence.
Lhabitant, F. S. (2008). Commodity trading strategies: Examples of trading rules
and signals from the CTA sector. In F. J. Fabozzi, R. Fuss, & D. G. Kaiser
(Eds.), The handbook of commodity investing. Hoboken, NJ: Wiley.
Li, F. W., & Wei, J. K. C. (2015). Momentum life cycle around the world: The roles
of individualism and limits to arbitrage. Asian Finance Association (AsianFA)
2015 Conference Paper. Retrieved October 20, 2015, from SSRN: http://ssrn.
Liu, L. X., & Zhang, L. (2008). Momentum profits, factor pricing, and macroeco-
nomic risk. Review of Financial Studies, 21(6), 2417–2448.
Locke, P. R., & Mann, S. C. (2005). Professional trader discipline and trade dis-
position. Journal of Financial Economics, 76(2), 401–444.
Lord, C., Ross, L., & Lepper, M. (1979). Biased assimilation and attitude polar-
ization: The effects of prior theories on subsequently considered evidence.
Journal of Personality and Social Psychology, 37, 2098–2109.
Lukac, L. P., Brorsen, B. W., & Irwin, S. H. (1988). A test of futures market dis-
equilibrium using twelve different technical trading systems. Applied Economics,
20(5), 523–639.
Luu, B. V., & Yu, P. (2012). Momentum in government-bond markets. Journal of
Fixed Income, 22(2), 72–79.
Menkoff, L., Sarno, L., Schmeling, M., & Schrimpf, A. (2011). Currency momen-
tum strategies. Retrieved October 21, 2015, from SSRN: http://ssrn.com/
Miffre, J., & Fernandez-Perez, A. (2015). The case for long-short commodity
investing. Journal of Alternative Investments, 18(1), 92–104.
Miffre, J., & Rallis, G. (2007). Momentum strategies in commodity futures mar-
kets. Journal of Banking and Finance, 31, 1863–1886.
Moskowitz, T. J., & Grinblatt, M. (1999). Do industries explain momentum?
Moskowitz, T. J., Ooi, Y. H., & Pedersen, L. H. (2012). Time series momentum.
Northcraft, G. B., & Neale, M. (1987). Experts, amateurs, and real estate: An
anchoring-and-adjustment perspective on property pricing decisions.
Organizational Behavior and Human Decision Processes, 39, 84–97.
Nosfinger, J. R., & Sias, R. W. (1999). Herding and feedback trading by institu-
tional and individual investors. Journal of Finance, 54(6), 2263–2295.
O’Neil, W. (2009). How to make money in stocks: A winning system in good times
and bad (4 ed.). New York: McGraw Hill Education.
Okunev, J., & White, D. (2000). Do momentum based strategies still work in
foreign currency markets. Journal of Financial and Quantitative Markets,
38(2), 422–457.
Olszewski, F., & Zhou, G. (2014). Strategy diversification: Combining momen-
tum and carry strategies within a foreign exchange portfolio. Journal of
Derivatives & Hedge Funds, 19(4), 311–320.
Orlov, V. (2015). Currency momentum, carry trade and market illiquidity. 27th
Australasian Finance and Banking Conference 2014 Paper. Retrieved October
21, 2015, from SSRN: http://ssrn.com/abstract=2480429
Osler, C. L. (2000). Support for resistance: Technical analysis and intraday
exchange rates. Economic Policy Review, 6, 53–65.
Pan, M. S., Liano, K., & Huang, G.-C. (2004). Industry momentum strategies
and autocorrelations in stock returns. Journal of Empirical Finance, 11(2),
185–202.
Park, C.-H., & Irwin, S. H. (2007). What do we know about the profitability of
technical analysis? Journal of Economic Surveys, 21(4), 786–826.
Park, K.-I., & Kim, D. (2013). Sources of momentum profits in international

stock markets. Accounting and Finance, 54(2), 567–589.
Pastor, L., & Stambaugh, R. F. (2003). Liquidity risk and expected stock returns.
Journal of Political Economy, 111(3), 642–685.
Pirrong, C. (2005). Momentum in futures markets. EFA 2005 Moscow Meetings
Paper. Retrieved October 21, 2015, from SSRN: http://ssrn.com/
Pojarliev, M., & Levich, R. M. (2013). A new look at currency investing. CFA
Institute Research Foundation Monograph. Retrieved October 20, 2015, from
SSRN: http://ssrn.com/abstract=2571391
Pospisil, L., & Zhang, J. (2010). Momentum and reversal effects in corporate
bond prices and credit cycles. Journal of Fixed Income, 20(2), 101–115.
Pouget, S., & Villeneuve, S. (2012). A mind is a terrible thing to change:
Confirmation bias in financial markets. IDEI Working Papers 720, Institut
d’Économie Industrielle (IDEI), Toulouse. Retrieved October 24, 2015, from
http://idei.fr/sites/default/files/medias/doc/wp/2012/wp_idei_720.pdf
Rabin, M., & Schrag, J. (1999). First impressions matter: A model of confirmatory
bias. Quarterly Journal of Economics, 114, 37–82.
Reidpath, D. D., & Diamond, M. R. (1995). A nonexperimental demonstration
of anchoring bias. Psychological Reports, 76, 800–802.
Rhea, R. (1932). The Dow theory. New York: Barrons.
Ro, S. H., & Gallimore, P. (2013). Real estate mutual funds: Herding, momen-
tum trading and performance. Real Estate Economics, 42(1), 190–222.
Roberts, H. (1967). Statistical versus clinical prediction of the stock market.
Unpublished manuscript.
Roberts, M. C. (2005). Technical analysis and genetic programming: Construction
and testing a commodity portfolio. Journal of Futures Markets, 25(7), 643–660.
Rouwenhorst, G. K. (1998). International momentum strategies. Journal of
Finance, 53(1), 267–284.
Sagi, J., & Seasholes, M. (2007). Firm-specific attributes and the cross section of
momentum. Journal of Financial Economics, 84(2), 389–434.
Samuelson, P. A. (1965). Proof that properly anticipated prices fluctuate randomly.
Industrial Management Review, 6(2), 41–49.
Schmidt, P. S., von Arx, U., Schrimpf, A., Wagner, A. F., & Ziegler, A. (2015). Size
and momentum profitability in international stock markets. Swiss Finance Institute
Research Paper No. 15–29. Retrieved October 20, 2015, from SSRN: http://
Schwager, J. D. (1994). The new market wizards: Conversations with America’s top
traders. New York: HarperCollins.
Schwager, J. D. (2003). Stock market wizards: Interviews with America’s top stock
traders. NewYork: HarperBusiness.
Schwager, J. D. (2012a). Hedge fund market wizards: How winning traders win?
Hoboken, NJ: Wiley.
Schwager, J. D. (2012b). Market wizards, updated: Interviews with top traders.
Hoboken, NJ: Wiley.
Seamans, G. (1939). The seven pillars of stock market success. Brightwaters: Windsor
Books.
Shefrin, H., & Statman, M. (1985). The disposition to sell winners too early and
ride losers too long: Theory and evidence. Journal of Finance, 40(3). Papers
and Proceedings of the Forty-Third Annual Meeting American Finance
Association (pp. 777–790). Dallas, TX, December 28–30.
Shiller, R. J. (1984). Stock prices and social dynamics. Brooking Papers on Economic
Activity, 2, 457–498.
Shiller, R. J. (1988). Portfolio insurance and other investor fashions as factors in
the 1987 stock market crash. NBER Macroeconomic Annual, 287–296.
Shleifer, A. (2000). Inefficient markets: An introduction to behavioral finance.
Oxford: Oxford University Press.
Silber, W. L. (1994). Technical trading: When it works and when it doesn’t.
Journal of Derivatives, 1, 39–44.
Slovic, P., & Lichtenstein, S. (1971). Comparison of Bayesian and regression
approaches to the study of information processing in judgement. Organizational
Behavior and Human Performance, 6, 649–744.
Soros, G. (2003). The alchemy of finance. Hoboken, NJ: Wiley.
Szakmary, A. C., & Zhou, X. (2015). Industry momentum in an earlier time:
Evidence from the Cowles data. Journal of Financial Research, 38(3), 319–347.
Szymanowska, M., de Roon, F., Nijman, T., & van den Goorbergh, R. (2014). An
anatomy of commodity futures risk premia. Journal of Finance, 69(1), 453–482.
Tibbs, S. L., Eakins, S. G., & DeShurko, W. (2008). Using style momentum to
generate alpha. Journal of Technical Analysis, 65, 50–56.
Tversky, A., & Kahneman, D. (1971). Belief in the law of small numbers.
Psychological Bulletin, 2, 105–110.
Tversky, A., & Kahneman, D. (1974). Judgement under uncertainty: Heuristics
and biases. Science, 185, 1124–1131.
Tversky, A., & Kahneman, D. (1982). Judgments of and by representativeness. In
D. Kahneman, P. Slovic, & A. Tversky (Eds.), Judgment under uncertainty:
Heuristics and biases (pp. 84–98). Cambridge: Cambridge University Press.
van Horne, J. C., & Parker, G. G. C. (1967). The random-walk theory: An empiri-
cal test. Financial Analyst Journal, 23(6), 87–92.
van Horne, J. C., & Parker, G. G. C. (1968). Technical trading rules: A comment.
Financial Analyst Journal, 24(4), 128–132.
Wason, P. C. (1960). On the failure to eliminate hypotheses in a conceptual task.

Quarterly Journal of Experimental Psychology, 12, 129–140.
Watson, S. R., & Buede, D. M. (1987). Decision synthesis: The principles and prac-
tice of decision analysis. Cambridge: Cambridge University Press.
Weber, M., & Camerer, C. F. (1998). The disposition effect in securities trading:
An experimental analysis. Journal of Economic Behavior and Organization,
33(2), 167–184.
Welch, I. (2000). Herding among security analysts. Journal of Financial Economics,
58, 69–396.
Wyckoff, R. F. (1924). How I trade in stocks and bonds: Being some methods evolved
and adapted during my thirty-three years’ experience in Wall Street. New York:
Magazine of Wall Street.
Zaremba, A. (2015). Momentum and low-volatility effects in country-level stock
market anomalies. Retrieved October 21, 2015, from SSRN: http://ssrn.
Zhang, X. F. (2006). Information uncertainty and stock returns. Journal of
Finance, 61(1), 105–137.
Zhang, C. Y., & Jacobsen, B. (2012). Are monthly seasonals real? A three century
perspective. Review of Finance, 17(5), 1743–1785.
CHAPTER 4
Is Small Beautiful? Size Effect in Stock

Markets
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.
SMALL FIRMS OUTPERFORM

The story of the size premium goes back to 1981, when Rolf Banz first
researched the relationship between the stock market capitalization and
expected returns. Banz examined the returns on stocks from the US
market over the 1936–1975 period and found that the small companies
indeed outperform. The returns earned by a fifth of the smallest compa-
nies were per month 0.4 % higher than the remaining companies. The
superior returns remained extraordinary even when adjusted for risk.
The discoveries of Banz (1981) were so astonishing that he quickly
found many followers. His results were shortly replicated in the US mar-
ket and in other stock markets around the world.2 Table 4.1 presents the
initial evidence on size effect from markets around the world. The size

DOI 10.1057/978-1-137-59191-3_4
Table 4.1 Size premium around the world in early studies

Country Size premium Study period Number of Source paper
(%) portfolios
United Kingdom 0.40 1958–1982 10 Levis (1985)

Australia 5.06 1974–1987 10 Beedles (1992)
Belgium 0.52 1969–1983 5 Hawawini et al. (1989)
Canada 0.98 1975–1992 5 Elfakhani et al. (1998)
China 0.92 1993–2000 2 Drew et al. (2003)
Finland 0.76 1970–1981 10 Wahlroos and Berglund
(1986)
Germany 0.49 1954–1990 9 Stehle (1997)
Ireland 0.47 1977–1986 5 Coghlan (1988)
Japan 0.97 1971–1988 4 Chan et al. (1991)
Mexico 4.16 1987–1992 3 Herrera and Lockwood
(1994)
The Netherlands 0.13 1973–1995 5 Doeswijk (1997)
Spain 0.56 1963–1982 10 Rubio (1988)
Turkey 3.42 1993–1997 4 Aksu and Onder (2003)
Note: The table reports monthly outperformance of the small-cap portfolio over the large-caps. Own
elaboration
effects vary from 0.13 % monthly in the Netherlands to 4.16 % in Mexico,

and almost universally higher returns were delivered by small stocks.
For a decade, the small-cap effect had been considered a stock market
curiosity until Eugene F. Fama and Kenneth R. French (1993) hinted that
the small-cap premium works as a compensation for risks that are not cap-
tured within the standard market model. Shortly after that, the size factor
entered the circle of the most respected return drivers in the stock market.
Now, along with the value, market, and momentum premia, it is has found
its way into the classical multifactor asset pricing models, as with the four-
factor model of Carhart (1997), for example.
The cumulative performance of small companies in the 1926–2015
period in the US stock market is presented in Fig. 4.1. Over the long term,
the small stock performance seems very impressive. Ignoring the taxes
and transaction costs, one dollar invested in the quintile of the largest
companies in June 1926 would grow to 3310 dollars in September 2015.
Meanwhile, the same dollar invested in small caps would have performed
over six times better and it would multiply to over 20,000 dollars.
Still, the size premium is one of the most intriguing factors of the stock
market and one that bears a number of most interesting traits.
IS SMALL BEAUTIFUL? SIZE EFFECT IN STOCK MARKETS 69
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)
Seasonality. The outperformance of small companies varies throughout

the year. Being particularly pronounced in January. This is the so-called
January effect, the phenomenon of exceptionally high returns of stock mar-
ket companies observable in January. The anomaly was first identified in
1976 by Rozeff and Kinney who found that within the 1904–1974 period
American listed companies earned an average return of 3.48 % in January
in comparison to the mere average of 0.42 % in the remaining months.
There seems to be some direct link between the January anomaly and
the small-cap premium.3 Over a half of the small-firm effect manifests itself
in January, half of it during its first week. Furthermore, over 10 % of the
outperformance is generated on the first trading day of the year (Keim
1983a, b). Across the 1963–1997 period, in the US the smallest stocks
outperformed the largest delivering on average five times higher returns
in January! On the contrary, during the remainder of the year, it was the
large caps that displayed a better performance (Horowitz et al. 2000a, b).
Lack of stability. The size effect is not particularly stable over time.
Although the smallest stocks have an impressive long-term track record, as
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).
DOES THE SIZE PREMIUM REALLY EXIST, AND WHY?

The small-cap premium on the stock level is a curious paradox. Let’s take
a large company that generates a certain cash flow. One day, the company
splits into 10 smaller firms, which are all identical and generate precisely
one-tenth of the cash flow. In the world of the small-cap premium, they
will now deliver higher returns than when they had been enclosed in a
single large entity. While mathematically it makes no sense, the small-cap
effect is perhaps one of the best-explained cross-sectional patterns. The
academic literature offers a whole range of explanations that may prove
useful in explaining the outperformance of small companies. Many of
them claiming that although the small-firm effect appears in the data, we
cannot really profit from it. Let us then review these explanations.6
Delisting bias. Companies do not remain on the stock exchange forever.
Once they fail to meet the listing criteria, they are removed. The reasons for
that may vary, but it usually coincides with some financial distress, resulting in
either a very low capitalization, a drop in the share price, or even bankruptcy.
Luckily for investors, delisting does not necessarily entail a loss of

the entire investment as some assets can be retrieved even in liquidation
while others can still be traded over-the-counter, and effectively sold.
Nonetheless, almost every time delisting is a harbinger of severe losses to
investors. Importantly, small companies are more prone to delisting, as the
business is less stable. And here is the crucial point: the small-cap premium
is usually estimated using databases often ignoring delisted stocks and
thus potentially artificially inflating the performance of small companies
(Shumway 1997). If all severe losses of the smallest firm were captured in
the databases, their performance could appear much worse.
The delisting bias was targeted in 1999 by Shumway and Warther,
who attempted to estimate its scale. Having analyzed the number of
performance-related delistings on Nasdaq in years 1973–1995, the
researchers declared over 5 % of companies delisted every year with the
highest fraction among the small companies. Within the period, 5 % of
the smallest companies delivered an average monthly return of 3.79 %,
while after adjusting for delisted companies it declined markedly to 1.97
%. Once accounted for the delisting bias, the small cap premium roughly
halved and no longer significantly differed from zero.
Although Shumway and Warther’s results (1999) were derived from
the Nasdaq stocks, they should be also relevant to other markets. Could
this explanation also account for the country-level size effect? Probably so.
Not all young stock markets succeed; some of them fail, perhaps partially
because investors grow impatient with the prolonged period of both poor
corporate governance and low returns. Studies of the small-country effect
have yet to account for such discontinued indices.
Trading costs. Small stocks are frequently more difficult and costly to
trade than large stocks: the transaction costs usually go beyond the costs
of liquid blue chips. This may stem from several factors. Firstly, small caps
usually have wider bid-ask spreads. Secondly, as the liquidity is poorer,
the price impact grows larger when purchasing or selling a considerable
number of shares. Finally, the lack of liquidity may also entail higher com-
mission fees when there is a minimum absolute fee irrespective of the trade
size.
Not surprisingly then, from the very beginning the researchers become
interested in the extent to which the trading costs impede the size pre-
mium. Stoll and Whaley (1983) ventured a closer look at this issue and
proved that trading costs were responsible for a significant part of the size
premium in the NYSE and AMEX markets.
In practice, the levered trading costs in the small-firm segments also

surface in the performance of investment funds. Even the passive index-
tracking investment vehicles are unable to fully replicate the performance
of small-cap indices: their long-term annual after-cost returns sometimes
sink 1 percentage point below the ones of the respective index (Damodaran
2012b, pp. 335–336).
Could these issues also explain the small-country effect? Perhaps yes.
Trading costs across small and illiquid markets are usually higher than in
the developed markets, so they can easily affect the performance of small-
country based strategies.7
Information risk. In picking stocks, investors rely on various sources
of information: financial reports, press releases, and analysts’ recommen-
dations. In the case of small and micro companies these sources are much
more modest compared to the blue chip companies. Additionally, in some
markets, micro companies can also publish their financial statements less
frequently. Furthermore, the biggest, most liquid firms are commonly
followed by up to 20 analysts, while for small caps the number is much
smaller,8 and some firms are not covered at all. Finally, also the press cover-
age is much more modest for tiny firms (Green et al. 2014b).
In other words, small-cap investors have their work cut out. While the
large-cap investors have tons of research at their disposal, small caps inves-
tors have to prepare everything by themselves; thus, not surprisingly, for
investing in micro companies investors demand an additional premium.
We find a parallel phenomenon on the country level. Indeed, there is
much less research on the exotic frontier markets then on Germany or
Japan and, therefore, it is rational to expect a higher premium for investors.
Outliers. The small-caps returns differ slightly from normal distribu-
tion, being full of outliers; namely, events very unlikely from the stand-
point of standard statistical distributions. In the research of Kalesnik and
Beck (2014) small firms outperformed the large caps by 23.6 percentage
points in January 1934. From the viewpoint of the standard distribution,
it is a one-in-67-million-year event. Additionally, small caps outperformed
large firms by 27.2 percentage points in September 1939, 33.8 percent-
age points in August 1932, and astonishingly by 51.6 % in May 1933,
while the last event should only occur at most once in the lifespan of our
universe.
Even more interestingly, all these outliers amassed in the 1930s. Had
none of them occurred, the size premium would have nearly halved
(Kalesnik and Beck (2014). Should we then consider these outliers when
forecasting future returns on small companies? On the one hand, the

1930s certainly were a specific period. On the other, it gives us important
information about the stock market behavior. Whether we should assume
these exceedingly rare events would be repeated in the future remains
controversial.
Liquidity risk. The most classical asset pricing models (CAPM), for
example, assume that the crucial parameter determining future returns is
the exposure to market risk measured with the stock’s beta. Meanwhile,
stock market investors might face other risks not fully reflected in the mar-
ket risk. Liquidity risk could serve as a good example. The threat of being
unable to sell assets when we want or to buy them when we need poses a
substantial risk for investors.
As small stocks are evidently less liquid than those of large companies,
the small-cap premium may be not a separate premium per se, but a mani-
festation of a liquidity premium. Although the impact of liquidity is par-
tially reflected in higher transaction costs, in fact, the liquidity premium
may be even higher.
The way illiquidity affects the returns is well-documented in academic
research. The source of abnormal returns springing from lower liquidity is
usually called illiquidity premium; paradoxically, it is used interchangeably
with liquidity premium. Less liquid stocks provide higher returns, no mat-
ter what particular measure of liquidity we apply: turnover, turnover ratio,
bid-ask spread, or any other liquidity based metric.9
The impact of liquidity is hardly limited to stocks. It has become evi-
dent in the realm of treasuries and corporate bonds.10 Furthermore, the
illiquidity effect also applies to some of the more exotic asset classes, like
hedge funds, private equity or even real estate.11 On the level of the coun-
try equity indices, the liquidity impact was tested by Zaremba (2015a)
who found that during the 1999–2014 period the least liquid markets
delivered returns only marginally higher than the liquid markets.
Lack of risk-adjusted benefits. Both liquidity and information risk are
risk types that escape the simple beta measure used in the CAPM model.
Still, some researchers claim small stocks do not outperform large stocks
even when using simple risk measures, as, for example, volatility. True,
small companies are usually much more volatile than the large firms. In
2014 Khalesnik and Beck calculated Sharpe ratios for small and large firms
across 18 developed markets and found in nearly half of the markets the
large firms deliver superior performance. This is true even for the US stock
market, where within the years 1926–2014 small stocks saw a Sharpe ratio
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.
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).
REFERENCES
Aksu, M. H., & Onder, T. (2003). The size and book-to-market effects and their role
as risk proxies in the Istanbul Stock Exchange. EFMA 2000 Athens; Koc
University, Graduate School of Business, Working Paper No. 2000-04.
Amihud, Y. (2002). Illiquidity and stock returns: Cross-section and time-series
effects. Journal of Financial Markets, 5, 31–56.
Amihud, Y., & Mendelson, H. (1986). Asset pricing and the bid–ask spread.
Amihud, Y., Mendelson, H., & Pedersen, L. H. (2005). Liquidity and asset prices.
Foundations and Trends in Finance, 1(4), 269–364.
Banz, R. W. (1981). The relationship between return and market value of com-
mon stocks. Journal of Financial Economics, 9, 3–18.
Barry, C., Goldreyer, E., Lockwood, L., & Rodriguez, M. (2002). Robustness of
size and value effects in emerging equity markets, 1985–2000. Emerging
Markets Review, 3, 1–30.
Beedles, W. L. (1992). Small firm equity cost: Evidence from Australia. Journal of
Small Business Management, 57, 65.
Brennan, M. J., Chordia, T., & Subrahmanyam, A. (1998). Alternative factor
specifications, security characteristics, and the cross-section of expected stock
Brown, P., Kleidon, A. W., & Marsh, T. A. (1983). New evidence on the nature of
size related anomalies in stock prices. Journal of Financial Economics, 12,
33–56.
Carhart, M. M. (1997). On persistence in mutual fund performance. Journal of
Finance, 52(1), 57–82.
Chan, L. K. C., Hamao, Y., & Lakonishok, J. (1991). Fundamentals and stock
returns in Japan. Journal of Finance, 46, 1739–1764.
Chan, L. K. C., Karceski, J., & Lakonishok, J. (2000b). New paradigm or same
old hype in equity investing? Financial Analysts Journal, 56(4), 23–36.
Chen, L., Lesmond, D. A., & Wei, J. (2007). Corporate yield spreads and bond
liquidity. Journal of Finance, 62(1), 119–149.
Coghlan, H. (1988). Small firms versus large on the Irish stock exchange: An
analysis of the performances. Irish Business and Administrative Research, 9,
10–20.
ing the value of any asset. 3rd edition. New York: Wiley.
Datar, V., Naik, N., & Radcliffe, R. (1998). Liquidity and stock returns: An alter-
native test. Journal of Financial Markets, 1, 203–220.
de Jong, F., & Driessen, J. (2012). Liquidity premia in corporate bond markets.
Quarterly Journal of Finance, 2(2).
De Moor, L., & Sercu, P. (2013a). The smallest firm effect: An international study.
Journal of International Money and Finance, 32, 129–155.
De Moor, L., & Sercu, P. (2013b). The smallest stocks are not just smaller: Global
evidence. European Journal of Finance, 21(2), 51–70.
Dichev, I. D. (1998). Is the risk of bankruptcy a systematic risk? Journal of Finance,
53(3), 1131–1147.
Dimson, E., & Marsh, P. (1999). Murphy’s law and market anomalies. Journal of
Dimson, E., Marsh, P., & Staunton, M. (2002). Triumph of the optimists: 101 years
of global investment returns. Princeton, NJ: Princeton University Press.
Doeswijk, R. Q. (1997). Contrarian investment in the Dutch stock market. De
Economist, 145, 198–573.
Domowitz, I., Glen, J., & Madhavan, A. (2002). Liquidity, volatility and equity
trading costs across countries and over time. International Finance, 4(2),
221–255.
Drew, M. E., Naughton, T., & Veeraraghavan, M. (2003). Firm size, book-to-
market equity and security returns: Evidence from the Shanghai Stock
Exchange. Australian Journal of Management, 28(2), 119–139.
Easley, D., Hvidkjaer, S., & O’Hara, M. (2002). Is information risk a determinant
of asset returns? Journal of Finance, 57, 2185–2221.
Easterday, K. E., Sen, P. K., & Stephan, J. A. (2009). The persistence of the small
firm/January effect: Is it consistent with investors’ learning and arbitrage
efforts? Quarterly Review of Economics and Finance, 49(3), 1172–1193.
Eleswarapu, V. R., & Reinganum, M. R. (1993). The seasonal behavior of the
liquidity premium in asset pricing. Journal of Financial Economics, 34(3),
373–386.
Elfakhani, S., Lockwood, L. J., & Zaher, T. S. (1998). Small firm and value effects
in the Canadian Stock Market. Journal of Financial Research, 21, 277–292.
Fama, E. F., & French, K. R. (1993). Common risk factors in the returns on stocks
and bonds. Journal of Financial Economics, 33, 3–56.
63(4), 1653–1678.
Fortin, R., & Roth, G. (2007). Analyst coverage of small cap firms in a period of
brokerage firm retrenchment. Journal of Business & Economics Research, 5(12),
61–68.
Franzoni, F., Nowak, E., & Phalippou, L. (2012). Private equity performance and
liquidity risk. Journal of Finance, 67(6), 2341–2373.
Ghysels, E., & Cherkaoui, M. (1999). Emerging markets and trading costs.
CIRANO Scientific Series working paper 99s-04. Retrieved November 1,
2015, from http://www.cirano.qc.ca/pdf/publication/99s-04.pdf
Goyenko, R., Subrahmanyam, A., & Ukhov, A. (2011). The term structure and
bond market liquidity and its implications for expected bond returns. Journal
of Financial and Quantitative Analysis, 46(1), 111–139.
Handa, P., Kothari, S. P., & Wasley, C. (1989). The relation between the return
interval and betas: Implications for the size effect. Journal of Financial
Economics, 23, 79–100.
Hawawini, G., Michel, P., & Corhay, A. (1989). A look at the validity of the
CAPM in light of equity market anomalies: The case of Belgian common
stocks. In S. Taylor (Ed.), A Reappraisal of the Efficiency of Financial Markets.

NATO ASI Series. Springer Verlag.
Herrera, M. J., & Lockwood, L. J. (1994). The size effect in the Mexican stock
market. Journal of Banking and Finance, 18, 621–632.
55(1), 265–295.
Horowitz, J. L., Loughran, T., & Savin, N. E. (2000a). The disappearing size
effect. Research in Economics, 54(1), 83–100.
Horowitz, J. L., Loughran, T., & Savin, N. E. (2000b). Three analyses of the firm
size premium. Journal of Empirical Finance, 7(2), 143–153.
Kalesnik, V., & Beck, N. (2014). Busting the myth about size. Research Affiliates:
Simply Stated research paper Retrieved November 1, 2015, from https://
www.researchaffiliates.com/Production%20content%20library/Busting%20
the%20Myth%20About%20Size.pdf
Kapadia, N., & Pu, X. (2012). Limited arbitrage between equity and credit mar-
kets. Journal of Financial Economics, 105(3), 542–564.
Karolyi, G. A., & Wu, Y. (2012). The role of investability restrictions on size, value,
and momentum in international stock returns. Working paper. Retrieved
October 31, 2015, from http://www.lse.ac.uk/fmg/events/capitalMarket/
pdf/CMW62A_Karolyi.pdf
Keppler, M., & Encinosa, P. (2011). The small-country effect revisited. Journal of
Investing, 20(4), 99–103.
Keppler, M., & Traub, H. D. (1993). The small-country effect: Small markets beat
large markets. Journal of Investing, 2(3), 17–24.
Lamoureux, C. G., & Sanger, G. C. (1989). Firm size and turn-of-the-year effects
in the OTC/NASDAQ market. Journal of Finance, 44, 1219–1245.
Levis, M. (1985). Are small firms big performers? Investment Analyst, 76, 21–27.
Lo, A. W., & MacKinlay, A. C. (1990). Data-snooping biases in tests of financial
asset pricing models. Review of FInancial Studies, 3(3), 431–467.
MacKinlay, A. C. (1995). Multifactor models do not explain deviations from the
CAPM. Journal of Financial Economics, 38(1), 3–28.
Michou, M., Mouselli, S., & Stark, A. W. (2010). Fundamental analysis and the
modelling of normal returns in the UK. Retrieved November 2, 2015 from
SSRN: http://ssrn.com/abstract=1607759 or http://dx.doi.org/10.2139/
ssrn.1607759
Musto, D., Nini, G., Schwarz, K. (2015). Notes on bonds: Liquidity at all costs in
the great recession. Working paper. Retrieved November 2, 2015, from http://
finance.wharton.upenn.edu/~kschwarz/Treasuries.pdf
Pradhuman, S. D. (2000). Small-cap dynamics: Insights, analysis, and models.
Princeton, NJ: Bloomberg Press.
Qian, W., & Liu, P. (2012). Does (and what) illiquidity matter for real estate prices?
Measure and evidence. Retrieved November 2, 2015, from SSRN: http://ssrn.
Roll, R. (1983). Vas ist das? The turn of the year effect and the return premia of
small firm. Journal of Portfolio Management, 9(2), 18–28.
Roll, R. (2003). Style return differentials: Illusions, risk premiums, or investment
opportunities. In T. D. Coggin & F. J. Fabozzi (Eds.), The handbook of equity
style management. Hoboken, NJ: Wiley.
Rozeff, M. S., & Kinney, W. R. (1976). Capital market seasonality: The case of
Shumway, T. (1997). The delisting bias in CRSP data. Journal of Finance, 51(1),
327–340.
Shumway, T., & Warther, V. A. (1999). The delisting bias in CRSP’s Nasdaq data
and its implications for the size effect. Journal of Finance, 54(6), 2361–2379.
Silva, A. C., & Chaves, G. (2004). Trading costs for emerging market stocks. IE
Working Paper DF8-108-1. Retrieved November 1, 2015, from http://
latienda.ie.edu/working_papers_economia/WP04-04.pdf
Stehle, R. (1997). Der Size-Effekt am Deutschen Aktienmarkt. Zeitschrift für
Bankrecht und Bankwirtschaft, 9, 237–260.
Stoll, H. R., & Whaley, R. E. (1983). Transaction costs and the small firm effect.
van Dijk, M. A. (2011). Is size dead? A review of the size effect in equity returns.
Journal of Banking & Finance, 35, 3263–3274.
van Holle, F., Annaert, J., Crombez, J., & Spinel, B. (2002). Value and size effects:
Now you see it, now you don’t. EFA 2002 Berlin Meetings Discussion Paper.
Retrieved November 1, 2015, from SSRN: http://ssrn.com/abstract=302653
Wahlroos, B., & Berglund, T. (1986). Anomalies and equilibrium returns in a
small stock market. Journal of Business Research, 14, 423–440.
Zaremba, A. (2015a). The January seasonality and the performance of country-
level value and momentum strategies. Copernican Journal of Finance &
Accounting, 4(2), 195–209.
Zaremba, A. (2015b). Country selection strategies based on value, size and
momentum. Investment Analyst Journal, 44(3), 171–198.
Zaremba, A. (2015c). Value, size, momentum, and unique role of microcaps in
CEE market stock returns. Eastern European Economics, 53(3), 221–241.
CHAPTER 5
Is Risk Always Rewarded? Low-Volatility

Anomalies
Deeply controversial is the relationship between risk and return in finan-

cial markets. It relates to one of the most profound questions in the finan-
cial literature: “Are safe assets better investments than risky ones?” The
fundamental assumption of the capital asset pricing model (CAPM) is the
existence of a positive relationship between systematic stock market risk
measured with betas and the expected returns. This was initially identified
by a series of tests in the US stock market.1 The CAPM is built upon the
modern portfolio theory, according to which investors should diversify
risk by holding a portfolio of various stocks. However, for various rea-
sons, such portfolios often end up being poorly diversified (Goetzman and
Kumar 2008). Once portfolios are not entirely diversified, the idiosyncratic
volatility, i.e. the volatility not stemming from broad market fluctuations,
should positively correlate with the expected returns in the cross-section
analysis. This assumption was originally proven by both theoretical analy-
sis and empirical evidence, which showed that securities with higher idio-
syncratic risk yield higher average returns.2 As both the systematic and
idiosyncratic risks sum up to total volatility, this total parameter should
also be positively correlated with returns. Indeed, there are several stud-
ies which seem to confirm this assumption by showing that risk measures
related to total variability are positively correlated with expected returns.
For instance, Bali and Cakici (2004) have found a strong positive link
between average returns and value at risk, staying robust against different
investment horizons and various levels of loss probability. In addition, Ang

DOI 10.1057/978-1-137-59191-3_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.
THE RISK AND RETURN IN FINANCIAL MARKETS

Before we start, let us clear out some terminological issues. By the low-
risk anomaly we mean the general phenomenon of occasional association
of low risk with high returns. We can then split the low-risk anomaly in
IS RISK ALWAYS REWARDED? LOW-VOLATILITY ANOMALIES 83
“sub-anomalies” based on how the risk is measured, for example low-

volatility or low-beta anomalies.
Standard deviation. Probably this is the most popular measure of
risk. In simple terms, when we investigate past returns, standard deviation
shows how much the returns are on average dispersed around the mean
return. When market practitioners evaluate past investment performance,
they usually calculate it on a yearly basis.
Based on the existing evidence, the relationship between the standard
deviation and future returns gravitates to being negative, irrespective of
the calculation method. In their seminal paper of 2007 Blitz and van Vliet
sorted stocks on the past 3-year volatility, derived from monthly returns,
and researched the performance of the international stocks in the FTSE
World Index throughout the 1985–2006 period. As they discovered, the
decile portfolio of low-volatility companies outperformed the same port-
folio of high-volatility companies on average by 5.9 % per annum.
In 2011 Baker et al. examined quantile portfolios formed on the stan-
dard deviation of monthly returns over the past 5 years. Having tested
the US companies within the 1968–2008 period, they arrived at similar
conclusion: the high-volatility stocks underperformed the low-volatility
stocks by 11.2 % annually.
Finally, van Vliet et al. (2011) compared the performance of volatile
and safe stocks under various methodological choices, considering for
example various capitalizations, sorting period, and risk measures. They
also confirmed that the profitability of the low-volatility approach seems
very robust compared to numerous methodological variations.
Low-volatility is not merely a stock market phenomenon; it has been
confirmed to extend to commodities, treasuries, and corporate bond mar-
kets.4 Yet, the evidence for the low-volatility effect appearing at the coun-
try level is rather flimsy. On the contrary, it rather seems in line with the
theoretical expectations of the classical models of financial markets; these
are the risky markets that yield higher returns. In early 1996 Erb et al.
compared the returns and volatilities across a panel of 28 equity mar-
ket indices within the years 1979–1995. They discovered the relationship
between these two metrics to be rather weak, albeit generally positive,
particularly among the emerging equity markets.
A fresher look at the risk-return relationship across countries was
offered by Bali and Cakici in 2010, who examined returns from 37 coun-
tries within the period from 1973 to 2006. They formed tertile portfolios
composed of country equity indices from sorts on total volatility measured
over the past 1–6 months. As they found, the risky countries markedly
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
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
Fig. 5.1 The performance of the betting-against-beta portfolio [%]

Note: The figure depicts the cumulative excess returns on the betting-against-beta
portfolio and on the capitalization-weighted global portfolio of global stocks from
23 international markets in the period from September 1988 to September 2015.
The underlying data is sourced as of 26 October 2015 from the website of QR
Capital Management, LLC: https://www.aqr.com/library/data-sets/. Copyright
©2014 Andrea Frazzini and Lasse Heje Pedersen
long-short portfolio (BAB) plotted against the market portfolio. The

cumulative excess return on the BAB portfolio composed of global stocks
in the 1988–2015 period amounted to almost 1200 % and was over seven
times higher than the cumulative excess return on the capitalization-
weighted portfolio of global stocks. The outperformance was stable and
consistent over time.
The relationship between beta and the returns on country equity indices
seems extremely weak, if not downright nonexistent. Although Frazzini
and Pedersen (2014) argued the low-beta markets outperformed the
high-beta markets, their study included merely 13 indices from the devel-
oped markets. Also, other studies have struggled to confirm any relations
between past beta and index returns. Bali and Cakici (2010), who exam-
ined 37 countries in the 1973–2006 period, identified no reliable relation
between past beta and future returns. The authors showed the tertile port-
folio of high-beta markets with raw returns per month 0.13–0.29 % higher
than in the low-beta portfolio. The outperformance was yet too small to
be statistically significant. Similar results were also reached in other studies
which relied on even broader and fresher samples.7
Idiosyncratic volatility. Idiosyncratic volatility is defined as the dif-

ference between total volatility and systematic risk. The standard CAPM
model implies that the idiosyncratic risk is never priced, so not influencing
future returns. The reason: the company-specific risks are largely uncor-
related, so substantial diversification benefits could be achieved by holding
even a relatively small number of various securities.8 After all, why should
the investor be rewarded for the risk that he could so easily eliminate?
Unfortunately, the evidence on pricing idiosyncratic volatility is not
that straightforward. While early studies hinted at a positive relationship
between returns and idiosyncratic volatility,9 the newer evidence indicates
that this relationship is rather negative. One of the most influential studies
of the impact of the idiosyncratic volatility was carried out by Ang et al. in
2006. They tested the performance of quantile portfolios from sorts on
idiosyncratic volatility in the US market (CRSP all) within the 1963–2000
period. Ang discovered the stocks with the highest idiosyncratic risk mea-
sured over the past month to underperform by as much 12.7 % per month
compared to the low risk stocks. In their later study the authors (Ang
et al. 2009) extended their research to other international markets and the
results proved consistent: the risky stocks underperformed the safe stocks
by 4.9 % and 3.2 % in Europe and Asia, respectively. Thus at the stock
level, lower idiosyncratic volatility entails higher return.10 An analogous
pattern has also been identified in commodity markets.11
Analogously, the idiosyncratic risk seems to behave differently at the
country level than at the stock level. The prevailing evidence shows that
the risky countries historically yielded slightly higher returns than the safe
markets. For example, in 2015 Umutlu investigated the returns on 23 local
country indices and demonstrated that the tertile portfolio of stock market
indices with high country-specific risk delivered in years 1973–2011 per-
formed better by 0.21–0.37 %, dependent on the methodological choices.
Nonetheless, the outperformance was too small to become significantly
abnormal. In an earlier study, however, researchers Bali and Cakici (2010)
tested 37 countries in a similar time period (1973–2006) and in their
sample the high-risk markets outperformed the low-risk countries by over
0.50 percentage points monthly.
The differences between the studies may stem from the fact that idio-
syncratic volatility better determines future returns in the case of small and
illiquid markets rather than in liquid and large markets.
While Umutlu focused predominantly on developed markets, Bali and
Cakici (2010) extended to include emerging markets. Given that for an
average country-level investor it proves much more difficult to diversify

across emerging markets, where the cross-country capital mobility con-
straints play a significant part, it should come as no surprise that taking up
the idiosyncratic risk is primarily rewarded in the undeveloped markets.
In his recent research Zaremba (2015a) created portfolios from dou-
ble sorts on both idiosyncratic volatility and stock market capitalization.
The broad sample covered 78 national stock markets, including devel-
oped, emerging, and frontier markets, throughout the years 1999–2014.
Zaremba found the spread in returns between the risky and safe countries
to be much broader within the small markets than within the large ones.
In small countries, the markets with high idiosyncratic volatility outper-
formed the markets of low volatility by 1.20 % per month whereas in the
medium and large markets the differences reached only 0.39 % and 0.50
%, respectively. The detailed returns on the nine size-risk portfolios are
reported in Fig. 5.2.
However compelling the performance of the portfolios formed on idio-
syncratic volatility within the small markets may look, profiting in a real
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
Fig. 5.2 Performance country portfolios from sorts on idiosyncratic volatility

and size
Note: The figure reports mean monthly excess returns (expressed as percentages)
on portfolios from double sorts on idiosyncratic volatility and total stock market
capitalization within the sample of 78 countries for years 1999–2014. It is our own
elaboration, based on the data from Table 3 in Zaremba (2015a)
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
choices of VaR calculations. Furthermore, other studies confirmed this

cross-sectional pattern appearing also in other countries, in Taiwan and
Pakistan, as well as amongst other asset classes like in the hedge fund
industry.13
Interestingly, the stock level return pattern related to VaR seems analo-
gous at the country level, where it is most pronounced among small coun-
tries. This last observation looks similar to the role of the idiosyncratic risk
at the country level. According to a study by Zaremba (2015a) testing
returns on 78 markets in the 1999–2014 period, the high VaR markets
indeed yield higher returns than the low VaR markets. The results, how-
ever, have been driven by a modest number of very small countries, so it
might prove difficult to profit from this effect. Furthermore, the anomaly
appears rather weak, to the point it disappears when different portfolio
weighting schemes are employed (Zaremba 2015b).
Skewness. While this parameter only indirectly measures volatility, it
is closely reflects the tail risk. So what precisely is skewness? It is a met-
ric capturing the asymmetry of return distribution. In essence, skewness
emerges in two forms: positive or negative. Positive skewness signals that
data points are skewed to the right, thus there are more extreme positive
returns than in the case of a normal distribution (e.g. Panel A of Fig. 5.3).
On the contrary, negative skewness indicates more extreme losses (e.g.
Panel B of Fig. 5.3).
Investment assets can be characterized by various return distributions.
Corporate bonds may serve as an example of the left skewed distribution:
PANEL A PANEL B
Fig. 5.3 Skewness of return distributions. Panel A left skewed distribution. Panel
B right skewed distribution
Note: Own elaboration
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
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.
WHY THE RISK PATTERNS WORK (OR NOT)

In the case of individual stock returns, the low risk anomaly is a powerful
cross-sectional pattern showing that low volatility and low beta companies
grossly outperform risky ones. At the country level, however, a parallel
effect is not so evident; in fact, the link between beta and returns seems
very weak, against the predictions of the CAPM, but the idiosyncratic risk
is rewarded with higher profits.
To better comprehend the nature of these discrepancies, and to deter-
mine the applicability of the risk-based strategies at the country level, we
should first understand why the low-risk anomaly exists. In fact, there is a
whole group of useful explanations, which fall into two main categories:
(1) investors’ behavior and psychology, and (2) limits to arbitrage.
Let us begin with the behavioral finance standpoint. There are at least a
few phenomena that may contribute to the low-risk anomaly.
Preference for lotteries. People like gambling. Lotteries and roulette
wheels are great manifestations of this simple truth. Although casinos are
widely associated with negative expected payoffs—players on average lose

money rather than gain––casinos have had their fans for centuries.
What if some investors use securities as betting instruments? In fact, to
some extent buying volatile individual stocks resembles a lottery. Although
this phenomenon is largely due to skewness of return distribution, at the
same time it is strongly linked to volatility (Mitton and Vorkink 2007; Boyer
et al. 2010).19 For example, if a start-up high-tech company goes bankrupt,
in the worst case we can lose 100 % of our investment, but if the start-up
grows to be another Microsoft, the stock price may rise by thousands of
percent. Individual investors display clear preference for low priced, vola-
tile, lottery-like stocks (Kumar 2009). This preference is reflected in high
demand and, thus, overvalued prices. There is an array of circumstantial
evidence that these lottery-like securities are truly overpriced.20
Representativeness. As we have already discussed representativeness
in the chapter on momentum, let’s only bring back the story of Linda
who was assumed to be a women activist although it was certainly not the
most probable answer. Does representativeness have anything to do with
the low-volatility anomaly? Clearly, Baker et al. (2011) argues so. Let’s
imagine what can a stock market layman have in mind when he considers
a substantial investment in another potential Apple or Microsoft, i.e. risky
high-tech companies who may dominate the industry while their stock
price surges by thousands percent. The investors might be inclined to
buy risky and volatile stocks, partly ignoring the fact that in the end only
a few will prove successful. This excessive irrational demand drives the
overpricing.
Overconfidence. Overconfidence is another powerful behavioral phe-
nomena.21 It leads us to believe that we know more than we in fact do. A
classic example––car drivers. Ninety-three percent of US car drivers think
they are better-than-average drivers (Svenson 1981). This is surely unlikely
from a mathematical standpoint, and so stock market investors are hardly
free from such overconfidence, which can prove detrimental to their long-
term performance. In general, overconfident investors trade more than
the less confident counterparts, and the additional trades generate no bet-
ter performance, but only higher transaction costs.
Such overconfidence effect may also influence the way investors make
their forecasts. For example, researchers were asked to estimate the popu-
lation of Massachusetts and to provide a 90 % confidence interval. Most
answers were too narrow, which indicates that people were prone to make
estimates more accurate than they really can (Baker et al. 2011).
Also, overconfident investors might become overoptimistic when valu-

ing stocks, forming too optimistic and overly precise forecasts. This effect
might be particularly pronounced in more uncertain outcomes such as
returns on volatile stocks (Baker et al. 2011). Thus, overconfidence can
also contribute to the overpricing of risky stocks (Cornell 2009).
Greed and envy. Classic financial models, as for example the CAPM,
assume that investors maximize their personal wealth, making no comparisons
against the wealth of others. In other words, it is only how much we have that
matters, and not whether we have more or less than others. The differences
may seem subtle as the increase of absolute wealth is usually accompanied by
parallel growth of the relative wealth. Nonetheless, these marginal discrepan-
cies may have substantial importance when pricing assets in financial markets.
Contrary to the CAPM assumptions, most researches into happiness evi-
dence that relative income is far more important than the absolute income
value.22 Perhaps the most famous evidence is the Easterlin Paradox, dis-
covered by Richard Easterlin in 1974. According to Easterling’s research,
happiness within a society is largely unaffected by the level of wealth
growing over time, as proved in various countries. Another interesting
manifestation of the relative utility was delivered by Frank in 2011. He
asked people whether they would rather earn $100,000 when others make
$90,000, or perhaps $110,000 when others earn $200,000. Surprisingly,
the overwhelming majority opted for the first proposition, being perfectly
happy to earn less as long as they were getting more than others.
To date, relative utility has been widely implemented in many economic
and financial models, and most importantly, it has been institutionalized
by investment industry.23 Portfolio managers are usually evaluated based
on their performance relative to the benchmark rather than based on their
absolute performance.24 In other words, it is more important to outper-
form other funds than to deliver high absolute returns. Over 90 % of US
mutual funds are benchmarked against a common index (Sensoy 2009).
This phenomenon has important implications for asset pricing: it leads to
the conclusion that asset managers may be interested in minimizing the
benchmark-relative risk (the so-called tracking error), and not the total
risk. Assuming therefore that there is a positive relationship between the
systematic risk (beta) and returns, and that we have two assets with identi-
cal tracking error but different systematic risk, the portfolio manager will
opt for the one with higher beta as it is associated with higher expected
returns. This way, investors may generate excessive demand for the high-
beta stocks, driving the overvaluation relative to the CAPM model.25
Attention grabbing. Today we have thousands of stocks listed in the

national equity markets and for an individual investor it might prove truly
overwhelming, first to know all the securities and then to sort out the bad
from the promising. As a result, investors typically focus on the attention-
grabbing stocks (Barber and Odean 2008); that is, the firms recently
appearing in the news, having experienced abnormally high volumes and
delivering extreme returns in the period. They are typically characterized
by above average volatility and belong to the “shiny” industries. In con-
sequence, the phenomenon may create excessive demand (and thus lower
expected returns) for the risky stocks and ignorance of boring companies
from more stable and mature industries.
Interestingly, Falkenstein (1996) has argued that the preference of
attention-grabbing stocks is hardly limited to individual investors. Mutual
funds also hold stocks of firms that we see more frequently in the news,
potentially creating a market-wide source of additional demand.
This behavioral phenomenon may well explain the grounds for the low-
volatility anomaly, but it fails to justify its existence. In an efficient market
this should be quickly arbitraged away by professional investors constantly
seeking new investment opportunities. If this doesn’t happen, something
must stand in the way. There can be at least three obstacles preventing
investors from arbitraging away the low risk anomaly: leverage constraints,
short-selling constraints, and regulatory constraints.
Leverage constraints. What should an investor do, when ready to take
on more risk in the equity portfolio? Basically, we have two options: either
to leverage the low-risk stocks, or to buy more high-beta stocks. However,
the leverage option may be not always be available. Even when available,
it may be markedly restricted by, for example, margin rules, tax rules, or
bankruptcy laws. So when leveraging a portfolio becomes impossible, the
only solution is buying high-beta stocks. As a result, the more restricted
the leverage availability, the higher the demand for high-beta stocks, which
is directly causing their overvaluation.
Many academic studies provide both theoretical and empirical grounds
confirming that leverage constraints may contribute to the low risk anom-
aly.26 Still, it has some shortcomings because, for example, it fails to answer
why the low-risk securities yield returns higher than the market portfolio.
Short-selling constraints. This concept is closely related to the limits
imposed on leverage. Let’s assume that the prices of the high-beta stocks
are too high. How can the equilibrium be restored, for instance, due to
short sellers who borrow overpriced socks and sell them on the market?
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
poses an astonishing anomaly for many investors. In the Part 2 of this

book we will see how these things work at the country level.
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
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.
REFERENCES
Abel, A. B. (1990). Asset prices under habit formation and catching up with the
Joneses. American Economic Review, 80(2), 38–42.
Alexander, C., & Sheedy, E. (2004). A guide to risk management best practices.
Wilmington: PRMIA Publications.
Alexeev, V. V., & Tapon, F. (2012). Equity portfolio diversification: How many
stocks are enough? Evidence from five developed markets. FIRN Research
Paper. Retrieved October 26, 2015, from SSRN: http://ssrn.com/
Andrade, S. C. (2009). A model of asset pricing under country risk. Journal of
International Money and Finance, 28(4), 671–695.
Ang, A. (2014). Asset management: A systematic approach to factor investing.
New York: Oxford University Press.
Ang, A., Chen, J., & Xing, Y. (2006a). Downside risk. Review of Financial Studies,
19, 1191–1239.
Ang, A., Chen, J., & Xing, Y. (2006b). The cross-section of volatility and expected
returns. Journal of Finance, 61, 259–299.
Ang, A., Hodrick, R., Xing, Y., & Zhang, X. (2009). High idiosyncratic volatility
and low returns: International and further U.S. evidence. Journal of Financial
Baker, M., Bradley, B., & Wurgler, J. (2011). Benchmarks as limits to arbitrage:
Understanding the low-volatility anomaly. Financial Analyst Journal, 67(1),
40–54.
Baker, N. L., & Haugen, R. A. (2012). Low risk stocks outperform within all observ-
able markets of the world. Working paper. Retrieved October 25, 2015, from
SSRN: http://dx.doi.org/10.2139/ssrn.2055431
Bali, T. G., & Cakici, N. (2004). Value at risk and expected stock returns. Financial
Analyst Journal, 60(2), 57–73.
Bali, T. G., & Cakici, N. (2008). Idiosyncratic volatility and the cross section of
expected returns. Journal of Financial and Quantitative Analysis, 43(1),
29–58.
Bali, C., & Cakici, N. (2010). World market risk, country-specifi c risk and
expected returns in international stock markets. Journal of Banking and
Finance, 34, 1152–1165.
Bali, T., Cakici, N., & Whitelaw, R. F. (2011). Maxing out: Stocks as lotteries and
the cross-section of expected returns. Journal of Financial Economics, 99(2),
427–446.
Bali, T. G., Gokcan, S., & Liang, B. (2007). Value at risk and the cross-section of
hedge fund returns. Journal of Banking & Finance, 31(4), 1135–1166.
Barber, B., & Odean, T. (2008). All that glitters: The effect of attention on the
buying behavior of individual and institutional investors. Review of Financial
Studies, 21(2), 785–818.
Barberis, N., & Huang, M. (2008). Stocks as lotteries: The implications of prob-
ability weighting for security prices. American Economic Review, 98(5),
2066–2100.
Barberis, N., Mukherjee, A., & Wang, B. (2014). Prospect theory and stock returns:
An empirical test. Fordham University Schools of Business Research Paper No
2528149. Retrieved October 28, 2015, from SSRN: http://ssrn.com/
Bekaert, G., Erb, C. B., Harvey, C. R., & Viskanta, T. E. (1996). The cross-sec-
tional determinants of emerging equity market returns. Retrieved September 21,
2015, from https://www0.gsb.columbia.edu/faculty/gbekaert/PDF_

Papers/The_cross-sectional_determinants.pdf
Bernard, S., Leippold., M., & Lohre, H. (2013). Risk-based commodity investing.
Working paper. Retrieved October 24, 2015, from http://viessmanncentre.
ca/wp-content/uploads/2014/05/Bernardi_Leiphold_Lohre1.pdf
Black, F. (1972). Capital market equilibrium with restricted borrowing. Journal of
Business, 45, 44–455.
Black, F., Jensen, M. C., & Scholes, M. S. (1972). The capital asset pricing model:
Some empirical tests. In M. C. Jensen (Ed.), Studies in the theory of capital
markets (pp. 79–121). New York: Praeger Publishers.
Blitz, D., & de Groot, W. (2014). Strategic allocation to commodity factor premi-
ums. Journal of Alternative Investments, 17(2), 103–115.
Blitz, D. C., Pang, J., & van Vliet, P. (2013). The volatility effect in emerging
markets. Emerging Markets Review, 16, 31–45.
Blitz, D. C., & van Vliet, P. (2007). The volatility effect: Lower risk without lower
return. Journal of Portfolio Management, 34(1), 102–113.
Blume, M. E. (1970). Portfolio theory: A step towards its practical application.
Journal of Business, 43(2), 152–174.
Blume, M. E., & Friend, I. (1973). A new look at the capital asset pricing model.
Boyer, B., Mitton, T., & Vorkink, K. (2010). Expected idiosyncratic skewness.
Review of Financial Studies, 23(1), 169–202.
Brennan, M. (1971). Capital market equilibrium with divergent borrowing and
lending rates. Journal of Financial and Quantitative Analysis, 6(5), 1197–1205.
Brennan, M. J., Cheng, X., & Li, F. (2012). Agency and institutional investment.
European Financial Management, 18(1), 1–27.
Campbell, J. Y., & Cochrane, J. H. (1999). By fore of habit: A Consumption-
based explanation of aggregate stock market behavior. Journal of Political
Economy, 107(2), 205–251.
Chan, L., Karceski, J., & Lakonishok, J. (1999). On portfolio optimization:
Forecasting covariances and choosing the risk model. Review of Financial
Studies, 12, 937–974.
Chen, D.-H., Chen, C. D., & Wu, S. C. (2014). VaR and the cross-section of
expected stock returns: An emerging market evidence. Journal of Business
Economics and Management, 15(3), 441–459.
Clark, A., & Oswald, A. (1996). Satisfaction and comparison income. Journal of
Public Economics, 61(3), 359–381.
Clarke, R., de Silva, H., & Thorley, S. (2006). Minimum-variance portfolios in the
US equity market. Journal of Portfolio Management, 33(1), 10–24.
Clarke, R., de Silva, H., & Thorley, S. (2010). Know your VMS exposure. Journal
of Portfolio Management, 36(2), 52–59.
Cornell, B. (2009). The pricing of volatility and skewness: A new interpretation.

Journal of Investing, 18(3), 27–30.
Dahlquist, M., & Bansal, R. (2002). Expropriation risk and return in global equity
markets. EFA 2002 Berlin Meetings Presented Paper. Retrieved September 21,
org/10.2139/ssrn.298180
de Carvalho, R. L., Dugnolle, P., Lu, X., & Moulin, P. (2014). Low-risk anomalies
in global fixed income: Evidence from major broad markets. Journal of Fixed
Income, 23(4), 51–70.
de Giorgi, E. G., Post, T., & Yalcin, A. (2013). A concave security market line.
Dimitriou, D., & Simos, T. (2011). The relationship between stock returns and
volatility in the seventeen largest international stock markets: A semi-paramet-
ric approach. Modern Economy, 2, 1–8.
Dittmar, R. F. (2002). Nonlinear pricing kernels, kurtosis preference, and evi-
dence from the cross section of equity returns. Journal of Finance, 57, 369–404.
Erb, C. B., Harvey, C. R., & Viskanta, T. E. (1995). Country risk and global
equity selection. Journal of Portfolio Management, 21(2), 74–83.
Falkenstein, E. G. (1994). Mutual funds, idiosyncratic variance, and asset returns.
PhD thesis, Northwestern University. Retrieved October 25, 2015, from
http://www.researchgate.net/publication/269698051
Falkenstein, E. (1996). Preferences for stock characteristics as revealed by mutual
fund portfolio holdings. Journal of Finance, 51(1), 111–135.
Falkenstein, E.G. (2009). Risk and return in general: Theory and evidence.
Falkenstein, E. G. (2012). The missing risk premium: Why low volatility investing
works. CreateSpace Independent Publishing Platform.
Fama, E. F., & French, K. R. (1992). The cross-section of expected returns.
Fama, E. F., & MacBeth, J. D. (1973). Risk, return and equilibrium: empirical
tests. Journal of Political Economy, 81(3), 607–636.
Fernandez-Perez, A., Frijns, B., Fuertes, A.-M., & Miffre, J. (2015). Commodities
as lotteries: Skewness and the returns of commodity futures. Retrieved October
org/10.2139/ssrn.2671165
Fernandez-Perez, A., Fuertes, A.-M., & Miffre, J. (2014). Is idiosyncratic volatility
priced in commodity futures markets? Retrieved October 24, 2015, fom SSRN:
http://ssrn.com/abstract=2120587 or http://dx.doi.org/10.2139/ssrn.
2120587
Ferrer-i-Carbonell, A. (2005). Income and well-being: An empirical analysis of

the comparison income effect. Journal of Public Economics, 89(5–6),
997–1019.
Fischhoff, B., Slovic, P., & Lichtenstein, S. (1977). Knowing with certainty: The
appropriateness of extreme confidence. Journal of Experimental Psychology.
Human Perception and Performance, 3(4), 552–564.
Frazzini, A., & Pedersen, L. H. (2014). Betting against beta. Journal of Financial
Friend, I., & Blume, M. (1970). Measurement of portfolio performance under
uncertainty. American Economic Review, 60, 561–575.
Fu, F. (2009). Idiosyncratic risk and the cross-section of expected returns. Journal
of Financial Economics, 91(1), 24–37.
Fuertes, A. M., Miffre, J., & Fernández-Pérez, A. (2015). Commodity strategies
based on momentum, term structure and idiosyncratic volatility. Journal of
Gali, J. (1994). Keeping up with the Joneses: Consumption externalities, portfolio
choice, and asset prices. Journal of Money, Credit and Banking, 26(1), 1–8.
Goetzmann, W. N., & Kumar, A. (2008). Equity portfolios diversification. Review
of Finance, 12(3), 433–463.
Han, Y., & Lesmond, D. (2011). Liquidity biases and the pricing of cross-sec-
tional idiosyncratic volatility. Review of Financial Studies, 24, 1590–1629.
Harvey, C. (2000). The drivers of expected returns in international markets.
Emerging Markets Quarterly, 4, 32–49.
Harvey, C. R. (2004). Country risk components, the cost of capital, and returns in
emerging markets. In S. Wilkin (Ed.), Country and political risk: Practical
insights for global finance (pp. 71–102). London: Risk Books. Retrieved
September 21, 2015, from SSRN: http://ssrn.com/abstract=620710 or
Harvey, C., & Siddique, A. (2000). Conditional skewness in asset pricing tests.
Haugen, R., & Baker, N. (1991). The efficient market inefficiency of capitalization-
weighted stock portfolios. Journal of Portfolio Management, 17(1), 35–40.
Haugen, R. A., & Baker, N. L. (1996). Commonality in the determinants of
expected stock returns. Journal of Financial Economics, 41(3), 401–439.
Haugen, R. A., & Heins, A. J. (1975). Risk and the rate of return on financial
assets: Some old wine in new bottles. Journal of Financial and Quantitative
Analysis, 10(5), 775–784.
Heaton, J. C., & Lucas, D. J. (2000). Portfolio choice and asset prices: The
importance of entrepreneurial risk. Journal of Finance, 55(3), 1163–1198.
Hong, H. G., & Sraer, D. A. (2015). Speculative betas. Retrieved October 28,
org/10.2139/ssrn.196746
Hou, K., & Loh, R. (2016). Have we solved the idiosyncratic volatility puzzle?
Houweling, P., Beekhuizen, P., Bus, S., Haesen, D., Kwaak, P., Verberk, V., &
Wang, R. (2012). The low risk anomaly in credits. Robeco Research Note.
Retrieved October 24, 2015, from https://www.robeco.com/images/the-
low-risk-anomaly-in-credits.pdf
Houweling, P., & van Zundert, J. (2014). Factor investing in the corporate bond
market. Retrieved October 25, 2015, from SSRN: http://ssrn.com/
Hueng, C. J., & Yau, R. (2013). Country-specific idiosyncratic risk and global
equity index returns. International Review of Economics & Finance, 25,
325–337.
Iqbal, J., & Azher, S. (2014). Value-at-risk and expected stock returns: Evidence
from Pakistan. Lahore Journal of Economics, 19(2), 71–100.
Jagannathan, R., & Ma, T. (2003). Risk reduction in large portfolios: Why impos-
ing the wrong constrains helps. Journal of Finance, 58(4), 1651–1684.
Jensen, M. C., Black, F., & Scholes, M. S. (1972). The capital asset pricing model:
Some empirical tests. In M. C. Jensen (Ed.), Studies in the theory of capital
markets. New York: Praeger Publishers.
Jorion, P. (2007). Financial risk manager handbook. Hoboken, NJ: Wiley.
Kahneman, D., & Tversky, A. (1979). Prospect theory: An analysis of decision
under risk. Econometrica, 47, 263–291.
Kapadia, N. (2006). The next Microsoft? Skewness, idiosyncratic volatility, and
expected returns. Retrieved October 28, 2015, from SSRN: http://ssrn.com/
Knight, J., Song, L., & Gunatilaka, R. (2009). Subjective well-being and its deter-
minants in rural China. China Economic Review, 20(4), 635–649.
Kraus, A., & Litzenberger, R. (1976). Skewness preference and the valuation of
risk assets. Journal of Finance, 31, 1085–1100.
Kumar, A. (2009). Who gambles in the stock market? Journal of Finance, 64(4),
1889–1933.
Lettau, M., & Ludvigson, S. (2001). Consumption, aggregate wealth, and
expected stock returns. Journal of Finance, 56(3), 815–849.
Levy, H. (1978). Equilibrium in an imperfect market: A constraint on the number
of securities in the portfolio. American Economic Review, 68, 643–658.
Liang, S. X., & Wei, K. C. J. (2006). Volatility and stock market returns around the
world. Working paper. Retrieved October 26, 2015, from https://www.eurofi-
dai.org/Xin_Liang.pdf
Luttmer, E. (2005). Neighbors as negatives: Relative earnings and well-being.
Quarterly Journal of Economics, 120(3), 963–1002.
Malkiel, B., & Xu, Y. (2004). Idiosyncratic risk and security returns AFA 2001
New Orleans Meetings. Retrieved October 25, 2015, from SSRN: http://ssrn.
Martellini, L. (2008). Toward the design of better equity benchmarks:

Rehabilitating the tangency portfolio from modern portfolio theory. Journal of
Merton, R. (1987). A simple model of capital market equilibrium with incomplete
information. Journal of Finance, 42, 483–510.
Miller, M. H., & Scholes, M. (1972). Rates of return in relation to risk: A reexami-
nation of some recent findings. In M. C. Jensen (Ed.), Studies in the theory of
capital markets. New York: Praeger.
Mitton, T., & Vorkink, K. (2007). Equilibrium underdiversification and the pref-
erence for skewness. Review of Financial Studies, 20(4), 1255–1288.
Narayan, P. K., & Ahmed, H. A. (2014). Importance of skewness in decision mak-
ing: Evidence from the Indian stock Exchange. Global Finance Journal, 25,
260–269.
Ng, K. Y., & Phelps, B. D. (2015). The hunt for a low-risk anomaly in the USD
corporate bond market. Journal of Portfolio Management, 42(1), 63–84.
Nowak A., & Zaremba A. (2015). Does historical skewness predict the cross-sec-
tion of stock returns on the Polish market? Zeszyty Naukowe Uniwersytetu
Szczecińskiego no. 854, “Finanse, Rynki Finansowe, Ubezpieczenia” no. 73.
Wydawnictwo Naukowe Uniwersytetu Szczecińskiego. Szczecin, 735–748.
Retrieved October 28, 2015, from http://www.wneiz.pl/nauka_wneiz/
frfu/73-2015/FRFU-73-735.pdf
Roll, R. (1992). A mean/variance analysis of tracking error. Journal of Portfolio
Roussanov, N. (2010). Diversification and its discontents: Idiosyncratic and entre-
preneurial risk in the quest for social status. Journal of Finance, 65(5),
1755–1788.
Schneider, P., Wagner, C., & Zechner, J. (2015). Low risk anomalies? Retrieved
November 17, 2015, from SSRN: http://ssrn.com/abstract=2593519 or
http://dx.doi.org/.10.2139/ssrn.2593519
Sensoy, B. (2009). Performance evaluation and self designated benchmark indexes
in the mutual fund management industry. Journal of Financial Economics,
92(1), 25–39.
Sharpe, W. F. (1981). Decentralized investment management. Journal of Finance,
36(2), 217–234.
Svenson, O. (1981). Are we all less risky and more skillful than our fellow drivers?
Acta Psychologica, 47(2), 143–148.
Szymanowska, M., de Roon, F., Nijman, T., & van den Goorbergh, R. (2014). An
anatomy of commodity futures risk premia. Journal of Finance, 69(1), 453–482.
Teplova, T., & Mikova, E. (2011). A higher moment downside framework for
conditional and unconditional CAPM in the the Russian stock market. Eurasian
Economic Review, 1, 157–178.
Tinic, S. M., & West, R. R. (1986). Risk, return and equilibrium: A revisit. Journal
of Political Economy, 94, 126–147.
Tversky, A., & Kahneman, D. (1992). Advances in prospect theory: Cumulative

representation of uncertainty. Journal of Risk and Uncertainty, 5(4), 297–323.
van Vliet, P., Blitz, D., & van der Grient, B. (2011). Is the relation between volatil-
ity and expected stock returns positive, flat or negative? Retrieved October 25,
org/10.2139/ssrn.1881503
Walkshausl, C. (2014). International low-risk investing. Journal of Portfolio
Yang, J., Zjou, Y., & Wang, Z. (2010). Conditional co-skewness in stock and bond
markets: Time series evidence. Management Science, 56(11), 2031–2049.
Zaremba, A. (2015a). Is there low-risk anomaly across countries? Eurasian
Economic Review, forthcoming.
Zaremba, A. (2015b). The January seasonality and the performance of country-
Accounting, 4(2), 195–209.
Zaremba, A., & Nowak, A. (2015). Skewness preference across countries. Business
and Economic Horizons, 11(2), 115–130.
CHAPTER 6
Is Good Company a Good Investment?

Quality Investing
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.

DOI 10.1057/978-1-137-59191-3_6
Still, a substantial part of recent publications seems to indicate that

quality is not fully priced in, i.e. historically quality stocks have outper-
formed low quality shares. This counterintuitive phenomenon is con-
firmed by many studies and refers to many ways of understanding the
quality, e.g., credit standing, leverage, growth, accruals, and profitability.
Also the synthesized measures of quality, which integrate a range of vari-
ous metrics, appear to be positively correlated with future returns.3
The concept of quality is very broad and not necessarily limited to the
realm of finance. For example, Antunovich et al. (2000) assessed compa-
nies based on Fortune magazine’s annual survey: America’s Most Admired
Companies (AMAC). They classified the stocks into 10 deciles, ranging
from the most to the least respected. In the period 1983–1995 the high-
reputation stocks strongly outperformed the low reputation stocks. The
most-admired decile delivered an average annual return of 7.8 %, while
the least-admired decile earned annually only 4.48 %. Furthermore, the
highly-respected stocks proved less risky in terms of both beta and stan-
dard deviation, showing that quality can outperform.
Here, we will investigate whether it is also possible to apply the stock-level
quality ideas to country selection. First, we will review the history and defini-
tions of stock-level quality investing, particularly focusing on financial quality.
We will then discuss how we can measure quality and how the quality-based
strategies perform. Finally, we will explain why quality impacts future returns,
and whether this pattern could be also applied at the country level.
HISTORY AND DEFINITIONS OF QUALITY INVESTING

Searching for the earliest traces of the quality investing, we come across its
potential origins in the bond and real estate markets, where both ratings
and expert attestations are key drivers in setting the prices—these concepts
later transferred to equity markets.
Plausibly, one of the founding fathers of quality investing was Benjamin
Graham—the same legendary investor who fathered the concept of value
investing. Interestingly, Graham never articulated these thoughts to the
effect of simply buying cheap companies, but rather advocated buying
undervalued companies, i.e. good quality firms that are reasonably priced
(Novy-Marx 2012b). Graham believed that an investor should “…apply
a set of standards to each [stock] purchase, to make sure that he obtains
(1) a minimum of quality in the past performance and current financial
IS GOOD COMPANY A GOOD INVESTMENT? QUALITY INVESTING 107
position of the company, and also (2) a minimum of quantity in terms of

earnings and assets per dollar of price” (Graham 2006). Strictly speaking,
Benjamin Graham indicated seven qualitative and quantitative criteria for
successful stock-picking:
1. Adequate size of the company;

2. Strong financial standing, i.e. current ratios exceeding two and net
current assets outweighing long-term debt;
3. Stable earnings, i.e. 10 consecutive years of positive earnings;
4. Stable record of dividend payments, at least 20 years long;
5. At least 1/3 increase in earnings per share over the past 10 years;
6. Low price-to-earnings ratios, typically below 15;
7. Low price-to-book ratios, typically under 1.5.
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.
4. Market Tenets:
(a) The company’s market value should be lower than the dis-
counted value of future earnings.
Indeed, Warren Buffett seems much more of a quality investor than

a value investor, which also transpires from his own comments. In the
2008 Annual Report of Berkshire Hathaway (Buffett’s investment com-
pany) he indicates that “whether we’re talking about socks or stocks, I
like buying merchandise when it is marked down”—then quality first,
and valuation second. Buffet’s adherence to quality rules is supported
not merely by anecdotal evidence. Frazzini et al. (2013b) in their paper
entitled “Buffett’s alpha” took a closer look at the returns on Buffet’s
investment vehicles. They found that his returns “appear to be neither
luck nor magic, but, rather, reward for the use of leverage combined
with a focus on cheap, safe, quality stocks.” Further, Frazzini, Kabiller
and Pedersen found that the abnormal returns delivered by Berkshire
Hathaway could be largely explained by a set of simple rules related to
quality and low-risk concepts.
The concept of quality has been also widely debated in the man-
agement economics literature, which spurred the development of the
BCG matrix by Boston Consulting Group in 1981. The principle of the
growth–share matrix involves companies being ranked in two specific
dimensions: life cycle and experience curve. The resulting matrix divides
firms into either two quality classes, dubbed Cash Cows or Stars, or two
non-quality classes, called Question Marks and Dogs. Subsequently, the
concept of quality gained much attention in the US management lit-
erature. The books like Built to Last by Jim Collins and Jerry Porras
(2004) or Good to Great by Jim Collins (2001) may serve as flagship
examples.
The investment community turned their attraction to quality investing
particularly after the burst of the dot-com bubble when many realized that
even large and seemingly well-run companies, like Enron or WorldCom,
could collapse. These corporate failures opened many investors’ eyes and
made them pay more attention to quality, by closely analyzing corporate
governance, earnings quality, and information transparency.
The modern concept of quality investing is very comprehensive and
lacks a straightforward definition. While there are numerous interpreta-
tions in the academic and practitioner’s literature, most of them rely on a
set of quantitative financial ratios. A good example in the academic world

offers the paper by Piotroski (2000) in which the researcher presented his
famous F-score, helping to separate future winners from losers. Piotroski,
relying on nine metrics: return on assets/net income, operating income,
cash flow, quality of earnings, leverage, liquidity, equity issuance, gross
margins, and asset turnover, showed that the performance of value strate-
gies could be improved by at least 7 % per year through the selection of
financially strong companies.
Many asset management companies, that nowadays frequently offer
products based on quality strategies, also take the approach of aggregat-
ing a set of financial ratios. AQR Capital Management, for example, the
famous hedge fund company run by Clifford S. Asness, associates the con-
cept of quality with three financial ratios: total profits to assets, gross mar-
gins, and free cash flow to assets (Frazzini et al. 2013b). On the other side,
Dimensional Fund Advisors, a company whose board of directors includes
Nobel Prize laureates Myron S. Scholes and Eugene Fama, base their
Direct Profitability approach on operating income before depreciation
and amortization minus interest expense scaled by book value (Hunstad
2014).
Recently, the concept of quality investing has become so widely popular
as to be incorporated in a number of stock market indices; for example,
the family of the MSCI Quality indices aiming to capture the performance
of quality companies by identifying stocks with high quality scores calcu-
lated using three main fundamental variables: high return on equity, stable
year-over-year earnings growth and low financial leverage (MSCI 2014c).
Figure 6.1 depicts how this quality selection method has performed in the
USA over the last 40 years.
Clearly, the quality companies have performed well in the US over the
last 40 years. The annual growth of the MSCI Quality Gross Index in the
1975–2015 period was 12.3 % and outperformed the simple MSCI USA
Gross Index, on average, by roughly 1 percentage point per annum.
HOW TO MEASURE QUALITY?

Summing up, the concept of quality is very comprehensive and touches
upon many aspects of a company, and it could be defined in numerous
ways. Let us therefore split the concept into pieces to tease out the ele-
ments contributing to quality. Considering the financial reflection of qual-
ity, we can attribute it to 10 distinct factors: (1) profitability, (2) margins,
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
(3) growth in profitability, (4), growth in margins, (5), leverage, (6),

financial constraints and distress, (7) earnings stability (8), net payout/
issuance, (9) growth activities (R&D, advertising expenses, etc.), and (10)
accounting quality (Kalesnik and Kose 2014).
Each of these quality factors is well-documented in the academic litera-
ture and proven to predict the future returns. Let’s briefly examine each
one of the factors.
Profitability. While a company’s profitability might be measured in
several ways, regardless of the approach, it always positively relates to
future returns. While, among the ratios proved to correlate with expected
returns, we find return on assets (ROA) and return on equity (ROE),4
perhaps the most popular and respected measure of profitability is the
so-called gross profitability, i.e. gross profit divided by total assets. This
measure was thoroughly examined by Novy-Marx in his famous paper of
2013 “The other side of value: The gross profitability premium”. Why
gross profitability premium? It is “the cleanest” of all profitability mea-
sures as indicated by Novy-Marx (2013): “the farther down the income
statement one goes, the more polluted profitability measures become, and
the less related they are to true economic profitability”. The other metrics,
like ROA, remain vulnerable to the company-specific accounting meth-
ods, investment activities, time-varying interests and taxes. Having formed
quintile portfolios of global stocks from sorts on gross profitability, Novy-

Marx has confirmed that in the 1990–2009 period the most profitable
stocks outperformed the least profitable stocks by over 0.76 percentage
points.
Margins. In search of the underlying source of profitability, some
authors try to split profitability further using, for instance, the Du Pont
analysis. This has led to investigations of margins as the predictors of
future returns which indeed proved useful in forecasting performance.5
Growth in profitability and growth in margins. According to the
academic evidence, it is not only the level of profitability or margins that
matters, but also its dynamics. The firms that show improvement in these
areas tend to outperform companies with fledgling margins or profitabil-
ity. This is reflected by Piotroski (2000) facilitating his famous F-score
with the change in gross profit margin and other authors pointing at the
importance of profitability improvement in relation to other metrics, like
sales (Abarbanell and Bushee 1998).
Leverage and financial distress. Initially, much evidence suggested
the leverage to be generally positively related to future returns. A seminal
study in this case was performed by Bhandari in 1988, investigating the
US stock market. Later, however, many studies painted different a differ-
ent picture. The matter has been approached in three distinct ways. First,
a number of authors examined the link between the composite distress risk
measures and future returns. They found a paradoxical and counterintui-
tive relationship: the lower the risk, the higher the returns.6 The second
stream of research concentrated on the external credit ratings and showed
that both levels (Avramov et al. 2009) and changes (Dichev and Piotroski
2001) in credit ratings are significantly related to future risk adjusted
returns, i.e. a low risk implies high returns. Finally, the last research strain
concentrated on individual financial ratios that help predict future perfor-
mance. For example, Palazzo (2012) investigating balance sheets mea-
sured with cash holdings has shown that an investing strategy long in
stocks of firms with a high cash-to-assets ratio and short in stocks of firms
with a low cash-to-assets ratio produces an average an excess return of
0.42 percentage points per month.7
Earnings stability. Importantly, it matters not only how high the prof-
its of a company are but also how stable they remain. This has been indi-
cated by Francis et al. (2004) who having analyzed a range of earnings
attributes of American stocks within the 1975–2001 period concluded
that the level of their variability helps predict future returns.
Net payout/issuance. The anomalies springing from the net payout

and issuance effect could be traced back to the initial investigations of
post-IPO performance. There is now robust academic evidence indi-
cating that companies entering the stock market tend to underperform
in the 3–5 years following their Initial Public Offering. The effect was
probably first documented by Ritter in 1991 by using a sample of over a
thousand IPOs from years 1975–1984. According to his findings, young
public companies earned on average 34 % in the three years following
their IPO, while their counterparts from the same industries delivered
mean return of 62 %. Although the underperformance is strongest during
the first 12 months documented following the IPO (Aggarwal and Rivoli
1990)—13.73 % abnormal returns for investors holding shares for 250
trading days, the undermined returns may last even 5 years after the first
trading day (Loughran and Ritter 1995). The phenomenon is robust and
well-documented globally, even in the emerging and frontier markets.8
Similarly, the long-run underperformance has been well documented
over various periods, including the pre-II World War years (Gompers and
Lerner 2003).
While increasing the number of shares generally adversely affects future
returns, decreasing it has exactly the opposite effect. Stock buybacks tend
to be a harbinger of good future performance and as indicated in a num-
ber of academic studies, stocks deliver positive abnormal returns even up
to four years after the buyback (Vermaelen 1981; Ikenberry et al. 1995).
The concept of net issuance or payout has emerged from a set of studies
attempting to aggregate various sources of changes in shareholder capital.
This strain of research has concentrated on the aggregated amount of
money transferred to or from investors in the form of dividends, share
buybacks or share offerings. In short, the more money is distributed to
investors and the less is taken from them, the better it is for the future
returns.9
Growth and investment activities. As a general rule, fast growing
companies tend to underperform the markets. Investors usually prefer
shiny and rapidly growing firms which invest considerable amounts and
promise quick improvement in their financial statements. This general
proclivity, however, can prove dangerous. First, the stocks of firms with
fast sales growth during the previous five years tend to underperform with
either low or negative revenue growth (Lakonishok et al. 1994). Second,
companies that invest heavily usually yield weak future returns. In fact, the
lower the investments in fixed or operating assets, the better the future
returns.10 Furthermore, the negative influence on future returns could be

also extended to advertising expenses (Lou 2014).
There is one type of investment which seems to positively predict
returns: investment in innovation. Clearly, investors tend to under-
react to changes in the level of innovation activities. This effect may
manifest in a number of ways. Stocks of firms with high and increasing
expenditures on research and development tend to outperform (Chan
et al. 2001; Eberhardt et al. 2004). The innovation level can also be
measured with patents and patent citations (Gu 2005; Hirshleifer et al.
2013). Finally, companies with successful past research and develop-
ment track records outperform the firms with less successful track
record.
Accruals. The accrual anomaly is a long and complex story. In invest-
ment accounting the term accruals refers to all non-cash components of
earnings, which include, among many others, accounts payable, accounts
receivable, goodwill, future tax liability, future interest expense, or inven-
tory. Interestingly, accruals seem also related—in this case, negatively—
with future returns.
Why would such a relation exist in the financial markets? According to
the early book of Graham and Dodd in 1934, investors are often lazy and
reluctant to analyze financial statements. They usually make their decisions
based on total earnings without considering the underlying structure.
When the reported earnings exceed expectations, investors buy the stocks
and its price rises. On the other hand, when the earnings disappoint, the
massive selling drives the price down. Meanwhile, the underlying quality
of various components of the profit is frequently ignored. As we already
know, cash is king. While the other components might be prone to manip-
ulation, cash is the strongest determiner of the intrinsic value, ruling over
all other components of secondary importance.
A simple, yet powerful, explanation of why accruals matter was given
by Dechow et al. (2011) in a story of two young businessmen: Bill and
Ted.11 The men decided to set up lemonade stands. Each of them chose
a slightly different approach: Bill did everything “just-in-time”: he rented
a stand and bought only the exact amount of supplies and inventory he
needed for each day. On the contrary, Ted purchased a new stand and
bought everything needed for the first 100 days in the lemonade business.
Total costs for Bill and Ted amount to $120 and $2100, respectively. As
the quality of both products was the same, both men earned $200 in sales
after the first day.
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.
For example, the cross-sectional impact of profitability is usually

explained with a very simple economic formula (Novy-Marx 2012b) stat-
ing that current stock price reflects market expectations of future payouts,
discounted by the required rate of return to the investor. Therefore, if
two companies have identical expected payoffs (i.e. profitability) but their
prices differ, then the differences must arise from different expected rates
of return.14 In other words, simple dividend discounting predicts the value
premium. Analogously, let’s take two firms with different expected profit-
abilities (thus also different expected payoffs), but identical prices. In this
situation, investors must require a higher rate of return for holding the
stock of the more profitable firm. Perhaps, the same economic reasoning
which predicts the value premium may also be used to explain the prof-
itability premium, as argued by Novy-Marx (2012b) who saw both the
quality and value phenomena as two sides of the same coin. Finally, the
profitability effects could be elevated to a broader concept of fundamen-
tal analysis anomalies, which are mostly explained on behavioral grounds
assuming that due to either constraints in information processing or biased
beliefs, investors are unable to discern the truly fundamentally relevant
information. Similarly, both the distress risk and indebtedness effects are
mostly explained with investor underreaction to new information, overop-
timistic expectations about future cash flows, or on flight-to-quality effects.
The anomalies associated with stock issuance and investment fall into
a separate category, being usually explained on either behavioral or ratio-
nal grounds. From the behavioral standpoint, it is argued that managers
successfully time equity markets and take advantage of investor sentiment
in their corporate decisions and thus issue new stocks when they assess
the shares to be overpriced. In the same time, cognitively overloaded
investors might be prone to overvalue firms with bloated balance sheets
(Jacobs 2015). From the rational viewpoint, the quantity of investments
is negatively linked with their marginal profitability. Simply speaking, if a
company invests only a little, the management probably carefully selects
only the most attractive projects. If it invests a large amount, the company
probably also accepts lower rates of return. Additionally, for large invest-
ments we need a considerable amount of capital, so investments are also
tightly linked with stock issuance.
Finally, the anomalies related to earnings quality and accruals are usually
explained with investors’ inability to distinguish correctly between cash
flows from operations and accounting adjustments (operating accruals).
As a result, they might grow too optimistic with the companies displaying
high accruals, and overprice their value. We summarize various explana-

tions of the quality anomalies in Table B1 in Appendix B.
Summing up, the concept of quality investing truly seems to lack a
single, uniformed explanation that would be broadly accepted by the aca-
demic community. Nonetheless, the empirical evidence seems so strong
that the quality aspect is well-worth considering by a stock market investor.
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).
REFERENCES
Abarbanell, J. S., & Bushee, B. J. (1998). Fundamental analysis, future earnings,
and stock prices. Journal of Accounting Research, 35, 1–24.
Amihud, Y. (2002). Illiquidity and stock returns: Cross-section and time-series
effects. Journal of Financial Markets, 5, 31–56.
Anderson, C. W., & Garcia-Feijoo, L. (2006). Empirical evidence on capital invest-
ment, growth options, and security returns. Journal of Finance, 61, 171–194.
Antunovich, P., Laster, D., & Mitnick, S. (2000). Are high-quality firms also high-
quality investments? Current Issues in Economics and Finances, 6(1), 1–6.
Avramov, D., Chordia, T., Jostova, G., & Philipov, A. (2009). Credit ratings and
the cross-section of stock returns. Journal of Financial Markets, 12, 469–499.
Balakrishnan, K., Bartov, E., & Faurel, L. (2010). Post loss/profit announcement
drift. Journal of Accounting and Economics, 50, 20–41.
Ball, R. (1978). Anomalies in relationships between securities’ yields and yield sur-
rogates. Journal of Financial Economics, 6(2–3), 103–126.
Berk, J. B. (1995). A critique of size-related anomalies. Review of Financial
Studies, 8(2), 275–286.
Bradshaw, M. T., Richardson, S. A., & Sloan, R. G. (2006). The relation between
corporate financing activities, analysts’ forecasts and stock returns. Journal of
Accounting and Economics, 42, 53–85.
Chan, L. K., & Jegadeesh, N. (2006). Earnings quality and stock returns. Journal
of Business, 79, 1041–1082.
Chan, L. K., Lakonishok, J., & Sougiannis, T. (2001). The stock market valuation
of research and development expenditures. Journal of Finance, 56, 2431–2456.
Collins, J. (2001). Good to great: Why some companies make the leap... and others
don’t. New York: HarperBusiness.
Collins, J., & Porras, J. I. (2004). Built to last: Successful habits of visionary compa-
nies. New York: HarperBusiness.
Cooper, M. J., Gulen, H., & Schill, M. J. (2008). Asset growth and the cross-
section of stock returns. Journal of Finance, 63, 1609–1651.
Damodaran, A. (2004). Investment fables: Exposing the myths of can’t miss invest-
ment strategies. London: FT-Press.
Damodaran, A. (2012a). Investment philosophies: Successful strategies and the inves-
tors who made them work. Hoboken: John Wiley & Sons.
ing the value of any asset. 3rd edition. New York: Wiley.
Daniel, K., & Titman, S. (2006). Market reactions to tangible and intangible
information. Journal of Finance, 61, 1605–1643.
Dechow, P. M., Khmich, N. V., Sloan, R. G. (2011). The accrual anomaly. In L. Sacks
(ed.), The handbook of equity market anomalies: Translating market inefficiencies
into effective investment strategies, Chap. 2, pp. 23–62. Hoboken, NJ: Wiley.
Dichev, I. D., & Piotroski, J. D. (2001). The long-run stock returns following
bond rating chances. Journal of Finance, 56, 173–202.
Eberhardt, A. C., Maxwell, W. F., & Siddique, A. R. (2004). An examination of
long-term abnormal stock returns and operating performance following R&D
increases. Journal of Finance, 59, 623–650.
Eckbo, B.E., Masulis, R.W., & Norli, O. (2007). Security offerings. In B.E. Eckbo
(ed.), Handbook of corporate finance: Empirical corporate finance, Chap. 6.
Amsterdam: Elsevier.
Fairfield, P. M. (2003). Accrued earnings and growth: Implications for future
profitability and market mispricing. Accounting Review, 58, 353–371.
Fama, E. F., & French, K. R. (2006). Profitability, investment and average returns.
63(4), 1653–1678.
Francis, J., LaFond, R., Olsson, P. M., & Schipper, K. (2004). Costs of equity and
earnings attributes. Accounting Review, 79(4), 967–1010.
George, T. J., & Hwang, C. Y. (2010). A resolution of the distress risk and lever-
age puzzles in the cross section of stock returns. Journal of Financial Economics,
96, 56–79.
Graham, B. (2006). The intelligent investor: The definitive book on value investing.
A book of practical counsel. New York: HarperBusiness.
Gu, F. (2005). Innovation, future earnings, and market efficiency. Journal of
Accounting, Auditing and Finance, 20, 385–418.
Hahn, J., & Lee, H. (2009). Financial constraints, debt capacity, and the cross-
section of stock returns. Journal of Finance, 64, 891–921.
Hanson, D., & Dhanuka, R. (2015). The “science” and “art” of high quality
investing. Journal of Applied Corporate Finance, 27(2), 73–86.
Haugen, R. A., & Baker, N. L. (1996). Commonality in the determinants of
expected stock returns. Journal of Financial Economics, 41(3), 401–439.
Hirshleifer, D., Hsu, P.-H., & Li, D. (2013). Innovative efficiency and stock
Hunstad, M. (2014). What is quality? Understanding the quality phenomenon;
what it is and why it exists. Northern Trust research paper. Retrieved October
29, 2015, from https://www.northerntrust.com/documents/commentary/
insights-on/defining-quality-investing.pdf
Ikenberry, D., Lakonishok, J., & Vermaelen, T. (1995). Market reaction to open
market share repurchases. Journal of Financial Economics, 39(2–3), 181–208.
Kalesnik, V., & Kose, E. (2014). The moneyball of quality investing. Research affili-
ates white paper. Retrieved November 4, 2015, from https://www.researchaffil-
iates.com/Our%20Ideas/Insights/Fundamentals/Pages
/259_The_Moneyball_of_Quality_Investing.aspx
Kogan, L., & Papanikolaou, D. (2013). Firm characteristics and stock returns:
The role of investment specific shocks. Review of Financial Studies, 25,
2718–2759.
Korajczyk, R. A., & Sadka, R. (2008). Pricing the commonality across alternative
measures of liquidity. Journal of Financial Economics, 87, 45–72.
Leippold, M., & Lohre, H. (2010). Data snooping and the global accrual anom-
aly. EFA 2007 Ljubljana Meetings Paper. Available at SSRN: http://ssrn.com/
abstract=962867 or http://dx.doi.org/10.2139/ssrn.962867.
Lev, B., & Thiagarajan, S. R. (1993). Fundamental information analysis. Journal
of Accounting Research, 31, 190–215.
Livnat, J., & Santicchia, M. (2006). Cash flows, accruals, and future returns.
Financial Analyst Journal, 62(4), 48–61.
Lou, D. (2014). Attracting investor attention through advertising. Review of
Financial Studies, 27, 1797–1829.
Loughran, T., & Ritter, J. (1995). The new issues puzzle. Journal of Finance, 50,
23–51.
Mohanram, P. (2005). Separating winners from losers among low book-to-market
stocks using financial statement analysis. Review of Accounting Studies, 10,
133–170.
Mohanram, P. S. (2014). Analysts’ cash flow forecasts and the decline of the accru-
als anomaly. Contemporary Accounting Research, 31(4), 1143–1170.
Novy-Marx, R. (2013). The other side of value: The gross profitability premium.
Ohlson, J. A. (1980). Financial ratios and the probabilistic prediction of bank-
ruptcy. Journal of Accounting Research, 18, 109–131.
Ou, J. A., & Penman, S. H. (1989). Financial statement analysis and the predic-
tion of stock returns. Journal of Accounting & Economics, 11, 295–329.
Palazzo, B. (2012). Cash holdings, risk, and expected returns. Journal of Financial
Economics, 104, 162–185.
Penman, S., Richardson, S., & Tuna, I. (2007). The book-to-price effect in stock
returns: Accounting for leverage. Journal of Accounting Research, 45, 427–467.
Piotroski, J. D. (2000). Value investing: The use of historical financial statement
information to separate winners from losers. Journal of Accounting Research,
38, 1–52.
Pontiff, J., & Woodgate, A. (2008). Share issuance and cross-sectional returns.
Richardson, S. A., Sloan, R. G., Soliman, M. T., & Tuna, I. (2005). Accrual reli-
ability, earnings persistence and stock prices. Journal of Accounting and
Economics, 39, 437–485.
Ritter, J. R., & Welch, I. (2002). A review of IPO activity, pricing, and allocations.
Robbins, K. (2011). Lemons or lemonade? Online article. Retrieved November 6,
2015, from http://www.zacks.com/commentary/19472/lemons-or-
lemonade
Shumway, T. (2001). Forecasting bankruptcy more accurately: A simple hazard
model. Journal of Business, 74, 101–124.
Sloan, R. G. (1996). Do stock prices fully reflect information in accruals and cash
flows about future earnings? Accounting Review, 71, 289–315.
Soliman, M. T. (2008). The use of DuPont analysis by market participants.
Accounting Review, 83, 823–853.
Thomas, J. K., & Zhang, H. (2002). Inventory changes and future returns. Review
of Accounting Studies, 7, 163–187.
Titman, S., Wei, K. J., & Xie, F. (2004). Capital investments and stock returns.
Journal of Financial and Quantitative Analysis, 39, 677–700.
Vermaelen, T. (1981). Common stock repurchases and market signalling: An
empirical study. Journal of Financial Economics, 9(2), 139–183.
Walkshäusl, C. (2016). Net payout yields and the cross-section of international
stock returns. Journal of Asset Management, 17(1), 57–67.
Wang, H., & Yu, J. (2013). Dissecting the profitability premium. AFA 2013 San
Diego Meetings Paper. Retrieved November 4, 2015, from SSRN: http://
dx.doi.org/10.2139/ssrn.1711856
Witkowska, M. (2006). Fundamentals and stock returns on the Warsaw Stock
Exchange: The application of panel data models. Department of Applied
Econometrics Working Paper No. 4-06. Retrieved November 4, 2015, from
SSRN: http://dx.doi.org/10.2139/ssrn.903167
Xie, H. (2001). The mispricing of abnormal accruals. Accounting Review, 76,
357–373.
Zaremba, A. (2014a). Quality investing in CEE emerging markets. Business,
Management and Education, 12(2), 159–180.
PART II
CHAPTER 7
Testing the Country Allocation Strategies
In this book we show the performance of various country-level strate-

gies based on real data. Thus, we form portfolios based on country stock
market indices and subsequently assess their performance under various
metrics.
The Data We Use

We base all our computations on stock market indices our accounting
data is sourced from the Bloomberg database. We aim to make the pre-
sented strategies as reliable and comprehensive as possible, so we base the
computation on a broad sample of 78 country equity markets: Argentina,
Australia, Austria, Bahrain, Bangladesh, Belgium, Brazil, Bulgaria, Canada,
Chile, China, Colombia, Croatia, Cyprus, Czech Republic, Denmark,
Egypt, Estonia, Finland, France, Germany, Greece, Hong Kong, Hungary,
Iceland, India, Indonesia, Ireland, Israel, Italy, Japan, Jordan, Kazakhstan,
Kenya, Kuwait, Latvia, Lebanon, Lithuania, Luxemburg, Malaysia,
Malta, Mauritius, Mexico, Morocco, Netherlands, New Zealand, Nigeria,
Norway, Oman, Pakistan, Peru, Philippines, Poland, Portugal, Qatar,
Romania, Russia, Serbia, Saudi Arabia, Singapore, Slovenia, South Africa,
South Korea, Spain, Sri Lanka, Sweden, Switzerland, Taiwan, Thailand,
Trinidad and Tobago, Tunisia, Turkey, Ukraine, United Arab Emirates,
United Kingdom, USA, Venezuela, and Vietnam. We use MSCI indices,
which are widely tracked global equity capitalization-weighted benchmarks

DOI 10.1057/978-1-137-59191-3_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
(Waszczuk 2014a)1 and so we denominate all the data in US dollars to

obtain comparable results on the international scale. To stay consistent,
whenever we need to use the risk-free rate (e.g. to calculate the excess
returns), we use the benchmark returns on the US 3-month Treasury Bills.
Within the country-level studies, we have two most popular approaches
to return calculation: gross and net, where the main differences lie in
accounting for dividend taxes. While the gross return approach ignores
the taxes, the net method adjusts the returns by dividend taxes. Some
index providers, MSCI for example, calculate country indices in both
ways. Throughout the book we rely on monthly returns, which is prob-
ably the most popular among these types of studies.2 Nonetheless, most of
the accounting data we use change only quarterly.
Perhaps the more popular approach across country-level studies adopts
calculations based on gross returns. This method reflects the perspec-
tive of an institutional investor who can avoid dividend taxes that vary
from country to country. For many individual investors, however, this
assumption might prove untrue, and the cross-sectional variation of divi-
dend tax rates might markedly impact the expected returns. In fact, the
impact of these taxes may be substantial for some strategies, for example in
value-oriented portfolios that heavily rely on incomes from dividends. To
account for these issues, we present returns in both conventions.
How We Build the Portfolios

While in this study we examine a lot of different strategies, all of them
are investigated with the use of similar portfolios, designed in an identical
fashion. In order to calculate returns in a given month (month t), we sort
the stock market indices in the sample at the end of the previous month
(month t−1) according to the investigated characteristic, e.g. book-to-
market ratio. In order to obtain index-level financial ratios, the stock-level
ratios are weighted according to the index methodology.3
A common problem encountered when measuring returns of quan-
titative strategies is the look-ahead bias. This bias emerges by the use of
information or data in the strategy simulation, which would not have
been known or available during the period it analyzes. This usually leads
to inflated inaccurate results. A good example could be a strategy that
assumes sorting stocks based on P/E ratio. When the investor backtests
the strategy in January, they need to be careful not to use financial data
from the last quarter of the previous year (ending in December), as it was
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.
How We Test the Strategies

In order to present the performance of various strategies in this book, we
provide an array of statistical data. We facilitate the basic statistics: mean
returns, volatilities, or skewness using other simple and popular ratios to
assess jointly the returns and risk of the strategies. First of them is the com-
monly used Sharpe ratio.
Sharpe ratio. The Sharpe ratio was invented by William Sharpe, later
a Nobel Prize winner. In his paper entitled “Mutual Fund Performance”
(Sharpe 1966) Sharpe described the index later named after him—the
ratio is still, without doubt, the most popular investment performance
measurement tool, which accounts for not only profit but also risk.
Under the most traditional definition, the Sharpe ratio measures the
excess rate of return per unit of risk taken by the investor (Sharpe 1966).
The ratio is calculated by dividing the excess return and the risk under-
stood as the volatility (standard deviation) of these excess returns.6 By
excess return we mean the difference between the return on the investi-
gated portfolio and the return of the risk-free instrument.7 Throughout
the book, it is represented by benchmark returns on the US 3-month
Treasury Bills.
The Sharpe ratio could be expressed with the following formula:
R
SR =
s (7.1)
whereby R represents the mean excess return on the investigated port-

folio over the examined period, and σ is its standard deviation of excess
returns.8 The Sharpe ratio is usually presented on an annual basis, i.e.
with yearly excess returns. Thus, although we base our computations on
monthly intervals, we use an annualized version of the Sharpe ratio. We
perform the annualization by simply multiplying the monthly Sharpe ratio
by the square root of 12.
The unquestionable virtue of the Sharpe ratio is its simplicity. On the
other hand, it also has numerous well-known weaknesses; for example, it
performs poorly in the environment of negative excess returns. For this
reason, we facilitate the Sharpe ratio with the so-called Jensen’s alpha.
Jensen’s alpha. The Jensen’s alpha is a measure derived from the
Capital Asset Pricing Model, abbreviated as CAPM (Sharpe 1964).9 The
CAPM is a simple model that was invented by the same researcher—
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.
Equation (3) could be easily rewritten to be used to evaluate past returns

on a portfolio:

( )
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).
Throughout this book, we present the significance of the mean and

abnormal returns of the tested strategies12 which aims to provide a better
view of how convincing the performance of the strategies is. If the abnor-
mal returns are significant at the 1 % or 5 % level, we can be fairly sure that
the strategy is not only a random return pattern. At the 10 % level signifi-
cance, the evidence is still firm, but less convincing. At the significance
levels below 10 %, the probability that the abnormal returns result from
pure chance is considerable, so it might be risky to assume that the good
performance will continue in the future.13
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
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
using a portfolio with a beta coefficient equal to 0 instead of a risk-free

return. Brennan (1970), on the other hand, constructed a model taking into
account taxes. Elton and Gruber (1995) suggested using a total risk instead
of a systematic one. Many papers also suggested putting additional attention
to the way the profit was earned and how the alpha coefficient was decom-
posed in respect of its origin (e.g., Treynor and Mazuy (1966), McDonald
(1973), Pogue et al. (1974), Merton (1981), Henriksson and Merton
(1981), Henriksson (1984), Grinblatt and Titman (1989)). Furthermore, a
substantial body of research attempts to improve the measure of systematic
risk. There are several basic strands in this line of studies. The first uses con-
ditional betas taking different values for growing and declining markets
(Ferson and Schadt 1996; Christopherson et al. 1999). The second approach
incorporates other risk factors and macroeconomic variables (e.g., Ross
(1976), Chen et al. (1986), Fama and French (1996), Carhart (1997)
Amenc and Le Sourd (2003)). Example of different types of systematic risk
could found in the models of Connor and Korajczyk (1986), based on the
arbitrage pricing theory, the index model by Elton et al. (1993), or the man-
agement style analysis according to Sharpe (1992).
12. All of the regression parameters in this book were estimated using the
ordinary OLS method. We followed the remarks of Cochrane (2005) who
regards this approach to be usually more robust than, for instance,
GLS. This approach has been employed, for example, by Fama and French
(2012). Furthermore, all of the t-statistics were estimated using the boot-
strap standard errors to avoid any distributional assumptions. Under our
null hypothesis, all of the intercepts equal zero whereas the alternative
hypothesis assumes the contrary. The bootstrap simulations are performed
with the use of 10,000 random draws. All the statistical analyses are per-
formed in R.
13. Further details could be found in basically any statistical textbook, e.g.
Aczel (2012).
References
Achour, D., Harvey, C., Hopkins, G., & Lang, C. (1998). Stock selection in
emerging markets: Portfolio strategies in Malaysia, Mexico, and South Africa.
Emerging Markets Quarterly, 2, 38–91.
Aczel, A. D. (2012). Complete business statistics (8 ed.). Morristown: Wohl
Publishing.
Amenc, N., & Le Sourd, V. (2003). Portfolio theory and performance analysis.
Hoboken, NJ: Wiley.
Ang, A. (2014). Asset management: A systematic approach to factor investing.
New York: Oxford University Press.
Avramov, D., & Chordia, T. (2006). Asset pricing models and financial market
anomalies. Review of Financial Studies, 19(3), 1001–1040.
Bali, T. G., Cakici, N., & Fabozzi, F. J. (2013). Book-to-market and the cross-
section of expected returns in international stock markets. Journal of Portfolio
Management, 39(2), 101–115.
Banz, R. W. (1981). The relationship between return and market value of com-
mon stocks. Journal of Financial Economics, 9, 3–18.
Barry, C., Goldreyer, E., Lockwood, L., & Rodriguez, M. (2002). Robustness of
size and value effects in emerging equity markets, 1985–2000. Emerging
Markets Review, 3, 1–30.
Bekaert, G., Harvey, C., & Lundblad, C. (2007). Liquidity and expected returns:
Lessons from emerging markets. Review of Financial Studies, 20, 1783–1831.
Black, F. (1972). Capital market equilibrium with restricted borrowing. Journal of
Business, 45, 44–455.
Brav, A., Geczy, C., & Gompers, P. (2000). Is the abnormal return following
equity issuance anomalous. Journal of Financial Economics, 56, 209–249.
Brennan, M. J. (1970). Taxes, market valuation and corporate financial policy.
National Tax Journal, 25, 417–427.
Brown, A., Du, D. Y., Rhee, S. G., & Zhang, L. (2008). The returns to value and
momentum in Asian markets. Emerging Markets Review, 9, 79–88.
Cakici, N., Fabozzi, F. J., & Tan, S. (2013). Size, value, and momentum in emerg-
ing market stock returns. Emerging Markets Review, 16, 46–65.
Campbell, J. Y., Lo, A. W., & MacKinlay, A. C. (1997). The econometrics of finan-
cial markets. Princeton, NJ: Princeton University Press.
Carhart, M. M. (1997). On persistence in mutual fund performance. Journal of
Finance, 52(1), 57–82.
Chan, L., Karceski, J., & Lakonishok, J. (1998). The risk and return from factors.
Chen, N. F., Roll, R., & Ross, S. (1986). Economic forces and the stock market.
Journal of Business, 59(3), 383–403.
Christopherson, J. A., Ferson, W. E., & Turner, A. L. (1999). Performance evalu-
ation using conditional alphas and betas. Journal of Portfolio Management,
26(1), 59–72.
Chui, A. C. W., Titman, S., & Wei, J. K. C. (2010). Individualism and momentum
around the world. Journal of Finance, 65(1), 361–392.
Cochrane, J. H. (2005). Asset pricing. Princeton, NJ: Princeton University Press.
Connor, G., & Korajczyk, R. (1986). Performance measurement with the arbi-
trage pricing theory: A new framework for analysis. Journal of Financial
Economics, 15, 374–394.
796–818.
Diacogiannis, G., & Kyriazis, D. (2007). Testing the performance of value strate-
gies in the Athens Stock Exchange. Applied Financial Economics, 17,
1511–1528.
Dowd, K. (2000). Adjusting for risk: An improved Sharpe ratio. International
Review of Economics and Finance, 9(3), 209–222.
Elton, E. J., & Gruber, M. J. (1995). Modern portfolio theory and investment anal-
ysis. Hoboken, NJ: Wiley.
Elton, E. J., Gruber, M. J., Das, S., & Hlavka, M. (1993). Efficiency with costly
information: A reinterpretation of evidence from managed portfolios. Review of
Financial Studies, 6(1), 1–22.
Erb, C. B., & Harvey, C. R. (2006). The strategic and tactical value of commodity
futures. Financial Analyst Journal, 62(2), 69–97.
Fama, E. F., & French, K. R. (1996). Multifactor explanations of asset pricing
anomalies. Journal of Finance, 51(1), 55–84.
Fama, E. F., & French, K. R. (1988). Dividend yields and expected stock returns.
Ferson, W. E., & Schadt, R. W. (1996). Measuring fund strategy and performance
in changing economic conditions. Journal of Finance, 51(2), 425–461.
Francis, J. C. (1990). Investments: Analysis and management. New York: McGraw
Hill Higher Education.
French, C. W. (2003). The Treynor capital asset pricing model. Journal of
Investment Management, 1(2), 60–72.
Griffin, J. M. (2002). Are the Fama and French factors global or country specific?
Grinblatt, M., & Titman, S. (1989). Portfolio performance evaluation: Old issues
and new insights. Review of Financial Studies, 2, 393–421.
Henriksson, R. D. (1984). Market timing and mutual fund performance: An
empirical investigation. Journal of Business, 57(1), 73–96.
Israelsen, C. L. (2005). A refinement to the Sharpe ratio and information ratio.
Journal of Asset Management, 5(6), 423–427.
Le Sourd, V. (2007). Performance measurement for traditional investments.

Literature survey. Research paper, DHEC Risk and Asset Management Research
Centre. Retrieved October 16, 2015, from http://www.edhec-risk.com/per-
formance_and_style_analysis/perf_measurement/index_html/attachments/
EDHEC%20Publi%20performance%20measurement%20for%20traditional%20
investment.pdf
Liew, J., & Vassalou, M. (2000). Can book-to-market, size and momentum be risk
factors that predict economic growth? Journal of Financial Economics, 57,
221–245.
Lintner, J. (1965a). Security prices, risk and maximal gains from diversification.
Lintner, J. (1965b). The valuation of risk assets and the selection of risky invest-
ments in stock portfolios and capital budgets. Review of Economics and Statistics,
47(1), 13–37.
Liu, M., Liu, Q., & Ma, T. (2011). The 52-week high momentum strategy in
international stock markets. Journal of International Money and Finance, 30,
180–204.
McDonald, J. (1973). French mutual fund performance: Evaluation of interna-
tionally diversified portfolios. Journal of Finance, 28(5), 1161–1180.
Merton, R. C. (1981). On market timing and investment performance: An equi-
librium theory of value for market forecasts. Journal of Business, 54(3),
363–406.
Mossin, J. (1966). Equilibrium in a capital asset market. Econometrica, 35(4),
768–783.
MSCI. (2014a). MSCI global investable market indexes methodology. Retrieved
October 14, 2015, from http://www.msci.com/eqb/methodology/meth_
docs/MSCI_Aug14_GIMIMethod.pdf
MSCI. (2014b). MSCI global market accessibility review. Retrieved October 14,
2015, from https://www.msci.com/eqb/pressreleases/archive/MSCI_
Aug15_QIRPR.pdf
Pogue, G., Solnik, B., & Rousselin, A. (1974). International diversification: A
study of the French mutual funds. Working paper, Sloan School of Management.
Retrieved October 17, 2015, from http://dspace.mit.edu/
handle/1721.1/48147
Roll, R. (1984). A simple implicit measure of the effective bid-ask spread in an
efficient market. Journal of Finance, 39, 1127–1139.
Ross, S. (1976). The arbitrage theory of capital asset pricing. Journal of Economic
Theory, 13(3), 341–360.
Sharpe, W. F. (1964). Capital asset prices: A theory of market equilibrium under
conditions of risk. Journal of Finance, 19(3), 425–442.
Sharpe, W. F. (1966). Mutual fund performance (pp. 119–138). January: Journal

of Business.
Sharpe, W. F. (1992). Asset allocation: Management style and performance mea-
surement. Journal of Portfolio Management, 18, 7–19.
Sharpe, W. F. (1994). The Sharpe ratio. Journal of Portfolio Management, 21(1),
49–58.
Treynor, J. L. (1961). Market value, time, and risk. Retrieved October 17, 2015, from
ssrn.2600356
Treynor, J. L. (1962). Toward a theory of market value of risky assets. Unpublished
manuscript. Final version in Asset Pricing and Portfolio Performance, 1999,
Robert A. Korajczyk, ed., London: Risk Books, pp. 15–22. Retrieved October
org/10.2139/ssrn.628187
Treynor, J., & Mazuy, K. (1966). Can mutual funds outguess the market? Harvard
Business Review, 44, 131–136.
Vaihekoski, M. (2004). Portfolio construction for tests of asset pricing models.
Financial Markets, Institutions and Instruments, 13, 1–30.
Waszczuk, A. (2014a). Assembling international equity datasets - Review of stud-
ies on the cross-section of returns. Procedia Economics and Finance: Emerging
Markets Queries in Finance and Business(EMQ 2013), 15, 1603–1612.
Waszczuk, A. (2014b). Diversity of empirical design - Review of studies on the cross-
section of common stocks. Working paper. Retrieved October 11, 2015, from
ssrn.2428054
Willenbrock, S. (2011). Diversification return, portfolio rebalancing, and the
commodity return puzzle. Financial Analyst Journal, 67, 42–49.
Wilmott, P. (2008). Paul Wilmott on quantitative finance. Hoboken, NJ: Wiley.
Zaremba, A. (2015). The financialization of commodity markets: Investing during
times of transition. New York: Palgrave Macmillan.
Zaremba, A., & Konieczka, P. (2014). Value, Size and Momentum across
Countries. Indian Journal of Finance, 8(9), 7–31.
CHAPTER 8
A Short Primer on International Equity

Investing
What is the simplest strategy of investing in the international equity mar-

kets? Perhaps to apply no strategy at all? If the markets are efficient, then
just holding a stock portfolio should ensure long-term positive returns;
with no research, valuations, or financial analysis––simply buying a portfo-
lio of stocks weighted by the capitalization of each of the companies and
waiting for returns to pour in. Surprisingly, even this simplistic approach
can yield satisfactory returns—oftentimes outperforming professional
portfolio managers.1
One crucial benefit of this passive approach is that without any signifi-
cant effort the investor can capture perhaps the most important source of
return in the stock market: the equity risk premium. What is the equity
risk premium? In essence, it is the extra return that investors demand over
and above the risk-free rate to invest in equities as a class (Damodaran
2013). Fundamental theories of financial markets imply that equities are
riskier than, for example, government bonds or Treasury bills (T-bills),
thus they should also deliver an additional return for investors. And this
excess return is precisely the equity risk premium.
Historically, the equity risk premium has been frequently interpreted
as the excess return from investing in the stock market over the risk-
free rate, that is, for example, government bonds. An investor putting
his money in the stock market may rationally expect to earn a positive
risk premium—certainly in the long term. And here lies one of the main
reasons to invest across international markets today when markets and

DOI 10.1057/978-1-137-59191-3_8
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
Mean monthly return [%] 0.41 0.37

Mean annual return [%] 4.97 4.50
Mean monthly excess return [%] 0.28 0.24
Mean annual excess return [%] 3.35 2.87
Annual volatility [%] 16.17 16.17
Sharpe ratio 0.21 0.18
Maximum drawdown [%] −54.57 −52.79
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
Investing across international markets helps cushion against stock mar-

ket swings within individual markets and reduces the risk of poor per-
formance over the long haul. Still, such portfolios remain relatively risky
and require true nerves of steel. Could this performance be somehow
improved? The quantitative country selection strategies could offer a rea-
sonable solution to improve the risk-return profile. Let us then begin our
review of the alternative strategies and see for ourselves which of the smart
approaches might prove useful for international investing.
NOTES
1. See, e.g., Malkiel (2007).
2. We calculate the statistics based on log-returns.
REFERENCES
Damodaran, A. (2013). Equity risk premiums (ERP) and stocks: Bullish or bearish
indicator. Retrieved November 29, 2015, from http://aswathdamodaran.
blogspot.com/2013/05/equity-risk-premiums-erp-and-stocks.html
Dimson, E., Marsh, P., & Staunton, M. (2011). Equity premia around the world.
Retrieved November 30, 2015, from SSRN: http://ssrn.com/abstract=1940165
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
Value-Oriented Country Selection
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.
VALUE VERSUS GROWTH ACROSS COUNTRIES

The interest among academics and market practitioners oriented to value
premium across various countries could be traced back to the 1990s when
a number of researchers tested the country-level implementation of value
strategies.1 In one of the first studies, Rosemary Macedo (1995b) exam-
ined the performance of country portfolios based on 18 country equity
indices. She first ranked the markets based on the aggregated valuation
portfolios, and subsequently created four equally weighted groups to test
three different indicators: the book-to-market ratio, dividend yield, and
earnings yield against the portfolio performance within the 1977–1996
period. To conclude, during this 20-year period, the “cheap” countries
outperformed the “expensive” markets, and the differential annual return
between the countries with the lowest and highest valuation ratios ranged
from 1.25 to 8.54, depending on the ratio selection, rebalancing fre-
quency and hedging policy.

DOI 10.1057/978-1-137-59191-3_9
The country level investigations were later occasionally reviewed using

broader data samples and longer time spans.2 Most of them were based
on the book-to-market (B/M) ratio; the most popular value discriminator
also at the level of the individual stock. One of the latest analyses was con-
ducted by Angelidis and Tessaromatis (2014), who investigated the per-
formance of 23 developed markets within the 1981–2012 period. They
found that the portfolio of low-B/M countries earned on average 15.03
% per year, effectively outperforming the global market by 4.43 % annu-
ally. The authors concluded that the comparison between stock and coun-
try value portfolios suggests that country-based portfolios implemented
through either index futures or country exchange-traded funds (ETFs)
capture a large part of return of the stock-based factor strategies. Given
both the complex nature and costs of implementation of stock-based fac-
tors, investors could utilize country-level strategies as a viable alternative.
Importantly, the investigations of the usefulness of the valuation ratios
for global asset allocation led to development of some indicators that can
be applied only at the country level. Perhaps, the most well-known exam-
ple is the cyclically adjusted price-to-earnings ratio, abbreviated ‘CAPE’.
This technique was originally advocated by Benjamin Graham and David
Dodd in their investment classic Security Analysis. The authors argued
for the smoothing earnings over past few years in order to calculate valu-
ation ratios. Nonetheless, the true father of the application of the CAPE
in equity market timing and asset allocation is Robert Shiller, the Nobel
laureate in 2013. In his 1988 paper coauthored by John Y. Campbell he
showed that “a long moving average of real earnings helps to forecast
future real dividends” (Campbell and Shiller 1988a). In consequence, it
might also be used to predict future returns.
CAPE, also called Shiller P/E, is calculated a market price divided
by the average of trailing 10-year earnings adjusted for inflation. It was
originally applied to the US stock market and Shiller found that it is well-
suited to predict long-term future returns, i.e. for the following years.
Nonetheless, the CAPE ratio drew a lot of attention in the investment
community and many practitioners found that it can also be used for other
markets and for predictions over a shorter term. Furthermore, a few stud-
ies showed that the CAPE can be used not only to forecast a risk premium
in a single equity market, but also for country selection and dynamic
asset allocation.3 A particularly interesting study was conducted by Faber
(2012), who examined the performance of 30 country equity markets in
the years 1980–2011. Once a year, Faber sorted all of the countries within
VALUE-ORIENTED COUNTRY SELECTION 143
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.
PERFORMANCE WITHIN RECENT YEARS

Let us now look how the cross-country value strategies have performed
throughout the global equity markets within the last two decades. We
first concentrate on the equity multiples and subsequently move to the
enterprise multiples.
Basically, in the last 20 years, the country equity markets with low
multiples delivered higher returns than the countries with high multiples.
Figure 9.1 provides a quick overview of the past performance of equal-
weighted portfolios from sorts on four characteristics: book-to-market
ratio, earnings-to-price ratio, cash flow-to-price ratio and dividend yield
(gross return approach). Across all the four ratios, it was the value markets
which displayed higher returns than the growth markets. The best per-
formers, however, were the markets of medium ratios. Table 9.1 provides
some further details on the returns on the country-level value and growth
strategies. Let’s analyze them one-by-one.
The book-to-market ratio, which is perhaps the most popular and wide-
spread value indicator, did not prove to be a very useful basis for portfolio
formation. Where the portfolios were equal-weighted, the high book-
to-market countries delivered only slightly higher returns than the low
book-to-market countries (Panel A). The returns on the zero-investment
portfolios amounted to over 0.20 % monthly, and did not significantly dif-
fer from 0. Neither was the risk adjusted performance particularly impres-
sive. The high book-to-market portfolios did display positive alphas, but
these were very small and insignificant. Finally, the value countries turned
out to be a bit riskier. The volatility of monthly gross returns equaled 6.23
% for the value markets, and 5.29 % for the growth markets.
The capitalization-weighted portfolios based on the B/M ratio look
even less convincing (Table 9.1, Panel B). The returns on zero-investment
portfolios—both raw and risk-adjusted—approximate zero or even turn
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
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
Growth Neutral Value V-G Growth Neutral Value V-G

Panel A
Book-to-market ratio
Mean 0.36 0.72** 0.60 0.23 0.27 0.41 0.55 0.27
(1.14) (2.18) (1.58) (1.12) (0.88) (1.13) (1.38) (1.21)
Volatility 5.29 5.14 6.23 3.63 5.34 5.78 6.44 4.01
Sharpe ratio 0.24 0.49 0.33 0.22 0.17 0.25 0.30 0.23
Alpha −0.08 0.29 0.11 0.18 −0.04 0.09 0.15 0.18
(−0.35) (1.58) (0.43) (0.81) (−0.24) (0.14) (0.32) (0.75)
Earnings-to-price ratio
Mean 0.35 0.69** 0.65* 0.30* 0.18 0.67** 0.52 0.34*
(1.19) (2.09) (1.65) (1.72) (0.63) (1.98) (1.28) (1.72)
Volatility 5.17 5.10 6.22 3.05 5.35 5.25 6.35 3.34
Sharpe ratio 0.24 0.47 0.36 0.35 0.12 0.44 0.28 0.35
Alpha −0.09 0.27 0.16 0.27 −0.15 0.34 0.14 0.30
(−0.54) (1.37) (0.59) (1.38) (−0.68) (1.04) (0.28) (1.50)
Cash flow-to-price ratio
Mean 0.40 0.64* 0.72** 0.30* −0.02 0.69* 0.63 0.57**
(1.24) (1.85) (2.01) (1.69) (0.10) (1.91) (1.60) (2.02)
Volatility 5.37 5.33 5.77 2.58 6.21 5.28 6.24 4.08
Sharpe ratio 0.26 0.42 0.43 0.41 −0.01 0.45 0.35 0.48
Alpha −0.04 0.19 0.26 0.29* −0.24 0.46 0.34 0.50**
(−0.21) (1.05) (1.12) (1.76) (−0.75) (1.50) (0.96) (1.98)
VALUE-ORIENTED COUNTRY SELECTION
Dividend yield
Mean 0.42 0.68** 0.65** 0.19 −0.05 0.88*** 0.67** 0.58**
145
(1.21) (2.03) (1.97) (0.99) (0.02) (2.64) (2.07) (2.36)
(continued)
Table 9.1 (continued)
146

Volatility 5.62 5.35 5.56 2.89 6.42 5.38 5.28 3.92
Sharpe ratio 0.26 0.44 0.41 0.23 −0.03 0.57 0.44 0.52
Alpha −0.09 0.19 0.16 0.20 −0.51* 0.49 0.34 0.72***
(−0.45) (0.95) (0.73) (1.04) (−1.79) (1.57) (1.00) (3.35)
Panel B
A. ZAREMBA AND J. SHEMER
Mean 0.46 0.13 0.35 −0.11 0.21 0.23 0.24 −0.02

(1.47) (0.48) (1.03) (−0.19) (0.66) (0.79) (0.71) (−0.04)
Volatility 5.04 5.34 6.85 4.64 5.60 5.37 6.16 4.19
Sharpe ratio 0.31 0.08 0.18 −0.08 0.13 0.15 0.14 −0.02
Alpha 0.01 −0.31 −0.19 −0.20 −0.05 0.04 −0.01 −0.02
(0.03) (−1.71) (−0.78) (−0.68) (−0.30) (0.00) (−0.20) (−0.02)
Earnings-to-price ratio
Mean −0.01 0.60* 0.46 0.50** −0.28 0.53 0.65 0.93***
(0.09) (1.90) (1.23) (1.98) (−0.68) (1.64) (1.63) (3.92)
Volatility 4.81 5.15 6.82 4.30 5.08 5.23 6.26 3.74
Sharpe ratio −0.01 0.40 0.23 0.40 −0.19 0.35 0.36 0.86
Alpha −0.44*** 0.15 −0.08 0.39 −0.51** 0.29 0.40 0.91***
(−3.19) (0.90) (−0.33) (1.48) (−2.14) (0.92) (0.96) (3.78)
Mean 0.12 0.50 0.69* 0.56** −0.01 0.50 0.56 0.57**
(0.51) (1.52) (1.87) (2.48) (0.13) (1.45) (1.36) (2.47)
Volatility 5.41 5.54 6.40 3.70 5.25 4.93 6.23 3.09

Sharpe ratio 0.08 0.31 0.37 0.52 −0.01 0.35 0.31 0.64
Alpha −0.34*** 0.06 0.16 0.50** −0.20** 0.33*** 0.35* 0.55***
(−1.92) (0.20) (0.61) (2.27) (−2.01) (2.83) (1.89) (2.71)
Dividend yield
Mean 0.11 0.50 0.55 0.44** −0.19 −0.06 0.49 0.65***
(0.47) (1.50) (1.59) (2.06) (−0.44) (0.01) (1.38) (3.02)
Volatility 4.74 5.49 6.09 3.86 5.07 7.39 5.77 3.44
Sharpe ratio 0.08 0.31 0.31 0.40 −0.13 −0.03 0.29 0.66
Alpha −0.36*** 0.01 0.01 0.37 −0.40* −0.39 0.23 0.61***
(−2.69) (0.00) (−0.05) (1.54) (−1.71) (−1.28) (0.62) (2.83)
Panel A: equal-weighted portfolios. Panel B: capitalization-weighted portfolios
Note: The table presents the mean monthly excess returns on the equal-weighted tertile portfolios from sorts on four characteristics: book-to-market ratio,
earnings-to-price ratio, cash flow-to-price ratio and dividend yield. Panels A and B present the performance of 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, 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 1995–2015
period, and the data are sourced from Bloomberg
147
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.
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
200 Earnings-to-price ratio

150
Dividend yield
100
50
0
1995 1996 1998 1999 2001 2002 2004 2005 2007 2008 2010 2011 2013 2014
-50
-100
Fig. 9.2 Cumulative outperformance of value countries over growth countries

Note: The figure presents the cumulative excess return (expressed in percentage
terms) on the zero-investment equal-weighted tertile portfolios from sorts on four
characteristics: B/M ratio, E/P ratio, CF/P ratio and dividend yield. The zero-
investment portfolio is long (short) the tertile of the value (growth). Calculations
based on the period 1995–2015; the data are sourced from Bloomberg
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
of selecting countries to add to the investment portfolio based on two

multiples derived from the enterprise value-level: EBITDA-to-EV ratio
and sales-to-EV ratio.
As we can see in Fig. 9.3, the portfolios from sorts on enterprise value
multiples historically display the same cross-sectional return pattern as the
portfolios formed on equity multiples: the value countries plainly out-
performed the growth countries. The difference in returns is particularly
remarkable for the EBITDA-to-EV ratio. While the “expensive” countries
earned no average excess return above 0.20 % monthly, the excess returns
on the “cheap” markets approached 0.90 % monthly. The outperformance
over the last two decades is evident.
More formal statistical interferences from the cross-country value and
growth strategies are reported in Table 9.2. Beginning with the sales-to-
EV ratio, the equal-weighted “value countries” delivered a mean gross
return of 0.70 % monthly, i.e. about 0.40 percentage points over the
“growth countries”. As a result, both raw and risk-adjusted returns on
dollar-neutral portfolios formed on sales-to-EV ratios were both positive
and significantly different from zero. Interestingly, all the portfolios bear
a similar level of risk, so the low-priced markets have also higher Sharpe
ratios.
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
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
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)
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)
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
153
Nonetheless, the capitalization-weighting approach casts some doubt

over the robustness of the sales-to-EV based strategies. Although in the net
approach the low-priced countries still outperform the high-priced countries,
in the gross approach this pattern is not all that evident. In fact, the mean
returns on the markets with low and high sales-to-EV ratios are fairly similar.
Finally, the second enterprise value multiple considered in Table 9.2
is the EBITDA-to-EV ratio. And here comes the surprise: the EBITDA-
to-EV strategy proves to be a super-performer over the past two decades.
Clearly, the numbers prove its superiority to all other value-oriented
approaches presented in this chapter.
Considering the gross-return approach, the equal-weighted zero-
investment portfolio formed on EBITDA-to-EV ratio earned on average
0.73 % monthly. Also the risk-adjusted return was significantly different
from zero and amounted to 0.70 %. Furthermore, although the value-
oriented country picking was slightly riskier in terms of standard devia-
tion, its return-risk relation was very good. The Sharpe ratio for the last
two decades reached 0.79. Finally, the net return approach basically con-
firms these observations.
Interestingly, the performance was even better. The outperformance
of the high EBITDA-to-EV markets in the gross (net) return approach
amounted to 1.14 % (0.89 %) monthly. Consequently, the Sharpe ratio
measured over gross returns even slightly exceeded 1. Thus, all in all, the
EBITDA-to-EV ratio seems to be a very powerful return discriminator.
One of the further advantages on the EBITDA-to-EV ratio-based selec-
tion is its stability over time, which also transpires from Fig. 9.4. The value
markets selected using this discriminator have consistently outperformed
the stock markets over the last 20 years. The performance does seem to
have deteriorated since 2011, yet it is still 4 years after the peak of other
value strategies, which have been falling since 2007. It also looks strong
relative to the other EV-based multiples related to sales as, for instance,
the country-selection method based on sales-to-EV ratio has virtually
delivered no positive returns since 2007.
HOW TO FIND MORE VALUE IN VALUE?

The value-oriented approach offers a number of country-selection strate-
gies which may prove useful for international investors. Tactical asset allo-
cation based on various ratios such as cash flow-to-price ratio, earnings
yield, dividend yield, or EBIDTDA-to-EV ratio have all yielded reasonable
returns over past 20 years. Although the implementation of country-level
700
Sales-to-EV ratio
600
500 EBITDA-to-EV ratio
400
300
200
100
0
1995 1996 1998 1999 2001 2002 2004 2005 2007 2008 2010 2011 2013 2014
-100
Fig. 9.4 Cumulative performance of country-selection strategies based on enter-

prise value multiples
terms) on the zero-investment equal-weighted tertile portfolios from sorts on two
characteristics: sales-to-EV ratio and EBITDA-to-EV ratio. The zero-investment
portfolio is long (short) the tertile of the value (growth). Calculations are based on
the period I 1995–VI 2015, and the data are sourced from Bloomberg.
value strategies may still bring about a number of challenges, paradoxically

they may also serve as opportunities to further improve the performance.
Patience and self-confidence. The nature of value-oriented strategies
implies a reasonable amount of short-term volatility. Furthermore, this
short term might sometimes extend to even a stretch of many years. It
demands a lot of patience and self-confidence to stick to any losing posi-
tions over such a long periods; particularly given that the value-oriented
country selection tends to gravitate towards risky and neglected markets.
It is no easy feat to consistently keep purchasing stocks in the markets
where other investors fear to tread.
Taxes. The countries with low valuation ratios might also be high divi-
dend payers. Therefore, one of the pitfalls of cross-country value investing
is dividend taxes which may potentially impede performance. Therefore,
from the investor’s standpoint it would pay to mitigate the effect of the
taxes, for instance, by investments in appropriate funds. Fortunately, the
abnormal returns on value strategies reported in this chapter seem not to
be markedly affected by dividend taxes. The “value countries” outperform

the “growth countries” in both the gross and net approaches.
Avoid the value trap. There is usually a good reason why the low-
priced assets are cheap. The underlying cause might be levered bankruptcy
risk or, in the case of countries, political or expropriation risk. As a result,
the raw value-oriented equity selection may gravitate towards risk assets of
a very poor quality.
There are many ways to mitigate this risk at least partly. One is to per-
form an additional sort on the quality characteristic to improve perfor-
mance. For example, Novy-Marx (2013) indicates that additional sort on
gross-profitability dramatically improves the performance of value-oriented
strategies. This approach also seems to work at the country level. In 2015
I tested the portfolios formed on profitability measured with return on
assets within the group of high-B/M markets and found that the equal-
weighted portfolio of profitable countries outperformed the unprofitable
ones by about 0.50 % per month (excluding taxes and transaction costs).
Focus on inefficient markets. As we discussed earlier, one of the explana-
tions of the value effect is related to behavioral frictions and market inefficien-
cies. Thus, the less efficient the markets are, the more profitable the value-based
country-selection strategies should be. However true this observation may
seem at the stock level, there might be many proxies for inefficiency. One of
them is size, as many studies indicate that anomalies appear stronger among
the smallest companies.5 Another indicator is the idiosyncratic risk. As Fan
et al. (2015) investigated a range of anomalies across the global markets, they
discovered their higher intensity in countries with high idiosyncratic risk.
At the country level the evidence is similar and, indeed, some strategies
perform better in small and close economies than among the large ones.6
Let’s take the B/M ratio. As we have already showed, during the last 20
years this indicator proved totally useless as a market discriminator for the
capitalization-weighted portfolios. Nonetheless, applying it within small
markets visibly improves the performance (Table 9.3).
Having applied the book-to-market sort within the small markets,
the capitalization-weighted portfolios of value indices delivered monthly
returns over 0.5 percentage points higher than the low-B/M countries.
The differential return is comparable to the returns on zero-investment
portfolios of the better performing cross-country value strategies, e.g.
earnings yield or cash flow-to-price ratio. Yet, the small-market portfolios
are much more volatile, so the abnormal returns remain insignificant and
the Sharpe ratios actually score relatively low.
Table 9.3 Performance of capitalization-weighted portfolios formed on B/M

among the small countries

Mean −0.10 0.23 0.63 0.63 0.22 0.52 0.86 0.57
return
(0.00) (0.76) (1.10) (1.19) (0.67) (1.33) (1.41) (1.23)
Volatility 6.70 6.65 8.55 6.86 6.38 5.96 7.85 5.88
Sharpe −0.05 0.12 0.26 0.32 0.12 0.30 0.38 0.34
ratio
Alpha −0.47 −0.18 0.07 0.46 0.04 0.34 0.63* 0.52
(−1.35) (−0.61) (0.13) (1.07) (0.18) (1.42) (1.81) (1.30)
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
Let us then sum up our consideration of the cross-country value strate-

gies. The value-based security selection seems to be a robust approach that
works across many assets, including country equity indices. Over the last
20 years these strategies have performed well, providing decent returns
under value-based country selections strategies. The exception is the most
popular value metric—book-to-market ratio—which has generally failed.
Yet even this strategy could be improved by, for example, focusing on
small markets. The most powerful measure to select countries was the
EBITDA-to-EV ratio, which also was the most stable as the performance
of other ratios notably deteriorated since 2007.
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).
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).
REFERENCES
Angelidis, T., & Tessaromatis, N. (2014). Global style portfolios based on country
indices. Bankers, Markets & Investors, March–April. Retrieved November 9,
2015, from https://mpra.ub.uni-muenchen.de/53094/
Asness, C. S., Liew, J. M., & Stevens, R. L. (1997). Parallels between the cross-
sectional predictability of stock and country returns. Journal of Portfolio
Management, 6, 79–86.
Blitz, D. C., & van Vliet, P. (2008). Global tactical cross-asset allocation: Applying
value and momentum across asset classes. Journal of Portfolio Management,
35(1), 23–38.
Butler, A., Philbrick, M., Gordillo, R., & Faber, M. T. (2012). Global CAPE
model optimization. Retrieved February 19, 2016, from SSRN: http://ssrn.
Campbell, J. Y., & Shiller, R. J. (1988a). Stock prices, earnings, and expected divi-
dends. Journal of Finance, 43(3), 661–676.
Desrosiers, S., Lemaire, N., & L’Her, J.-F. (2007). Residual income approach to
equity country selection. Financial Analyst Journal, 63(2), 76–89.
Desrosiers, S., L’Her, J.-F., & Plante, J.-F. (2004). Style management in equity
country selection. Financial Analyst Journal, 60(6), 40–54.
Faber, M. T. (2012). Global value: Building trading models with the 10 year
CAPE. Cambria Quantitative Research, No. 5. Retrieved February 19, 2016,
from SSRN: http://ssrn.com/abstract=2129474
Fan, S., Opsal, S., & Yu, L. (2015). Equity anomalies and idiosyncratic risk around
the world. Multinational Finance Journal, 19(1), 33–75.
Golob, J. E. (2014). A pragmatist’s guide to long-run equity returns, market valu-
ation, and the CAPE. Retrieved February 19, 2016, from SSRN: http://ssrn.
Gray, W. R., & Vogel, J. (2012). Analyzing valuation measures: A performance
horse race over the past 40 years. Journal of Portfolio Management, 39(1),
112–121.
55(1), 265–295.
Keimling, N. (2014). CAPE: Predicting stock market returns. StarCapital Research
Publication, February 2014. Retrieved February 19, 2016, from SSRN:
http://ssrn.com/abstract=2558474
Keppler, M. (1990a). Further evidence on the predictability of international equity
returns. Journal of Portfolio Management, 18(1), 48–53.
Keppler, M. (1990b). The importance of dividend yields in country selection.
Journal of Portfolio Management, 17(2), 24–29.
Klement, J. (2015). CAPE around the world update 2015 – Return differences and
exchange rate movements. Retrieved February 19, 2016, from SSRN: http://
Loughran, T. (1997). Book-to-market across firm size, exchange, and seasonality:
Is there an effect? Journal of Financial and Quantitative Analysis, 32(3),
249–268.
Lowenstein, R. (2001). When genius failed: The rise and fall of long-term capital
management. New York: Random House Trade Paperbacks.
Macedo, R. (1995a). Country-selection style. In R. A. Klein & J. Lenderman
(Eds.), Equity style management (pp. 333–355). Chicago: Irwin Professional
Publishing.
Macedo, R. (1995b). Style-based country-selection strategies. In P. Carman (Ed.),
Quantitative investing for the global markets: Strategies, tactics, advanced ana-
lytical techniques (pp. 145–167). New York: Routledge.
Macedo, R. (1995c). Value, relative strength and volatility in global country selec-
tion. Financial Analyst Journal, 51(2), 70–78.
Novy-Marx, R. (2013). The other side of value: The gross profitability premium.
Tower, E. (2011). Tobin’s Q versus CAPE versus CAPER: Predicting stock market
returns using fundamentals and momentum. Economic Research Initiatives at
Duke (ERID) Working Paper. Retrieved February 19, 2016, from SSRN: http://
Zaremba, A. & Konieczka, P. (2015). Do quantitative country selection strategies
really work? Jounal of Investment Strategies, 5(2), 1–33.
Zhang, X. F. (2006). Information uncertainty and stock returns. Journal of
Finance, 61(1), 105–137.
CHAPTER 10
Momentum Effect Across Countries
As we have already seen in Chap. 3, momentum can be a powerful and

profitable tool across many different assets. But does it also work across
countries? Can we use momentum for country-asset allocation? The
answer seems to be positive and the evidence relatively broad and con-
vincing. Balvers and Wu (2006) have examined a Jegadeesh and Titman
(1993)-style portfolio based on stock market indices from 18 developed
equity markets within the 1969–1999 period. They have found strong
momentum effects, which worked particularly well in combination with
the mean reversion patterns. In the same year, Bhojraj and Swaminathan
(2006) published a paper which examined a broader sample of 38 country
indices within the same periods. The authors indicated that the quintile
of the best performing countries over past 6 months continued to sig-
nificantly outperform the laggard indices during next three quarters. The
mean return on the long/short portfolio within a year after its formation
amounted to 7.65 %.
The country-level momentum seems robust across time and markets.
Geczy and Samonov (2015) applied simple momentum trading rules
to the data sourcing back to the beginning of the nineteenth century.
Whereas Muller and Ward (2010) extended the sample to 70 markets
covered by MSCI—the momentum strategy still worked.1

DOI 10.1057/978-1-137-59191-3_10
BASIC MOMENTUM STRATEGIES

Let’s now look at the robustness of momentum strategies during the last
20 years. We first present our calculations on simple momentum strate-
gies, and next enhance them with additional sorts.
Figure 10.1 shows mean excess returns on the three most basic momen-
tum strategies: First, the short-term momentum, where countries are sorted
on a six-month performance, based on the seminal study by Jegadeesh and
Titman (1993). The second approach relies on the cumulative 12-month
trailing return excluding the most recent month. The last strategy in
Fig. 10.1 is the intermediate momentum proposed by Novy-Marx (2012a),
based on sorts by 6-month performance lagged also 6-months (months t−12
to t−7). All tertile portfolios depicted in Fig. 10.1 are equally weighted.
At the first glance, all three seems useful for international investors. In
all three cases the markets with the highest past return revealed better per-
formance over the next month. While the monotonic cross-sectional pat-
tern is least evident for the short-term momentum, it is still clearly visible.
Further insights in the momentum strategies are shown in Table 10.1.
Let’s first look at the equal-weighted portfolios (Panel A). For all three
Panel A Panel B Panel C

1.00 1.00 1.00
0.80 0.80 0.80
0.60 0.60 0.60
0.40 0.40 0.40
0.20 0.20 0.20
0.00 0.00 0.00
Fig. 10.1 Mean excess returns on basic momentum strategies. Panel A: Short-
term momentum. Panel B: Long-term momentum. Panel C: Intermediate
momentum
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
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
164

Bottom Neutral Top T-B Bottom Neutral Top T-B
Panel B
Short-term momentum
Mean return 0.17 −0.06 0.48 0.11 0.16 0.13 0.20 −0.08
(0.51) (0.03) (1.38) (0.37) (0.53) (0.43) (0.59) (−0.28)
Volatility 6.56 6.01 5.49 5.12 6.05 5.55 5.71 4.27
Sharpe ratio 0.09 −0.03 0.30 0.08 0.09 0.08 0.12 −0.06
Alpha −0.31 −0.52** 0.05 0.17 −0.04 −0.07 0.01 −0.06
(−1.17) (−2.25) (0.13) (0.58) (−0.21) (−0.59) (0.00) (−0.16)
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)
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
momentum strategies, short-term momentum, long-term momentum, and

intermediate momentum, the high-momentum portfolios outperformed
the low-momentum portfolios. While the outperformance varied, the
returns on the long-short portfolios, which assume long (short) position
in the high (low) momentum markets, always remain positive and signifi-
cantly different from 0. The outperformance has survived the adjustment
for risk (according to the global CAPM) reaching approximately 0.5 %
monthly in both net and gross approaches. The weakest performing vari-
ant is the 6-month-based short-term momentum whereas the highest
abnormal returns are delivered by the intermediate momentum where the
risk-adjusted returns on the zero-investment portfolios exceed 0.6 %.
The last interesting feature of the equal-weighted momentum port-
folios is the fact that higher returns are uncorrelated with higher risk. In
fact, the standard deviation is usually the highest among the past losers
rather than the past winners. Thus, implementing these momentum strat-
egies seems beneficial for both the return and risk mitigation of the whole
portfolio.
Despite the outstanding performance of the equal-weighted portfolio,
the capitalization-weighted momentum returns reveal the Achilles’ heel of
the strategy. Essentially, when particular markets are weighted in the port-
folios according to their total stock market capitalization, the momentum
effect almost entirely evaporates. Nowhere are the returns on the zero-
investment portfolios simultaneously positive and different from 0. This
remains so even when adjusted for the market risk or on dividend taxes. In
other words, we find no evidence that momentum has worked within the
capitalization-weighted portfolios of country indices for the last 20 years
and the returns of the past winners hardly differ from the earnings of the
past losers.
The discrepancy between the equal-weighted and capitalization-weighted
momentum strategies poses an interesting challenge. Why has momentum
worked only under a particular weighting scheme? Perhaps, momentum, as
a stock market anomaly, is stronger in the small markets. In other words, the
less efficient a market, the more probable that the trend-following strategy
will prove profitable. Yet before we consider this issue, let’s examine the
stability of the returns on country-level momentum over time.
The cumulative excess gross returns on the equal-weighted momentum
portfolios are presented in Fig. 10.2. In comparison with, the inter-market
value strategies, the momentum returns reveal a much higher degree of
stability. The strategy has provided consistent and positive earnings for the
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
Fig. 10.2 Cumulative excess returns on basic momentum strategies

Note: The figure presents the cumulative excess gross return (expressed in percent-
age terms) on zero-investment equal-weighted tertile portfolios from sorts on
cumulative past returns in months t−6 to t−1 (short-term momentum), t−12 to
t−2 (long-term momentum), and months t−12 to t−7 (intermediate momen-
tum). The zero-investment portfolio is long (short) in the tertile of the high (low)
past returns. The calculations are based on the I 1995–VI 2015 period, and the
data sourced from Bloomberg
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.
IMPROVING THE COUNTRY-LEVEL MOMENTUM

When investigating the performance of the basic momentum strategies,
we hypothesized that the stronger phenomenon of the equal-weighted
portfolios might be driven by stronger momentum across the small and
less efficient markets. We directly address this issue in Table 10.2, where
we present the performance of momentum portfolios within five sub-
markets: small markets, young markets, markets with high idiosyncratic
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.
ALTERNATIVE MOMENTUM TECHNIQUES

So far we have discussed the performance of various relative momentum
strategies across global equity markets. Nonetheless, the trend following
approach could also be implemented in other ways, for example by rely-
ing on absolute momentum or moving averages. The first approach was
thoroughly tested by Georgopoulou and Wang (2015), who implemented
a very simple absolute momentum strategy: they went long on a market
Table 10.2 Performance of portfolios based on enhanced momentum strategies
168
Low Neutral High L-H Low Neutral High L-H

Panel A
Size-enhanced momentum
Mean return −0.18 0.52 0.68* 0.47 0.26 0.68 1.03** 0.58
(−0.15) (1.08) (1.78) (0.94) (0.67) (1.37) (2.45) (1.59)
Volatility 8.28 7.70 6.05 6.89 6.84 6.44 5.72 5.08
Sharpe ratio −0.08 0.23 0.39 0.24 0.13 0.37 0.63 0.39
Alpha −0.66 0.04 0.35 0.61 0.07 0.50* 0.87*** 0.60*
(−1.63) (0.10) (1.10) (1.52) (0.25) (1.71) (3.37) (1.74)

Age-enhanced momentum
Mean return 0.14 0.05 0.58 0.21 0.24 0.13 0.65* 0.27
(0.42) (0.22) (1.64) (0.55) (0.62) (0.38) (1.71) (0.80)
Volatility 7.23 5.75 5.66 5.36 6.47 5.77 5.59 4.18
Sharpe ratio 0.07 0.03 0.36 0.13 0.13 0.08 0.40 0.23
Alpha −0.34 −0.35 0.22 0.32 0.03 −0.05 0.48 0.31**
(−1.03) (−1.45) (0.85) (1.04) (0.00) (0.21) (−0.26) (2.03)
Idiosyncratic volatility-enhanced momentum
Mean return 0.33 0.56 0.75 0.25 0.48 0.54 0.63 0.03
(0.82) (1.31) (1.57) (0.52) (1.08) (1.17) (1.29) (−0.08)
Volatility 7.36 6.59 6.71 5.06 6.92 6.61 6.64 4.44
Sharpe ratio 0.16 0.29 0.39 0.17 0.24 0.29 0.33 0.02
Alpha −0.16 0.12 0.32 0.31 0.26 0.33 0.42* 0.04
(−0.49) (0.38) (1.03) (0.92) (1.13) (1.36) (1.71) (0.11)
Book-to-market-enhanced momentum
Mean return 0.27 0.48 0.85** 0.43 0.35 0.41 0.83* 0.37
(0.73) (1.31) (2.11) (1.24) (0.85) (1.01) (1.90) (1.22)
Volatility 6.91 5.68 6.02 4.49 6.62 5.80 6.09 3.98
Sharpe ratio 0.14 0.29 0.49 0.33 0.18 0.24 0.47 0.32
Alpha −0.20 0.08 0.44* 0.48* 0.15 0.22 0.64*** 0.38
(−0.69) (0.29) (1.76) (1.77) (0.60) (1.14) (2.98) (1.36)
Turnover ratio-enhanced momentum
Mean return 0.25 0.23 0.36 −0.01 0.24 0.12 0.24 −0.11
(0.69) (0.59) (0.85) (−0.21) (0.69) (0.37) (0.58) (−0.58)
Volatility 6.74 5.81 6.08 4.03 6.73 5.86 6.25 3.95
Sharpe ratio 0.13 0.13 0.21 −0.01 0.12 0.07 0.13 −0.10
Alpha 0.04 0.04 0.18 0.01 0.14 0.03 0.14 −0.11
(0.21) (0.28) (1.03) (0.07) (0.00) (0.69) (0.19) (0.87)
Panel B
Size-enhanced momentum
Mean return −0.46 0.41 0.75* 0.82* −0.10 0.51 0.92* 0.81**
(−0.65) (0.86) (1.78) (1.69) (−0.04) (1.01) (1.92) (2.05)
Volatility 8.50 7.95 6.65 7.23 7.31 6.83 6.46 5.58
Sharpe ratio −0.19 0.18 0.39 0.39 −0.05 0.26 0.49 0.50
Alpha −0.97** −0.10 0.37 0.94** −0.31 0.30 0.73** 0.83**
(−2.40) (−0.28) (1.07) (2.12) (−0.97) (1.06) (2.55) (2.21)
Age-enhanced momentum
Mean return −0.33 0.27 0.01 −0.08 0.01 0.34 0.18 −0.07
(−0.44) (0.63) (0.19) (−0.15) (0.15) (0.79) (0.52) (−0.17)
Volatility 8.82 7.89 6.75 7.25 7.83 6.73 6.70 5.67
Sharpe ratio −0.13 0.12 0.00 −0.04 0.00 0.17 0.09 −0.04
Alpha −0.87** −0.25 −0.42 0.03 −0.23 0.13 −0.03 −0.04
(−2.09) (−0.76) (−1.36) (0.05) (−0.70) (0.51) (−0.12) (−0.08)
MOMENTUM EFFECT ACROSS COUNTRIES
Idiosyncratic volatility-enhanced momentum

Mean return −0.01 0.68 0.16 −0.14 0.23 0.74 0.31 −0.15
169
(0.21) (1.24) (0.39) (−0.48) (0.60) (1.36) (0.64) (−0.54)
(continued)
170
Low Neutral High L-H Low Neutral High L-H
Volatility 9.09 8.50 8.10 6.91 8.19 7.63 7.64 6.18

Sharpe ratio 0.00 0.28 0.07 −0.07 0.10 0.34 0.14 −0.08
Alpha −0.55 0.16 −0.37 −0.14 −0.01 0.51 0.07 −0.15
(−1.25) (0.31) (−1.14) (−0.34) (0.00) (1.61) (0.22) (−0.36)
Book-to-market-enhanced momentum
Mean return −0.23 0.53 0.52 0.28 0.31 0.49 0.61 0.01
(1.21) (1.36) (0.45) (0.77) (1.18) (1.43)
(−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)
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
250
Size
Age
200
Idiosyncrativ volatility
150
Turnover ratio
100
50
0
1999 2001 2002 2003 2004 2005 2006 2008 2009 2010 2011 2012 2013 2015
-50
Fig. 10.3 Cumulative excess returns on enhanced momentum strategies

terms) on the zero-investment equal-weighted tertile portfolios formed from dou-
ble 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 month t−1), and turnover ratio (total dol-
lar turnover to total stock market capitalization averaged over months t−12 to
t−1). The zero-investment portfolio is long (short) in the tertile of the high (low)
past returns. The calculations are based on the I 1995–VI 2015 period, and the
data sourced from Bloomberg
with a positive absolute return in a given look-back period and short on a

market with negative return in the same period. Having analyzed a range
of various sorting and holding periods they tested the strategies in a broad
sample of 45 MSCI indices for the years 1969–2013. What they found is
presented in Fig. 10.4.
Figure 10.4 displays the annualized mean returns for the zero-invest-
ment portfolios with long (short) positions during the holding period in
equity market indices with positive (negative) returns during the look-
back periods. Essentially, the strategy delivered positive returns, the
highest for the very short holding periods of one month. The highest
return was delivered by the strategy based on the 9-month sorting period
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
Fig. 10.4 Performance of time-series momentum strategies across equity markets

Note: The figure reports annualized mean returns for time-series momentum strat-
egies across equity indices for various look-back and holding periods. The sample
covers the period from January 1970 to December 2013. Own elaboration based
on Georgopoulou and Wang (2015), p. 30, Table 2, Panel B
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).
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
performance of past winners is far less impressive. In fact, the differences

between markets with high current index to moving average ratio com-
pared to the countries with low such ratios are close to zero. In none of
the cases did the raw or risk-adjusted returns turn out significantly positive
over the past 20 years. This phenomenon, which apparently affects many
types of trend following strategies, may potentially cast serious doubts on
the reliability of momentum profits.
While the returns on moving average strategies seem to survive the test
of time, they are less stable than the returns on simple equal-weighted
momentum portfolios. The cumulative excess returns over the past 20
years, depicted in Fig. 10.1, shows these strategies to have successively
provided profits over the last two decades. Nevertheless, they were still
adversely affected by the momentum crash of 2009 and it needed almost
5 years to completely recover (Fig. 10.6).
300
10-month moving average
250
200
150
100
50
0
1995 1997 1998 2000 2001 2003 2004 2005 2007 2008 2010 2011 2012 2014
-50
Fig. 10.6 Cumulative excess returns on strategies based on moving average

Note: The figure presents the cumulative excess return (expressed in percent-
age terms) on the zero-investment equal-weighted tertile portfolios formed
on the ratio of current index value to its 20-month and 24-month moving
average. The zero-investment portfolio is long (short) on the tertile of the
high (low) ratio. The calculations are based on the I 1995–VI 2015 and the
period, data sourced from Bloomberg
Table 10.3 Performance of portfolios based on moving averages

Low Neutral High H-L Low Neutral High H-L

Panel A
Mean 0.23 0.61* 0.89** 0.52* 0.11 0.54* 0.83** 0.59**
return
(0.67) (1.85) (2.48) (1.94) (0.35) (1.69) (2.36) (2.13)
Volatility 6.38 5.17 5.34 3.96 6.27 5.17 5.27 4.00
Sharpe 0.13 0.41 0.57 0.46 0.06 0.36 0.55 0.51
ratio
Alpha −0.27 0.17 0.47** 0.60** −0.24 0.25 0.54* 0.64***
(−1.04) (0.90) (2.22) (2.56) (−0.79) (0.66) (1.74) (2.69)
Mean 0.22 0.64* 0.86** 0.51* 0.05 0.59* 0.80** 0.61**
return
(0.66) (1.87) (2.39) (1.87) (0.22) (1.78) (2.25) (2.18)
Volatility 6.37 5.25 5.39 4.02 6.28 5.24 5.29 4.05
Sharpe 0.12 0.42 0.56 0.44 0.03 0.39 0.52 0.53
ratio
Alpha −0.25 0.24 0.48** 0.59** −0.25 0.34 0.54* 0.66***
(−0.97) (1.18) (2.25) (2.47) (−0.84) (0.93) (1.76) (2.73)
Panel B
Mean 0.11 0.36 0.46 0.17 0.13 0.29 0.25 0.01
return
(0.35) (1.13) (1.39) (0.62) (0.44) (0.86) (0.74) (0.03)
Volatility 6.60 5.43 5.39 4.88 6.17 5.26 5.64 4.05
Sharpe 0.06 0.23 0.30 0.12 0.07 0.19 0.15 0.01
ratio
Alpha −0.41 −0.08 0.02 0.24 −0.08 0.10 0.07 0.04
(−1.49) (−0.43) (0.03) (0.81) (−0.45) (0.98) (0.31) (0.18)
Mean 0.14 0.07 0.58* 0.24 0.23 0.24 0.34 0.00
return
(0.46) (0.38) (1.68) (0.69) (0.70) (0.73) (0.93) (−0.09)
Volatility 6.76 5.84 5.37 5.03 6.21 5.34 5.56 4.07
Sharpe 0.07 0.04 0.38 0.16 0.13 0.15 0.21 0.00
ratio
Alpha −0.34 −0.33 0.18 0.31 0.02 0.05 0.16 0.02
(−1.23) (−1.36) (0.81) (1.04) (0.11) (0.47) (0.83) (0.13)
(continued)

Note: The table presents the performance of equal-weighted and capitalization-weighted tertile portfolios from
sorts on the ratio of current index value to its 10-month and 12-month moving average. “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 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. 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
ANY OTHER RETURN PATTERNS?

So far, we have discussed numerous trend following strategies derived
from the idea that the past price movements tend to continue rather than
discontinue. However, the empirical evidence suggests the contrary. While
considering the 3–12 month trailing performance, the trend indeed seem
to persist, but when different time spans are investigated, the outcomes
might be entirely different. There are two popular phenomena implying
that when different time periods are considered, the price movements
tend to rather revert than to continue.
Short-term reversal. When we concentrate on a very short period of
time, i.e. a single month, the price shows a tendency to revert. In other
words, the past performance over the previous month tends to negatively
predict the future: the top performers are likely to underperform, while
the market losers can outperform (Jegadeesh 1990; Lehmann 1990). For
example, a study by Jegadeesh reported profits of about 2 % per month
over the 1934–1987 period using a simple reversal strategy across indi-
vidual stocks. His approach relied on buying and selling securities on the
basis of their prior-month returns and holding them for one month. The
short-reversal effect has been explained in many ways, including investor
overreaction, liquidity considerations, or microstructure issues.4
Long-term reversal. The security returns tend to revert not only
in the very short periods but also in the long term. Particularly, stocks
underperforming over 3–5 years tend to outperform further in the future
while securities with high returns over past 3–5 years are likely to become
laggards in the next month. This phenomenon was initially discovered
in individual stocks (DeBondt and Thaler 1985), and later also detected
across a number of assets (Asness et al. 2013). As with many other anoma-
lies, the long-term reversal effect is stronger among the stocks with high
idiosyncratic volatility (McLean 2010). It is mostly explained on the

behavioral basis, or on the grounds of tax considerations, data snooping,
or other rational explanations.5 It is also closely related to the concept of
value investing (Wu and Li 2010; Asness et al. 2013).
Could these phenomena also be applied at the country level? Can they
be used for inter-market tactical asset allocation? While the short-term
reversal effect has not been extensively explored, the long-run reversal
provided some promising results. A number of studies identified this
phenomenon at the country level and suggested it could be employed to
form successful strategies, particularly in combination with the momen-
tum effect.6 The recent evidence, however, is less optimistic: Table 10.4
shows the key insights of a study by Zaremba (2015a) investigating tertile
portfolios formed on the short-term and long-term reversal anomalies.
The performance of reversal anomalies vividly deteriorated over the
years with none of the two strategies delivering positive returns over the
20-year period. In fact, in some cases they even delivered negative returns
when past winners outperformed past losers. In other words, we observed
more of a continuation rather than reversal effect. Given the evidence,
building a country-level portfolio based on momentum anomalies may
not be a fully justified approach.
Concluding this chapter, we have to state that past prices might con-
vey important message for investors. While the reversal effect hardly
proved useful over the past two decades, the equal-weighted momentum
Table 10.4 The performance of zero-investment country equity indices based

on short-term and long-term reversal anomalies
Equal-weighted portfolios Capitalization-weighted portfolios
Gross return Net return Gross return Net return

Short-term reversal −0.37** −0.37* −0.35 −0.33
(−1.96) (−1.74) (−1.18) (−1.21)
Long-term reversal −0.11 −0.29 −0.67** −0.42
(−0.37) (−1.44) (−2.27) (−1.34)
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)
portfolios delivered consistent returns, consistently robust to different

measurement methods. The trend following proved profitable both with
the use of moving average strategies or mere sorting, and it was particu-
larly pronounced among the small markets.
On the other hand, the analysis of the last 20 years has also revealed an
important weakness of the inter-country momentum: it disappears under
the impact of capitalization weighting, so once the markets are weighted
according to their size, we can no longer see significant momentum prof-
its. This soft spot poses a substantial risk for international investors and
casts doubt on the true reliability of the country-level momentum strategy.
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).
REFERENCES
Andreu, L., Swinkels, L., & Tjong-A-Tjoe, L. (2013). Can exchange traded funds
be used to exploit industry and country momentum? Financial Markets and
Avramov, D., Chordia, T., & Goyal, A. (2006). Liquidity and autocorrelations in
individual stock returns. Journal of Finance, 61, 2365–2394.
Balvers, R. J., & Wu, Y. (2006). Momentum and mean reversion across national
equity markets. Journal of Empirical Finance, 13, 24–48.
Barberis, N., Shleifer, A., & Vishny, R. (1998). A model of investor sentiment.
Berk, J. B., Green, R. C., & Naik, V. (1999). Optimal investment, growth options
and security returns. Journal of Finance, 54, 1153–1607.
Bhojraj, S., & Swaminathan, B. (2006). Macromomentum: Returns predictability
in international equity indices. Journal of Business, 79(1), 429–451.
Black, F. (1986). Noise. Journal of Finance, 41, 529–543.
Brav, A., & Heaton, J. B. (2002). Competing theories of financial anomalies.
Campbell, J. Y., Grossman, S. J., & Wang, J. (1993). Trading volume and serial
correlation in stock returns. Quarterly Journal of Economics, 108, 905–939.
Chabot, B., Ghysels, E., & Jagannathan, R. (2014). Momentum trading, return
chasing, and predictable crashes. Federal Reserve Bank of Chicago Working
Paper 2014-27. NBER Working Paper No. 20660. Retrieved November 17,
2015, from http://www.nber.org/papers/w20660
Conrad, J., Cooper, M., & Kaul, G. (2003). Value versus glamour. Journal of
Finance, 58, 1969–1995.
Conrad, J., Kaul, G., & Nimalendran, M. (1991). Components of short-horizon
individual security returns. Journal of Financial Economics, 29, 365–384.
Daniel, K., Hirshleifer, D., & Subrahmanyam, A. (1998). A theory of overconfi-
dence, selfattribution, and security market under- and over-reactions. Journal
of Finance, 53, 1839–1885.
Daniel, K. D., & Moskowitz, T. J. (2013). Momentum crashes. Swiss Finance Institute
Research Paper No. 13-61; Columbia Business School Research Paper No. 14-6;
Fama-Miller Working Paper. Retrieved November 17, 2015, from SSRN: http://
DeBondt, W. F. M., & Thaler, R. (1985). Does the stock market overreact?
Evans, A., & Schmitz, C. (2015). Value, size and momentum on equity indices - A
likely example of selection bias. WINTON Global Investment Management
working paper. Retrieved November 11, 2015, from https://www.winto-
ncapital.com/assets/documents/research-papers/ValueSizeMomentum
onEquityIndices2015-09-07.pdf
Geczy, C., & Samonov, M. (2015). 215 Years of global multi-asset momentum:
1800-2014 (equities, sectors, currencies, bonds, commodities and stocks). Retrieved
October 20, 2015, from SSRN: http://ssrn.com/abstract=2607730 or
George, T. J., & Hwang, C.-Y. (2004). The 52-week high and momentum invest-
ing. Journal of Finance, 59, 2145–2176.
Georgopoulou, A., & Wang, G. J. (2015). The trend is your friend: Time-series
momentum strategies across equity and commodity markets. Retrieved November
11, 2015, from SSRN: http://ssrn.com/abstract=2618243
Grobys, K. (2016). Another look at momentum crashes: Momentum in the
European monetary union. Applied Economics, 48(19), 1759–1766.
Grossman, S., & Miller, M. H. (1988). Liquidity and market structure. Journal of
Finance, 43, 617–633.
Guilmin, G. (2015). The effective combination of risk-based strategies with momen-
tum and trend following. Retrieved October 11, 2015, from SSRN: http://
Heidari, M. (2015). Momentum crash management. Retrieved November 17,
org/10.2139/ssrn.2578296
Hong, H., & Stein, J. (1999). A unified theory of underreaction, momentum trad-
ing, and overreaction in asset markets. Journal of Finance, 54(6), 2143–2184.
Jegadeesh, N. (1990). Evidence of predictable behavior of security returns. Journal
of Finance, 45, 881–898.
Kaniel, R., Saar, G., & Titman, S. (2008). Individual investor trading and stock
returns. Journal of Finance, 63, 273–310.
Klein, P. (1999). The capital gains lock-in effect and equilibrium returns. Journal
of Public Economics, 71, 355–378.
Lehmann, B. N. (1990). Fads, martingales and market efficiency. Quartarly
Journal of Economics, 105, 1–28.
Lewellen, J., & Shanken, J. (2002). Learning, asset-pricing tests, and market effi-
ciency. Journal of Finance, 57, 1113–1145.
Malin, M., & Bornholt, G. (2013). Long-term return reversal: Evidence from
international market indices. Journal of International Financial Markets,
Institutions and Money, 25, 1–17.
McLean, R. D. (2010). Idiosyncratic risk, long term resersal, and momentum.
Muller, C., & Ward, M. (2010). Momentum effects in country equity indices.
Journal for Studies in Economics and Econometrics, 34(1), 111–127.
Novy-Marx, R. (2012a). Is momentum really momentum? Journal of Financial
Economics, 103, 429–453.
Pastor, L., & Stambaugh, R. F. (2003). Liquidity risk and expected stock returns.
Journal of Political Economy, 111(3), 642–685.
Richards, A. J. (1997). Winner-loser reversals in national stock market indices:
Can they be explained? Journal of Finance, 52, 2129–2144.
Shiller, R. J. (1984). Stock prices and social dynamics. Brooking Papers on Economic
Activity, 2, 457–498.
Stiglitz, J. E. (1989). Using tax policy to curb speculative trading. Journal of
Financial Services, 3, 101–115.
Subrahmanyam, A. (2005). Distinguishing between rationales for short-horizon
predictability of stock returns. Financial Review, 40, 11–35.
Summers, L. H., & Summers, V. P. (1989). When financial markets work too well:
A cautious case for a securities transactions tax. Journal of Financial Services, 3,
261–286.
Vu, J. D. (2012). Do momentum strategies generate profits in emerging stock
markets? Problems and Perspectives in Management, 10(3), 2012.
Wu, Y., & Li, Y. (2010). Long-term return reversals: Value and growth or tax? UK
Evidence. Journal of International Financial Markets, Institutions and Money,
21(3), 347–368.
Zaremba, A. (2015a). Investor sentiment, limits on arbitrage, and the performance
of cross-country market anomalies. Working paper. Retrieved February 21,
2016, from http://adamzaremba.pl/data/uploads/wps.pdf
CHAPTER 11
Small-Country Effect
In Chap. 4 we discussed the size anomaly at the level of individual securi-

ties. Could it also be applied across countries? Should an investor focus
on smaller countries to gain superior returns? This issue was first directly
addressed by Keppler and Traub (1993) who compared the performance
of an equal-weighted portfolio of various countries with the capitalization-
weighted MSCI index. Since the equal-weighted portfolio visibly outper-
formed the capitalization-weighted counterpart, they concluded it must
result from abnormal returns on the smaller markets. Indeed, once they
calculated the return on the portfolio of small countries within the MSCI
universe, they found that over the 1974–1992 period it returned on aver-
age 19.2 % per annum, compared to 12.7 % delivered by the broad MSCI
index. Furthermore, the small markets had smaller downside risk, so they
were not only more profitable, but also safer.1
The seminal results of Keppler and Traub were later replicated by other
authors, for example by Asness et al. (1997). More than 18 years later, in
2011 Michael Keppler along with Peter Encinosa decided to revisit their ini-
tial findings. The new study covered a 40-year period running from 1969 to
2009, more than doubling their original range. The updated study confirmed
the long-established adage that “small is beautiful”. The smallest markets
outperformed the MSCI World Index by 5 percentage points per annum and
performed favorably even after a number of risk measures were taken into
account. The country-level size premium also proved very stable: the small
markets beat the large counterparts in 7 out of 8 five-year periods.

DOI 10.1057/978-1-137-59191-3_11
The size effect seems robust also in comparison to particular indices.

For example, Li and Pritamani (2015), concentrating solely on emerging
and frontier markets, tested a set of 51 indices calculated by Standard &
Poor’s (S&P). Within the years 1990–2013 they found the small markets
outperform the large markets by over 6 % per annum on average, i.e.
about 0.5 % monthly.
Nevertheless, not all recent studies are that optimistic. Evans and
Schmitz (2015), having examined 18 developed markets, found the
Sharpe ratios on the size-based strategy (and other factor strategies) have
significantly deteriorated over the last two decades. The researchers regard
it a classic example of selection bias. Similarly, Zaremba (2015) has docu-
mented the outperformance of small countries to be rather modest in
recent years.
SMALL COUNTRIES DO NOT ALWAYS OUTPERFORM

Table 11.1 presents the performance of portfolios from sorts on size
within our sample of 78 countries for years 1995–2015. In effect, we are
unable to confirm the size effect. The returns on small countries do not
markedly differ from the returns on large countries. In fact, in three out of
four configurations we have examined (equal-weighted vs. capitalization-
weighted and gross vs. net returns) the raw and risk-adjusted returns on
dollar-neutral portfolios are indistinguishable from 0. Moreover, the small
markets are also slightly riskier in terms of the standard deviation.
To be precise there is one exception in our calculations. When consid-
ering net returns, the small markets significantly outperformed the large
countries by about 0.4 % per month. This single exception does not alter
the broader picture that the size-based strategies do not appear particu-
larly successful in our sample.
Summing up, our outcomes do not confirm the earlier studies of the
country-size effects. We find no convincing evidence that “small is really
beautiful” in the case of country selection. It is interesting why our results
differ so much from the earlier studies. A few explanations are possible.
First, our sample is broader than in the previous research; thus the results
may also differ. Second, some of the phenomena observed in the earlier
papers were incorrectly ascribed to the small-country effect. For instance,
the higher returns on the equal-weighted portfolios, when compared to
the capitalization-weighted portfolios, as reported by Keppler and Traub
SMALL-COUNTRY EFFECT 185
Table 11.1 Performance of portfolios from sorts on total capitalization

Large Medium Small S-L Large Medium Small S-L

Equal-weighted portfolios
Mean return 0.35 0.59 0.4 −0.01 0.45 0.22 0.64 0.14
(1.15) (1.54) (1.10) (0.05) (1.34) (0.58) (1.55) (0.45)
Volatility 5.42 6.35 6.34 4.74 5.70 6.14 6.14 4.13
Sharpe ratio 0.22 0.32 0.22 −0.01 0.27 0.12 0.36 0.12
Alpha −0.18 0.02 −0.05 0.08 0.18 −0.03 0.40 0.16
(−1.10) (0.03) (−0.19) (0.32) (0.47) (−0.24) (1.08) (0.65)
Capitalization-weighted portfolios
Mean return 0.37 0.67* 0.27 −0.11 0.37 0.26 0.77** 0.39*
(1.39) (1.74) (0.88) (−0.20) (1.27) (0.67) (2.07) (1.79)
Volatility 4.64 6.24 6.31 4.49 4.89 6.22 5.83 3.74
Sharpe ratio 0.28 0.37 0.15 −0.09 0.26 0.15 0.46 0.36
Alpha −0.11 0.12 −0.18 −0.08 0.12 0.01 0.57 0.43*
(−1.04) (0.44) (−0.62) (−0.24) (0.35) (−0.13) (1.46) (1.71)
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
100
80
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
with the beginning of the great financial crisis. The underperformance of

small countries, which subsequently followed, wiped out the entire small-
country premium accumulated over the previous decade. This observation
holds true for both equal-weighted and capitalization-weighted portfolios.
Finally, there is one more interesting point about the country-level size
effect and its recent risk-adjusted performance. Many of the explanations
of the stock-level size effect are related to some non-market risks, like, for
example, information risk or default risk. In fact, the international inves-
tors also face numerous risks, which are not captured by market volatility.
An expropriation risk may serve as just an example. Interestingly, Zaremba
(2016) showed that small markets in some periods indeed markedly out-
perform large ones, but this outperformance is fully explained by their
non-market risk. In other words, the small markets might really deliver
superior returns, but the reason is simple: they are just more risky.
IS THERE A CROSS-COUNTRY LIQUIDITY PREMIUM?

One of the explanations of the size effect at the individual stock level
is linked to liquidity. As the small companies are less liquid, they might
bear additional premium for the resulting liquidity risk. Let’s exam-
ine this relationship more closely. Table 11.2 shows the performance
of the tertile portfolios from sorts on two distinct liquidity measures:
turnover (volume × price) and turnover ratio (turnover/stock market
capitalization).
Unfortunately, we identify no reliable pattern here. We should expect
that the least liquid countries should bear some premium relative to the
liquid ones. Nonetheless, no such relationship is visible in the data. The
returns on both liquid and illiquid countries remain similar.
In Fig. 11.2 we additionally plot the cumulative returns on equal-
weighted zero-portfolios in order to see how the returns changed over
time. Interestingly, the pattern bears some resemblances to the returns
on size. The strategy delivered attractive returns, but only until 2008.
Subsequently, a series of lean years wiped out more than half of all profits
accumulated since 1995.
Let’s conclude our discussion on the size effect and its applicability at the
country level. Although the small-cap-based strategies populate the market,
their validity is highly controversial. A number of recent studies point out
the initial evidence on size effect to be rather fragile and the whole small-
firm anomaly can be a mix of time- and sample-specific selection bias.
Consequently, at the country level the reliability of the size strategy
might prove equally doubtful. The effect documented in early 1990
among the MSCI indices, fails to survive out-of-sample tests and rig-
orous scientific scrutiny. In other words, being unable to confirm the
country-level size effect, nor any related liquidity premia, we believe
that the famous small-country effect could be simply a result of sample-
specific outcomes and return miscalculations. Within our dataset, small
country investing proves to be an unprofitable strategy throughout the
last 20 years.
Table 11.2 Performance of portfolios from sorts on liquidity
188
Illiquidy Neutral Liquid I-L Illiquidy Neutral Liquid I-L

Panel A
Turnover
Mean return 0.46 0.40 0.78** 0.28 0.32 0.50 0.43 0.06
(1.39) (1.09) (1.99) (1.22) (1.01) (1.32) (1.09) (0.20)
Volatility 5.51 6.17 5.73 3.43 5.57 5.87 6.13 4.14
Sharpe ratio 0.29 0.23 0.47 0.28 0.20 0.29 0.24 0.05
Alpha 0.02 −0.07 0.39 0.33 0.04 0.22 0.15 0.05
(0.09) (−0.41) (1.50) (1.52) (−0.01) (0.50) (0.35) (0.26)

Turnover ratio
Mean return 0.32 0.61* 0.32 −0.12 0.41 0.63 0.29 −0.20
(0.92) (1.65) (0.91) (−0.48) (1.15) (1.64) (0.76) (−0.77)
Volatility 6.51 5.95 6.13 4.24 6.07 5.83 6.34 4.37
Sharpe ratio 0.17 0.35 0.18 −0.10 0.23 0.37 0.16 −0.16
Alpha −0.14 0.14 −0.10 −0.07 0.17 0.36 0.02 −0.23
(−0.55) (0.62) (−0.45) (−0.32) (0.31) (0.99) (−0.09) (−0.71)
Panel B
Turnover
Mean return 0.36 0.57 0.03 −0.31 0.37 0.19 0.42 0.02
(1.28) (1.47) (0.30) (−0.76) (1.30) (0.53) (1.17) (0.21)
Volatility 4.69 6.19 7.01 5.01 4.87 6.18 6.01 4.15
Sharpe ratio 0.26 0.32 0.02 −0.22 0.27 0.11 0.24 0.02
Alpha −0.04 0.11 −0.42 −0.36 0.13 −0.05 0.20 0.05
(−0.44) (0.40) (−1.34) (−1.13) (0.39) (−0.30) (0.44) (0.18)
Turnover ratio
Mean return 0.28 0.78** 0.18 −0.11 0.17 0.68** 0.23 0.05
(0.99) (2.46) (0.53) (−0.49) (0.64) (1.98) (0.61) (0.16)
Volatility 4.91 4.98 6.21 3.95 5.01 5.15 6.20 3.79
Sharpe ratio 0.20 0.54 0.10 −0.09 0.12 0.46 0.13 0.05
Alpha −0.09 0.39** −0.25 −0.16 −0.04 0.44 −0.02 0.02
(−0.51) (2.40) (−0.97) (−0.65) (−0.31) (1.49) (−0.25) (0.05)
Note: The table presents the performance of equal-weighted and capitalization-weighted tertile portfolios from sorts on liquidity, i.e. turnover (average
12-month trailing the dollar volume) and turnover ratio (average 12-month trailing ratio of the dollar volume to total stock market capitalization). “Illiquid”,
“Neutral”, and “Liquid” are portfolios of markets with low, medium, and high liquidity, respectively. “I-L” is a zero-investment portfolio with long (short)
position in illiquid (liquid) 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 sourced from Bloomberg
SMALL-COUNTRY EFFECT
189
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
Fig.11.2 Cumulative excess returns on strategies based on market liquidity.

terms) on zero-investment equal-weighted tertile portfolios from the sorts the
liquidity, i.e. turnover (average 12-month trailing dollar volume) and turnover
ratio (average 12-month trailing ratio of dollar volume to total stock market capi-
talization). The calculations are based on the I 1995–VI 2015 period, and the data
sourced from Bloomberg
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).
REFERENCES
Angelidis, T., & Tessaromatis, N. (2014). Global style portfolios based on country
indices. Bankers, Markets & Investors, March–April. Retrieved November 9,
2015, from https://mpra.ub.uni-muenchen.de/53094/
Evans, A., & Schmitz, C. (2015). Value, size and momentum on equity indices - A
likely example of selection bias. WINTON Global Investment Management
working paper. Retrieved November 11, 2015, from https://www.wintoncapi-
tal.com/assets/documents/research-papers/ValueSizeMomentumonEquity
Indices2015-09-07.pdf
Li, T., & Pritamani, M. (2015). Country size and country momentum effects in
emerging and frontier markets. Journal of Investing, 24(1), 102–108.
Willenbrock, S. (2011). Diversification return, portfolio rebalancing, and the
commodity return puzzle. Financial Analyst Journal, 67, 42–49.
Zaremba, A. (2015). Country selection strategies based on value, size and momen-
tum. Investment Analyst Journal, 44(3), 171–198.
Zaremba, A. (2016). Risk-based explanation for the country-level size and value
effects. Finance Research Letters, 18, 226–233.
CHAPTER 12
Risk-Based Country Asset Allocation
The risk-return patterns have been documented across many types of

stocks and assets. Let us now review how the situation unfolded at the
country level. Some of the evidence has been already reviewed in Chap. 5.
Let us now focus on the last 20 years.
BETA, VOLATILITY AND OTHER “PRICE” RISKS

Figure 12.1 provides a quick overview of this issue—it depicts the mean
monthly excess returns on the equal-weighed tertile portfolios from sorts
on 4 distinct risk measures: beta, standard deviation, value at risk, and
idiosyncratic volatility. The first look suggests that the risk measures are
loosely related to the future returns. The cross-sectional patterns are rather
flat and in fact hard to find for beta or value at risk. The monotonically
increasing returns along with the rise in price risk are in turn clearly visible
for the standard deviation and idiosyncratic volatility. Yet, even there the
cross-sectional differences are insubstantial.
These initial insights are confirmed with a more in-depth analysis
reported in Table 12.1. Risky markets appear associated with slightly
higher returns, but the outperformance is too small and irregular to be
statistically significant. For example, when we focus on the equal-weighted
portfolios from the sorts on the simple standard deviation, the volatile
markets display the mean monthly gross (net) returns over 0.31 (0.36)

DOI 10.1057/978-1-137-59191-3_12
Panel A Panel B
0.80
194
0.80
0.60 0.60
0.40 0.40
0.20 0.20
0.00 0.00
Low Medium High Low Medium High
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
Low Medium High H-L Low Medium High H-L
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
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)
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)
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
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.
DOES SKEWNESS MATTER?

Discussing the background of low-risk investing, we have already indi-
cated that some studies suggest that this strategy may relate to the skew-
ness effect, i.e. the phenomenon that the right-skewed assets frequently
underperform the left-skewed assets. Could it also hold true at the coun-
try level? It might be possible that investors assess the markets by their his-
torical performance and also favor the right-skewed markets. This would
imply that the stock markets with high skewness of historical return distri-
bution might underperform those with low skewness. The initial evidence
on this issue suggests this to be true: in 2000, Harvey identified skew-
ness as a price factor at the country level. Let’s then investigate its impact
within the last 20 years.
Table 12.2 presents the performance of both equal-weighted and
capitalization-weighted portfolios formed on skewness. We have used a
very straightforward approach and simply sorted stocks on the skewness
of the monthly returns over the past two years. At first, the approach
seems to deliver. In all four approaches (gross, net, equal-weighted,
RISK-BASED COUNTRY ASSET ALLOCATION 199
Table 12.2 Performance of portfolios from sorts on skewness

High Neutral Low L-H High Neutral Low L-H
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)
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)
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
capitalization-weighted) the markets with high skewness have outper-

formed the ones with low skewness. In three out of four cases the
returns on the zero-investment portfolios rise significantly above 0.
Analyzing, for example, the gross returns on capitalization-weighted
portfolios we see the left-skewed markets earning a mean excess return
of 0.78 % monthly while the right-skewed markets only 0.08 %, with
a comparable level of risk across all the portfolios. The broad spread
in returns was significant even after adjusting for the market risk and
exceeded 0.60 %.
350
300 Equal-weighted portfolios
250 Capitalization-weighted portfolios
200
150
100
50
0
1997 1998 1999 2001 2002 2003 2005 2006 2007 2009 2010 2011 2013 2014
-50
Fig. 12.2 Cumulative excess returns on strategies based on skewness

terms) on the zero-investment equal-weighted tertile portfolios from sorts on
skewness of the return distribution based on 24-month trailing monthly returns as
available (min. 12 months). The calculations are based on the I 1995–VI 2015
period, and the data sourced from Bloomberg
Interestingly, the returns on the skewness-based strategy were also rela-

tively stable over time (see Fig. 12.2). Although we see some differences in
returns between the equal-weighted and capitalization-weighted portfolios,
both approaches deliver consistent and positive returns without major draw-
downs. Many of the strategies we have already discussed displayed a sub-
stantial deterioration in performance in the post-2007 period. Fortunately
for investors, in this case no such phenomenon is visible. In short, skewness
may constitute a valuable tool for country-level asset allocators.
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.
Table 12.3 depicts performance of the country-level portfolios formed

based on the fundamental country risk.1 As a proxy for the country risk
we have used the Economist Intelligence Unit (EIU) indicators, calcu-
Table 12.3 Performance of portfolios from sorts on country fundamental risk

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)
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
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
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
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
Fig. 12.3 Performance of equal-weighted tertile portfolios from sorts on five

components of the country risk
Note: The figure presents mean returns on zero-investment equally-weighted ter-
tile portfolios from sorts on five individual metrics related to sovereign risk, cur-
rency risk, banking sector risk, political risk, and economic structure risk. The
means are expressed in percentage terms. The data in the table are sourced from
Zaremba (2015): Table 3
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.
55
50
45
40
35
30
Small Big
25
20
1997 1998 2000 2001 2003 2004 2006 2008 2009 2011 2012 2014
Fig. 12.4 Country risk within subgroups classified by market size

Note: The figure presents the mean EIU composite country risk indicators within
the subgroups of countries above and below median values of the total stock
market capitalization.
Source: Zaremba (2015), Fig. 1, Panel A
Here we have discussed a wide range of country-level strategies based

on various types of risk and quasi-risk indicators. Not all have stayed the
same as at the stock level, nor proved particularly useful for country selec-
tion purposes. Simple risk indicators, like standard deviation or idiosyn-
cratic volatility, tend to be negatively related with future returns, a paradox
from the standpoint of the classic market theories. At the country level,
however, with the imperfectly integrated financial markets, the relationship
proved to be rather positive, with higher risk followed by higher expected
returns. Sadly, we have found the relationship very weak and unreliable as
the most volatile countries in last two decades have delivered only margin-
ally higher return, and the relationship was hardly statistically significant.
Fortunately, the alternative risk-related measures proved much more
successful. The strategy based on the past skewness of returns delivered
robust profits consistently across the time and various approaches. The
countries with the lowest skewness markedly outperformed the markets
with the highest skewness by about 0.3–0.6 percentage points per month.
Finally, the fundamental aspect of country risk related to sovereign,
political, or banking sector exposures seems also to be reflected in price as
the risky countries deliver substantially higher returns than the safe ones.
Unfortunately, the superior returns were mostly concentrated in the small

and illiquid markets, so, albeit profitable, the strategy might prove hard
to implement.
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
Country Selection Based on Quality
While the literature on stock-level quality investing is fairly abundant (see

Chap. 6), the impact of quality on future returns at the country level has
yet to be extensively examined. Initial evidence points to the outperfor-
mance of the country equity markets populated with companies of low
leverage or high balance liquidity; the general evidence, however, is still
rather scarce.1 In this section, we will look at three categories of quality
indicators—leverage, profitability, and issuance—and we will examine the
tertile portfolios formed on these metrics.
LEVERAGE AND DISTRESS RISK

Let’s begin with leverage. To test the importance of country specific lever-
age for future returns, we sort the country equity markets on two separate
ratios: equity-to-debt ratio, and EBITDA-to-debt ratio. In each case, the
higher the ratio for a given market, the better the financial standing of an
average company listed in this market.
Table 13.1 reports the performance of various portfolios from sorts
on leverage. As usual, we present four distinct versions of the results:
gross returns, net returns, equal-weighted portfolios, and capitalization-
weighted portfolios. Although the impact of leverage varies across the
approaches, it seems useful for country selection. In every case, the less
leveraged markets delivered historically higher returns than the highly

DOI 10.1057/978-1-137-59191-3_13
Table 13.1 Performance of portfolios from sorts on financial leverage
208
High Medium Low L-H High Medium Low L-H

Panel A
Equity-to-debt ratio
Mean return 0.30 0.74** 0.64* 0.28 0.07 0.77** 0.55 0.44*
(0.98) (2.14) (1.76) (1.36) (0.32) (2.13) (1.45) (1.96)
Volatility 5.68 5.18 5.78 3.39 5.65 5.39 5.95 3.44
Sharpe ratio 0.18 0.50 0.38 0.29 0.04 0.50 0.32 0.44
Alpha −0.17 0.32 0.17 0.28 −0.27 0.43 0.19 0.42**
(−0.79) (1.55) (0.74) (1.31) (−1.00) (1.31) (0.51) (2.05)
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
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)
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)

Note: The table presents the performance of equal-weighted and capitalization-weighted tertile portfolios from sorts on the following leverage measures:
equity-to-debt ratio and EBITDA-to-debt ratio. “Low”, “Medium”, and “High” are portfolios of markets with low, medium, and high leverage, respectively.
“L-H” is a zero-investment portfolio with long (short) position in the markets of low (high) leverage. “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 th e 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 10 %, 5 % and 1 %, respectively. The calculations are based on the I 1995–VI 2015 period, and the data sourced from
Bloomberg
COUNTRY SELECTION BASED ON QUALITY
209
leveraged country markets. The outperformance measured with raw

returns on the zero-investment portfolios fluctuated substantially from
0.03 % to 0.67 %, but in none of the cases did the mean return on the
zero-investment portfolios turn negative. Let us take the gross perfor-
mance of the tertile equal-weighted zero-investment portfolio formed
on EBITDA-to-debt ratio. Within this particular approach, the least lev-
eraged markets earned an average excess return of 0.74 % per month,
with the leverage reaching only 0.35 % per month. The level of volatil-
ity associated with all the portfolios was fundamentally comparable. The
mean monthly raw excess return on the dollar-neutral portfolio—long the
least leveraged markets, and short the most leveraged ones—delivered a
mean return of 0.38 % per month. After adjusting it for the market risk
according to the CAPM, the abnormal returns decreased gently to 0.35 %.
Both mean returns on the zero-weighted portfolio, i.e. the raw and risk-
adjusted, were positive and significantly different than 0.
Figure 13.1 sheds some light on the performance of low-indebted and
high-indebted markets over time. The low indebted markets flourished in
the 1999–2011 period delivering mixed results in other years. From 1995
to 1998 the low-leveraged markets lagged behind the highly leveraged
markets by approximately 50 percentage points. Additionally, following
2011 the outperformance of low-indebted markets deteriorated even fur-
ther. While it is still difficult to tease out the sources of this volatility in
returns, interestingly, the major drawdowns of the low-debt strategy coin-
cided with the spur of the worldwide sovereign debt crises: the Russian
crisis of 1998 and the PIIGS crisis in the recent years. The two credit crises
may be linked via the banking sector and exploring this issue in further
studies might bring a new valuable tool for international investors.
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
150
100
50
0
1995 1996 1998 1999 2001 2002 2004 2005 2007 2008 2010 2011 2013 2014
-50
-100
Fig. 13.1 Cumulative excess returns on strategies based on leverageNote: The

figure presents cumulative excess return (expressed in percentage terms) on
the zero-investment equal-weighted tertile portfolios from sorts on two
leverage measures: equity-to-debt ratio and EBITDA-to-debt ratio. The cal-
culations are based on the I 1995–VI 2015 period, with the data sourced
from Bloomberg
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

Panel A
Return on assets
Mean return 0.47 0.56* 0.65* 0.15 0.28 0.55* 0.55 0.25
(1.45) (1.68) (1.74) (0.76) (0.87) (1.71) (1.38) (1.19)
Volatility 5.50 5.15 5.86 2.98 5.62 5.04 6.28 3.49
Sharpe ratio 0.30 0.37 0.38 0.17 0.17 0.38 0.30 0.25
Alpha 0.01 0.13 0.18 0.14 −0.07 0.28 0.15 0.20
(0.07) (0.63) (0.75) (0.75) (−0.36) (0.77) (0.36) (0.96)
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)

Note: The table presents the performance of equal-weighted and capitalization-weighted tertile portfolios from sorts on profitability: return on assets and
return on equity. “Low”, “Medium”, and “High” are portfolios of markets with low, medium, and high leverage, respectively. “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, vola-
tilities, 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
213
were adjusted for country-specific taxes on dividends, the large portion of

the profits evaporated.
In the capitalization weighting approach, the performance of various
groups of portfolios changed visibly: especially the strategies based on
return on assets and return equity, which really outperformed against the
gross margin-based tertiles displaying obscure cross-sectional patterns,
and the mean monthly returns on the dollar-neutral portfolios falling to
around 0.1 % monthly.
On the other hand, sorting by return on equity proved to be the best
performing strategy. For this profitability measure, in both gross and net
approaches, the raw returns on the countries populated with the least prof-
itable companies turned even slightly negative. Adding to that the very
decent performance of the most profitable markets, the mean monthly
returns on the long/short portfolios substantially exceeded 0.50 % per
month. The zero-investment portfolios delivered also significant alphas of
0.58 % (0.56 %) in the gross (net) return approach.
Figure 13.2 depicts cumulative returns on three profitability charac-
teristics over the 1995–2015 period. Naturally, the mean returns—as we
have already showed—varied fundamentally across the portfolio weight-
ing methods and return calculation approaches. Thus, Fig. 13.2 should
be treated only as an example giving a feeling of the time-series behavior
of the strategy. Generally, the returns were quite stable, but not entirely
deprived of some variability. The strategies performed very well in the first
year of our study (1995–1998), when the sample encompassed mostly
developed markets. Then came a stretch of underperformance, followed
by another phase of a stable outperformance of profitable markets.
Summing up, the profitability strategies might constitute a useful tool
for international investors. They could be particularly beneficial as they
largely benefit from the patterns across large and liquid markets, which are
easily accessible by international investors.
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.
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
Fig. 13.2 Cumulative excess returns on strategies based on profitabilityNote:

The figure presents cumulative excess return (expressed in percentage terms)
on the zero-investment equal-weighted tertile portfolios from sorts on prof-
itability measures: return on asset, return on equity, and gross margin. The
calculations are based on the I 1995–VI 2015 period, with the data sourced
from Bloomberg
We could use the aggregate share issuance as the predictor of future

return because the market-wide perception of initial public offering activity
is often considered a gauge of investor optimism. Large number of IPOs
and excessive share issuance may signal over-optimism and overvaluation,
while low frequency of IPOs and modest issuance is considered to indicate
the contrary, which is supported by a number of studies on IPO-related
phenomena. Lee et al. (1991) and Lowry (2003), for example, have sup-
plied convincing evidence supporting that “hot issue” periods coincide with
low closed-end funds’ discounts, so can be then employed as a measure
of investor sentiment. Further on, Dorn (2009) has documented investor
sentiment to be a key driver of retail demand for IPO shares whereas a con-
siderable correlation among the market sentiment, IPOs and stock market
valuations has also been found by Campbell et al. (2008).
This phenomenon might have cross-sectional implications for interna-
tional investors. If the size of the IPO issuance in the market is an indicator
of investor sentiment and the potential market over- or undervaluation,
than it could be used to forecast the returns on the international equity

markets in the cross-section strategy. In other words, the markets with
high stock issuance are recognized as overvalued and thus they are charac-
terized by low future returns. To the contrary, the low market-wide share
issuance is a potential indicator of undervaluation and high future returns.
Thus, we might expect the markets with low issuance to outperform mar-
kets with high issuance.
The initial evidence on the use of aggregate issuance was fairly opti-
mistic. For example, Zaremba and Okoń (2015) showed that sorting
markets on their past issuance indeed generated extraordinary returns.
It demanded, however, allocating money into equal-weighted portfolios
of extreme markets. Here, the underlying assumption on the reason for
the negative relationship between the country-level issuance and future
returns is to be found in behavioral phenomena, which cannot be easily
arbitraged away. If one of the contributing factors were cross-country cap-
ital mobility preventing the inter-market mispricing from being instantly
arbitraged away, then the impact of issuance should be stronger when the
capital mobility becomes more difficult. And indeed Zaremba and Okoń
(2015) have indicated that the country-level issuance-based strategies
demanded allocating money into equal-weighted portfolios of extreme
markets. Furthermore, the outperformance was mostly driven by the very
small markets. So let’s see how this strategy performs in more diversified
equal-weighted and capitalization-weighted tertile portfolios.
Table 13.3 reports the performance cross-country portfolios formed
on past issuance. The cross-sectional pattern related to issuance seems fee-
ble within our sample. In the equal-weighting approach the low-issuance
markets delivered only marginally higher returns than the high-issuance
markets. When gross returns are considered, the countries with the least
IPOs and SPOs delivered on average 0.65 %, while the markets with the
largest number of equity offerings only 0.32 %. The spread was eventually
too small to be statistically significant, and the outperformance of low-
issuance countries disappeared totally after weighting the markets relative
to their total stock market capitalization. In this case the historical mean
returns on the low-issuing countries were even smaller than on the high
issuance countries.
Figure 13.3 depicts cumulative returns on the zero-investment port-
folios from sorts on past issuance, i.e. portfolios long in the tertile of the
markets with the lowest IPO volume, and short in the markets with the
highest issuance. While the equal-weighted portfolios display modest
Table 13.3 Performance of portfolios from sorts on issuance
High Medium Low L-H High Medium Low L-H
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)
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
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
120
100
60
40
20
0
1995 1997 1998 2000 2001 2003 2004 2006 2007 2009 2010 2012 2013 2015
-20
-40
-60
-80
Fig. 13.3 Cumulative excess returns on strategies based on issuanceNote: The

figure presents the cumulative excess return (expressed in percentage terms) on
the zero-investment of equal-weighted and capitalization-weighted tertile portfo-
lios from sorts on issuance, i.e. the average ratio of total value of IPOs and SPOs
in the market to the total stock market capitalization over trailing 6 months. The
calculations are based on the I 1995–VI 2015 period, with the data sourced from
Bloomberg
but relatively consistent returns, the performance of the capitalization-

weighted portfolios is very disappointing. It suffered remarkable losses in
years 1995–1998 and it was unable to recover during the next 15 years.
The issuance-based sorts display mediocre results. Clearly, the strategy
might be driven by returns on the small number of tiny markets, so the
benefits are difficult to capitalize in the tertile portfolios, particularly when
they are capitalization weighted.
Still, the issuance anomaly might also be approached in a much simpler
way; for instance, by sorting markets on their age. This approach is a clear
parallel to the IPO long-term underperformance anomaly, which implies
that securities underperform in a few years following the IPOs. This
approach would closely correspond to the stock level study of Jiang et al.
(2005) who have ranked stocks on their age and found the young com-
panies underperforming. Interestingly, dividing the markets into young
and old would also be closely related to other strategies; for example, with
the strategies based on fundamental country risk described in our chap-

ter devoted to risk-based investing. In practice, the countries with young
capital markets tend to bear larger political and sovereign risk than the
mature markets. Furthermore, sorting markets on age should also capture,
to some extent, variability of size-based strategies proposed by Keppler
and Traub (1993)—stating that younger markets are also smaller.
The results in Table 13.4 suggest that the old markets indeed delivered
historically larger returns than the new markets. The effect is particularly
pronounced in the gross returns equal-weighted portfolios. The old mar-
Table 13.4 Performance of portfolios from sorts on age

Young Medium Old O-Y Young Medium Old O-Y
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)
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)
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
kets outperformed the young markets by almost 0.50 % monthly on a raw

return basis. The alphas on the zero-investment portfolios were positive
and reached almost 0.40 % per month. The concept that young markets
underperform is somewhat related to the results of the country-level size
effect. Yet, as we showed in our chapter devoted to the cross-country size
and liquidity premia, we were unable to find any evidence supporting the
outperformance of small markets.
While the returns on the old markets are higher than on the young
markets, the outperformance is fledgling. Figure 13.4 shows that the
long-term profits generated by the age-based strategies are composed
of interchangeable periods of returns and losses. The years 1995–1999
brought a superior performance of the old markets, but the larger part was
then erased in the entire decade of outperformance of the young markets.
250
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
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
Dorn, D. (2009). Does sentiment drive the retail demand for IPOs? Journal of
Financial and Quantitative Analysis, 44, 85–108.
Jiang, G., Lee, C. M., & Zhang, Y. (2005). Information uncertainty and expected
returns. Review of Accounting Studies, 10, 185–221.
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
Zaremba, A. (2015a). The financialization of commodity markets: Investing during
times of transition . New York: Palgrave Macmillan.
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
What Next? Combining and Improving

Country Selection Strategies
The previous chapters offered a number of different country-level strate-

gies. They have been based on various underlying concepts and economic
intuitions, exhibited different risk-return profiles and performed differ-
ently at various times. Thus, the critical question for every investor is how
to select the right strategies and blend them together within a portfolio.
There are two elementary ways to further improve the performance
of the portfolio implementing the quantitative country-selection strate-
gies. First, the investor can diversify his portfolio across various strategies
which, stemming from different philosophies, might also be more loosely
correlated with each other. Thus, relying on many strategies can decrease
the risk within the entire portfolio. Second, the investor can dynamically
change the allocation to various strategies, so as to capture the periods of
strong performance, and avoid the times of low returns on some anoma-
lies. This, in turn, would still demand appropriate tools that could help
forecast the future performance of particular anomalies.
In this chapter we will lay out some basic ideas of how to further
improve the quantitative approach to country selection and how to blend
different approaches within a single portfolio. We will start by presenting
the potential benefits of diversification across anomalies to move on to
some phenomena that may prove useful in tactical asset allocation across
these strategies: behavior in various market conditions, and seasonality and
momentum effect within these strategies.

DOI 10.1057/978-1-137-59191-3_14
DIVERSIFICATION ACROSS STRATEGIES

Since Markowitz (1952) deployed his groundbreaking paper “Portfolio
selection”, we have known that volatility of the portfolio springs from two
elementary sources. The first essential is the risk of each portfolio com-
ponent. Clearly, the more volatile the component stocks are, the riskier
the entire portfolio. The second element is how the returns on individual
portfolio components correlate with each other: where low correlation
may evoke rapid risk reduction within the portfolio.
Once adopted for country-level strategies, the diversification effect
might prove particularly beneficial. When the correlation among individ-
ual assets soars, investors need a relatively large volume of assets to diver-
sify their portfolios. However, when the correlation is low, it might be
sufficient to include a few assets to win most of the diversification benefits.
The hedge fund portfolios might serve as a perfect example. As the cor-
relation among various strategies is low, adding even 5–10 different funds
in one portfolio would yield most of the diversification benefits (Lhabitant
and Learned 2002). This phenomenon might be equally beneficial as the
country-level strategies stem largely from different philosophies.
Let’s consider a simple example with three representative strategies.
Having reviewed various stock-level factors, researchers Hsu and Kalesnik
(2014) have concluded that only three are particularly robust: value,
momentum, and risk. Let’s follow up on their approach and examine how
efficient a portfolio of these three factors is at the country level.
In the example below, we have applied all three strategies. From among
the value strategies we have selected the EBITDA-to-EV ratio, as it turns
out to be the most efficient approach. For the momentum, we have picked
the standard 12-month momentum, skipping the last month. Finally, the
case of risk looms the trickiest. First, unlike in the stock-level universe,
the risk-return relation at the country level appears more positive than
negative. Second, the returns seem to be more determined by the funda-
mental country risk related rather to the political and economic situation
than mere volatility. As a result, we have used the strategy based on the
aggregate country risk assessed by the Economist Intelligence Unit (EIU)
in line with our reasoning in the chapter on risk. For all the strategies, we
have built equal-weighted zero-investment portfolios and reported the
results based on gross total returns. Finally, we have facilitated the three
strategies with a simple market portfolio comprising all the markets in the
sample.
WHAT NEXT? COMBINING AND IMPROVING COUNTRY SELECTION STRATEGIES 225
Table 14.1 presents the correlation coefficients among the excess

returns on these portfolios. Essentially, the correlations seem weak, and
oscillate around zero. The strongest relationship appears between the
strategies based on value and on country risk. As one explanation of the
value premium indicates that low valuation in some countries is driven
by the country risk, the value premium could be attributed to the non-
market risk. On the other hand, the market risk factor displays negative
correlation in momentum. Indeed, the global momentum performed par-
ticularly well during the sharp fall in prices in 2008. Importantly, the cor-
relation coefficients over monthly horizons in general stay quite low, so
the portfolio of the strategies should benefit from diversification.
Figure 14.1 and Table 14.2 depict the benefits of diversification across
the four factor portfolios related to market risk, country risk, value and
momentum. Panel A of Fig. 14.1 presents the cumulative excess returns on
the four zero-investment portfolios and displays very different time-series
returns, except for the pair of risk and value. The two portfolios seem to be
clearly correlated in the long term. In fact, this phenomenon was investi-
gated by Zaremba (2016), who showed that country risk can largely explain
the small-country anomaly. The statistics of the four portfolios disclosed in
Table 14.2 report the portfolio risk. The annual volatilities vary from 10.0
% (value factor) to 15.8 % (market portfolios) while corresponding Sharpe
ratios range from 0.18 to 0.64. An investor allocating capital to a single
strategy would also experience substantial drawdowns oscillating from 22.6
% to 54.6 % whereas for many investors such losses might prove unbearable.
Table 14.1 Correlation across the country-level strategies

Market Value Momentum
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
150 Value + momentum + risk
100
50
0
1998 2000 2001 2003 2004 2006 2007 2008 2010 2011 2013 2014
-50
-100
Fig. 14.1 Cumulative excess returns on country-level factor portfolios. Panel A:

single-strategy portfolios. Panel B: double-strategy portfolios. Panel C: triple-
strategy portfolios
Table 14.2 Performance of portfolios of country-level factor strategies

Mean Annual Sharpe Maximum Beta
annual excess volatility [%] ratio drawdown [%]
return [%]
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
Note: The table reports performance statistics of portfolios based on cross-country

value, momentum, and risk factors, and the market portfolio. The table also 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 calcula-
tions are based on monthly gross returns denominated in the US dollars in the
period January 1999–June 2015. The underlying data are sourced from Bloomberg,
and the mean returns, volatilities and drawdowns are presented in percent
Pairing the strategies brings about a substantial reduction of risk. The

returns time-series become significantly more stable (see Panel B in Fig. 14.1)
displaying much more attractive risk characteristics. The annual volatilities
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
drop below 8 % per annum, at least 20 % below their counterparts in the

single-strategy portfolios. Even in the combination of risk-based strategy and
the value factor volatility records a substantial decline and the maximum draw-
down statistics score lower—staying under 21 %.
Finally, the blend of all three quantitative country-selection strategies
based on risk, value, and momentum yields even better results. Annual
volatility and maximum drawdown fall to 6.4 % and 9.1 %, correspond-
ingly, and as a result, the Sharpe ratio reaches 0.91.
The benefits of diversifying among the four inter-market factors are
also reflected in Fig. 14.2, which presents the risk-return efficient frontier
of the four factor portfolios. We can clearly see that combining various
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 [% ]
Fig. 14.2 Performance of portfolios of country-level factor strategies

Note: The figure presents an efficient frontier of country-level factor strategies
portfolios based on cross-country value, momentum, and risk factors as well as the
market portfolio. The allocation to the respective strategies ranges from 0 to 100
%. 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
US dollars in the period from January 1999 to June 2015. The underlying data are
sourced from Bloomberg and the mean returns and volatilities are presented in
percent on an annualized basis
factors within a single portfolio dramatically improves the portfolio pro-

file, and the reduction of risk is unquestionable.
Summing up, investments in a diversified portfolio of factor strategies
might be very beneficial for international investors. In fact, implementing
just a handful of strategies could greatly reduce the portfolio’s volatility
and limit the drawdowns. The risk-return profile improves radically even
when combining merely two or three strategies.
TIMING THE COUNTRY-LEVEL STRATEGIES

This book offers a large number of country-level strategies that may prove
useful for international investors. As we have already seen, the correlation
amongst them is relatively low. Throughout the year, some strategies out-
perform the others and therefore the ability to pick the right ones would
notably improve the portfolio’s efficiency.
Stock level investors have an array of tools at their disposal to predict
the future returns. On the one hand, the relationship of the factor strate-
gies with various economic variables is very well researched. On the other
hand, there are some dedicated tools designed solely to predict the factor
performance, for instance, the value spread, which reflects the dispersion
of the book-to-market value across the stock market universe.
And what about the country-level strategies? Here we have fewer tools
available. Still, there are some interesting insights that might be useful.1
Summarizing the earlier considerations, the current state of the debate
in behavioral finance suggests that the majority of asset-pricing anoma-
lies, which result in cross-sectional patterns of expected returns, could be
explained based on two major foundations: investor irrational behavior,
which enables the emergence of these anomalies, and limits on arbitrage,
which, in turn, prevent investors from exploiting the mispricing.2 These the-
oretical concepts have very practical implications, which, once tested with
empirical data, suggest that inefficiencies should be more pronounced in
times of more severe arbitrage constraints or increased irrationality of inves-
tors. Therefore, examining this phenomenon could not only yield some new
theoretical insights in asset pricing but also equip investors with tools to
optimize their market timing and dynamic asset-allocation strategies.
This relationship was elevated to a new country-level dimension in the
study by Zaremba (2015a) who tested how the performance of inter-
market strategies was affected by market-wide proxies for limits on both
arbitrage and sentiment.
To test the impact of time-varying limits on arbitrage and market

sentiment, Zaremba (2015a) constructed composite measures repre-
senting both variables. Each of the measures included four separate, well-
documented and reliable metrics of sentiment and arbitrage limits.
The investor sentiment was proxied with the use of four measures: (1) the
Baker and Wurgler (2006) market-level investor sentiment index, (2) the
State Street Investor Confidence Index, (3) the Sentix Economic Indices
Global Aggregate Overall Index, and (4) the GDP Weighted Manufacturing
& Non-Manufacturing Composite Purchasing Managers’ Index.3 On the
other hand, the four indicators of investor sentiment included: (1) the Ted
spread, (2) the credit spread, (3) the term spread, and (4) the VIX volatil-
ity index.4 The four proxies within the respective groups referring to limits
on arbitrage and investor sentiment were subsequently standardized with
the use of the so-called z-scores and averaged to form composite indica-
tors. Eventually, having calculated the above measures, the study used some
econometric techniques to isolate the impact of the above-median limits on
arbitrage and sentiment on the performance of cross-country stock market
anomalies. The results are displayed in Fig. 14.3.5
The anomalies were categorized into four major groups: momen-
tum, quality, skewness, and value. Apparently in all of these groups the
market-wide changes in limits on arbitrage and investor sentiment had a
visible impact on future performance. On the one hand, the country-level
strategies markedly underperform when the limits on arbitrage are high.
Particularly, the momentum, skewness, and value strategies displayed disap-
pointing performance, recording 0.75–1.37 percentage points lower than
in times when limits on arbitrage are not that high. On the contrary, the
times of levered sentiment usually favored the cross-country anomaly per-
formance. Particularly, the value-based strategies benefited from such situa-
tions, delivering returns by 1.34 percentage points higher than the average.
Summing up, it appears that the cross-country anomalies are to some
extent influenced by the swings in moods and limits on arbitrage. If so,
then an investor may attempt to capitalize on these fluctuations and time
the allocation to various country-level strategies.
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
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.
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.
2.50
2.00
Mean return [%]
1.50
1.00
0.50
January
0.00
Other
December
Fig. 14.4 Mean monthly returns on country-level value strategies during

various months
Note: The figure reports mean monthly returns (expressed in percentage terms) of
anomaly-based strategies in three parts of the year: January, December, and the
remaining months (“Other”). The strategies are represented by gross returns on
equal-weighted zero-investment portfolios from sorts on earnings-to-price ratio
(“EP”), EBITDA-to-EV ratio (“EBEV”), EBITDA-to-price ratio (“EBP”), and
sales-to-EV (“SEV”). The figure also presents the meta-strategies, which is the
monthly-rebalanced equal-weighted portfolio of all the four individual strategies
(“Composite”).
Source: Zaremba (2015c), Table 2. Sample period: 1995–2015, underlying data:
Bloomberg
Although the results in Fig. 14.4 suggest a clear cross-sectional pat-

tern, they should be treated with particular caution. We have at least two
arguments for that. First, due to a relatively short study period, as for sea-
sonal patterns, the results lack statistical significance. Although the 1.2 %
percent difference in average returns in January and December may seem
high, it may still be just a pure chance effect. Finally, the phenomenon is
hardly robust and not equally visible under different portfolio weighting
schemes.
IS THERE MOMENTUM ACROSS STRATEGIES?

The momentum effect, which we have already discussed in a separate
chapter, is usually defined as the tendency of assets with good (poor)
past performance to outperform (underperform) in the future. This phe-
nomenon is one of the most pervasive anomalies ever discovered. The
evidence for momentum has been found across numerous asset classes,
including equity, commodities, sovereign and corporate bonds, currencies
and equity indices.8
Yet, can we apply the momentum at the meta-level and use it to pick the
best performing anomalies? Is it possible to apply momentum to selecting
country-level investment strategies? If so, it could prove very useful for
international investors employing quantitative strategies.
The concept of applying meta-strategies to anomalies or factor portfo-
lios is not entirely new. Multiple research papers have demonstrated it pos-
sible to apply momentum strategies to successfully rotate between styles
(Chen and De Bondt 2004; Tibbs et al. 2008; Clare et al. 2010; Chen
et al. 2012a, b).9 Most of the existing evidence has focused on stock-level
factors; this approach, however, could be extended to include country-
level strategies (Zaremba 2015d).
Figure 14.5 summarizes the results of the study of Zaremba (2015d),
who investigated the time-series patterns in the performance of 15 country-
level stock market strategies. In the study, the strategies, examined within
the years 1995–2015, were grouped into three tertile portfolios based
on the past performance. The procedure was then repeated every month,
so that the portfolios were monthly rebalanced. Figure 14.5 depicts the
results with the formation period set to 3–12 months.
Indeed, the past performance throughout 3–12 months seems to predict
to some extend the future performance. The strategies which displayed the
highest returns for over 3–12 months tended to continue to outperform
in the future. The effect was particularly significant for the 6–12 month
sorting period. The difference in returns between past winners and losers
looms substantial and reaches 0.40 %–0.52 %, dependent on the length of
the sorting period. Simply speaking, the past winners outperform.
The observations resulting from Fig. 14.5 might be useful and impor-
tant mainly for practitioners, for example fund pickers and asset managers
with a global investment mandate. The empirical evidence seems to sug-
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
Fig. 14.5 Momentum across country-level stock market anomaliesNote: The

table presents the performance of equally weighted portfolios of country-level
strategies formed on the past performance. “Low” denotes markets with the low-
est past returns and “High” with the highest. The means are expressed in percent-
age terms.Source and methodology: Zaremba (2015d), Table 5, Panel A. Sample
period: 1995–2015, underlying data from Bloomberg
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.
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
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.
REFERENCES
Akbas, F., Armstrong, W. J., Sorescu, S. M., & Subrahmanyam, A. (2014). Capital
market efficiency and arbitrage efficacy. AFA 2013 San Diego Meetings Paper.
Retrieved November 27, 2015, from SSRN: http://dx.doi.org/10.2139/
ssrn.2022485
Ang, A., Gorovy, S., & van Inwegen, G. B. (2011). Hedge fund leverage. Journal
of Financial Economics, 102, 102–126. Retrieved November 27, 2015
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.
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.
Chen, L. H., George J. J., Xu, D., & Yao, T. (2012a). Dissecting the idiosyncratic
volatility anomaly, Retrieved October 28, 2015, from SSRN: http://ssrn.
Chen, L. H., Jiang, G. J., & Zhu, X. (2012b). Do style and sector indexes carry
momentum? Journal of Investment Strategies, 1(3), 67–89.
Clare, A., Sapuric, S., & Todorovic, N. (2010). Quantitative or momentum-based
multi-style rotation? UK experience. Journal of Asset Management, 10,
370–381.
Davis, J. (1994). The cross-section of realized stock returns: The pre-COMPUSTAT
evidence. Journal of Finance, 49, 1579–1593.
Engelberg, J., Pengjie, G., & Ravi, J. (2008). An anatomy of pairs trading: The role
of idiosyncratic news, common information and liquidity. Paper presented at the
Third Singapore International Conference on Finance 2009. Retrieved
November 27, 2015, from SSRN: http://dx.doi.org/10.2139/ssrn.1330689
Estrella, A., & Mishkin, F. S. (1998). Predicting U.S. recessions: Financial vari-
ables as leading indicators. Review of Economics and Statistics, 80, 45–61.
Gromb, D., & Vayanos, D. (2010). Limits of arbitrage: The state of the theory.
Annual Review of Financial Economics, 2, 251–275.
Hanson, S. G., & Sunderan, A. (2014). The growth and limits of arbitrage:
Evidence from short interest. Review of Financial Studies, 27, 1238–1286.
Haug, M., & Hirschey, M. (2006). The January effect. Financial Analyst Journal,
62(5), 78–88.
Haugen, R., & Jorion, P. (1996). The January effect: Still there after all these
years. Financial Analysts Journal, 52, 27–31.
Haugen, R. A., & Lakonishok, J. (1988). The incredible January effect: The stock
market’s unsolved mystery. Homewood, IL: Dow Jones-Irwin.
Ho, Y. (1990). Stock return seasonalities in Asia Pacific markets. Journal of
International Financial Management and Accounting, 2, 47–77.
Hsu, J., & Kalesnik, V. (2014). Finding smart beta in the factor zoo. Research Affi
liates white paper. Retrieved November 28, 2015, from https://www.
researchaffi liates.com/Our%20Ideas/Insights/Fundamentals/Pages/223_
Finding_Smart_Beta_in_the_Factor_Zoo.aspx

Lakonishok, J., Shleifer, A., Thaler, R., & Vishny, R. (1991). Window dressing by
pension fund managers. American Economic Review, 81(2), 227–231.
Lhabitant, F.-S., & Learned, M. (2002). Hedge fund diversification: How much
is enough? Journal of Alternative Investments, 5(3), 23–49.
Loughran, T. (1997). Book-to-market across firm size, exchange, and seasonality:
Is there an effect? Journal of Financial and Quantitative Analysis, 32(3),
249–268.
Markowitz, H. (1952). Portfolio selection. Journal of Finance, 7(1), 77–91.
Moskowitz, T. J., Ooi, Y. H., & Pedersen, L. H. (2012). Time series momentum.
Novy-Marx, R. (2012b). Quality investing. Retrieved October 29, 2015, from
http://rnm.simon.rochester.edu/research/QDoVI.pdf
Rosenberg, M. (2004). The monthly effect in stock returns and conditional het-
eroskedasticity. American Economist, 48, 67–73.
Rozeff, M. S., & Kinney, W. R. (1976). Capital market seasonality: The case of
Shleifer, A., & Vishny, R. W. (1997). The limits of arbitrage. Journal of Finance,
52(1), 35–55.
Szyszka, A. (2013). Behavioral finance and capital markets: How psychology influ-
ences investors and corporation. New York: Palgrave Macmillan.
Tibbs, S. L., Eakins, S. G., & DeShurko, W. (2008). Using style momentum to
generate alpha. Journal of Technical Analysis, 65, 50–56.
Tonchev, D., & Kim, T. (2004). Calendar effects in Eastern European financial
markets: Evidence from the Czech Republic, Slovakia and Slovenia. Applied
Financial Economics, 14, 1035–1043.
Umutlu, M. (2015). Idiosyncratic volatility and expected returns at the global
level. Financial Analyst Journal, 71(6), 58–71.
Vayanos, D. (2004). Flight to quality, flight to liquidity, and the pricing of risk.
NBER Working Paper No. 10327. Retrieved November 27, 2015, from
http://www.nber.org/papers/w10327
Yao, Y. (2012). Momentum, contrarian, and the January seasonality. Journal of
Zaremba, A. (2015a). Investor sentiment, limits on arbitrage, and the perfor-
mance of cross-country market anomalies. Journal of Behavioral and
Experimental Finance, forthcoming.
Zaremba, A. (2015c). The January seasonality and the performance of country-
Accounting, 4(2), 195–209.
Zaremba, A. (2015d). Momentum and low-volatility effects in country-level stock

market anomalies. Retrieved October 21, 2015, from SSRN: http://ssrn.
Zaremba, A. (2016). Risk-based explanation for the country-level size and value
effects. Finance Research Letters, 18, 226–233.
Zhang, C. Y., & Jacobsen, B. (2012). Are monthly seasonals real? A three century
perspective. Review of Finance, 17(5), 1743–1785.
CHAPTER 15
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

DOI 10.1057/978-1-137-59191-3_15
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
Frazzini, A., & Pedersen, L. H. (2014). Betting against beta. Journal of Financial
APPENDIX A: LIST OF COUNTRIES
INVESTIGATED IN THE STUDY

DOI 10.1057/978-1-137-59191-3
Table A1 Research sample
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$] [%] [%]
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
[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)
[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
[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
Table B1 Major stock market anomalies with their explanations

Value Momentum Size Low-risk Profitability Distress risk Issuance
investing effects effect effect and leverage
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)

DOI 10.1057/978-1-137-59191-3
252 APPENDIX B: MAJOR CROSS-SECTIONAL PATTERNS WITH THEIR EXPLANATIONS
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
Note: The authors’ own elaboration

REFERENCES
Aggarwal, R., Hiraki, T., & Rao, R. (1988). Earnings/price ratios, size, and sea-
sonal anomalies in the Japanese securities market. Working paper. John Caroll
University.
Aggarwal, R., & Rivoli, P. (1990). Fads in the initial public offering market?
Financial Management, (winter), 45–57.
Antonacci, G. (2012). Risk premia harvesting through dual momentum. Retrieved
November 11, 2015, from SSRN: http://ssrn.com/abstract=2042750 or
Asness, C. S., Frazzini, A., & Pedersen, L. H. (2014a). Low-risk investing without
industry bets. Financial Analyst Journal, 70(4), 24–41.
Asness, C. S., Frazzini, A., & Pedersen, L. H. (2014b). Quality minus junk.
Bali, C., & Cakici, N. (2010). World market risk, country-specific risk and expected
returns in international stock markets. Journal of Banking and Finance, 34,
1152–1165.
Belo, F., & Lin, X. (2012). The inventory growth spread. Review of Financial
Studies, 25, 278–313.
Bhandari, L. C. (1988). Debt/equity ratio and expected common stock returns:
Empirical evidence. Journal of Finance, 43, 507–528.
Black, F. (1993a). Beta and return: Announcements of the ‘death of beta’ seem
premature. Journal of Portfolio Management, 20(1), 8–18.
Blitz, D., Falkenstein, E., & van Vliet, P. (2014a). Explanations for the volatility
effect: An overview based on the CAPM assumptions. Journal of Portfolio

DOI 10.1057/978-1-137-59191-3
254 REFERENCES
Blitz, D., van der Grient, B., & Hanauer, M. (2014b). What drives the value pre-
mium? White paper. Robeco. Retrieved October 13, 2015, from https://www.
robeco.com/images/20141016-what-drives-the-value-premium-june-2014.
pdf
Boussaidi, R. (2013). Representativeness heuristic, investor sentiment and over-
reaction to accounting earnings: The case of the Tunisian stock market.
Procedia—Social and Behavioral Sciences, 81, 9–21.
Cambell, C. J., Rhee, S. G., Du, Y., Tang., N. (2008a). Market sentiment, IPO under-
pricing, and valuation. Working paper. Retrieved November 22, 2015, from
ssrn.1108540
Chabot, B., Ghysels, E., & Jagannathan, R. (2008). Price momentum in stocks:
Insights from Victorian age. NBER Working Paper No. 14500. Retrieved
October 20, 2015, from http://www.nber.org/papers/w14500
Chan, K., Hameed, A., & Tong, W. (2000a). Profitability of momentum strategies
in the international equity markets. Journal of Financial and Quantitative
Analysis, 35(2), 153–172.
Chen, L. H., George J. J., Xu, D., & Yao, T. (2012a). Dissecting the idiosyncratic
volatility anomaly. Retrieved October 28, 2015, from SSRN: http://ssrn.
Chen, L. H., Jiang, G. J., & Zhu, X. (2012b). Do style and sector indexes carry
momentum? Journal of Investment Strategies, 1(3), 67–89.
Chen, L., Li, S., & Wang, J. (2011a). Liquidity, skewness and stock returns: Evidence
from Chinese stock market. Asia-Pacific Financial Markets, 18, 405–427.
Chen, L., Novy-Marx, R., & Zhang, L. (2011b). An alternative three-factor
model. Retrieved November 4, 2015, from SSRN: http://ssrn.com/
Clayman, M. (1994). Excellence revisited. Financial Analysts Journal, 50, 61–66.
Da, Z., Liu, Q., & Schaumburg, E. (2014b). A closer look at the short-term
return reversal. Management Science, 60, 658–674.
DeMarzo, P., Kaniel, R., & Kremer, I. (2004). Diversification as a public good:
Community effects in portfolio choice. Journal of Finance, 59(4), 1677–1715.
Easterlin, R. (1995). Will raising the incomes of all raise the happiness of all?
Journal of Economic Behavior and Organization, 27, 35–47.
Edwards, W. (1983). Human cognitive capabilities, representativeness, and ground
rules for research. In P. Humphreys, O. Svenson, & A. Vari (Eds.), Analysing
and aiding decision processes (pp. 507–513). Amsterdam, North-Holland.
EIU. (2015a). Country risk model. The economist intelligence unit. Retrieved
ashx?mode=m&fi=risk-section/country-risk-model.pdf
EIU. (2015b). Country risk service. The economist intelligence unit. Retrieved
ashx?mode=m&fi=risk-section/country-risk-service.pdf
REFERENCES 255
Engelberg, J., Pengjie, G., & Ravi, J. (2008). An anatomy of pairs trading: The role
of idiosyncratic news, common information and liquidity. Paper presented at the
Third Singapore International Conference on Finance 2009. Retrieved
November 27, 2015, from SSRN: http://dx.doi.org/10.2139/ssrn.1330689
Erb, C. B., Harvey, C. R., & Viskanta, T. E. (1996b). Political risk, economic risk,
and financial `risk. Financial Analyst Journal, 52(6), 29–46.
EY. (2014). EY global ETF survey: 2015 and beyond. Retrieved November 29,
2015, from http://www.ey.com/Publication/vwLUAssets/ey-global-etf-
survey-2015-and-beyond/$FILE/ey-etf-survey-2015-and-beyond.pdf
Fama, E. F. (1970). Efficient capital markets: A review of theory and empirical
work. Journal of Finance, 25(2), 383–417.
Ferson, W. E., & Harvey, C. R. (1994). Sources of risk and expected returns in
global equity markets. Journal of Banking and Finance, 18, 775–803.
Fink, J., Fink, K., & He, H. (2010). Idiosyncratic volatility measures and expected
return. Financial Management, 41(3), 519–553.
Frank, R. H. (2011). The Darwin economy: Liberty, competition, and the common
good. Princeton, NJ: Princeton University Press.
Frazzini, A., Israel, R., Moskowitz, T. J., & Novy-Marx, R. (2013a). A new core
equity paradigm: Using value, momentum, and quality to outperform markets.
AQR Capital Management white paper. Retrieved November 3, 2015, from
https://www.aqr.com/library/aqr-publications/a-new-core-equity-paradigm
Frazzini, A., Kabiller, D., Pedersen, L. H. (2013b). Buffet’s alpha. NBER Working
Paper No. 19681. Retrieved November 3, 2015, from http://www.nber.org/
papers/w19681
Gillan, S. (1990). An investigation into CAPM anomalies in New Zealand: The
small firm and price earnings ratio effects. Asia-Pacific Journal of Management,
7, 63–78.
Gompers, P. A., & Lerner, J. (2003). The really long-run performance of initial
public offerings: The pre-Nasdaq evidence. Journal of Finance, 58(4), 1355–1392.
Gray, W. R., & Carliste, T. (2012). Quantitative value: A practitioner’s guide to
automating intelligent investment and eliminating behavioral errors. New York:
Wiley.
Green, J., Hand, J. R. M., & Zhang, F. (2014b). The remarkable multidimension-
ality in the cross-section of expected U.S. stock returns. Retrieved November 29,
org/10.2139/ssrn.2262374
Grinblatt, M., & Keloharju, M. (2000a). The investment behavior and preference
of various investor types: A study of Finland’s unique data set. Journal of
Harvey, C. R., Liu, Y., & Zhu, H. (2015). …and the cross-section of expected
returns. Working paper. Retrieved October 14, 2015, from SSRN: http://ssrn.
256 REFERENCES
Henrriksson, R. D., & Merton, R. C. (1981). On market timing and investment
performance II: Statistical procedures for evaluating forecasting skills. Journal
of Business, 54(4), 513–533.
Hsu, J., & Kalesnik, V. (2014). Finding smart beta in the factor zoo. Research
Affiliates white paper. Retrieved November 28, 2015, from https://www.
researchaffiliates.com/Our%20Ideas/Insights/Fundamentals/Pages/223_
Finding_Smart_Beta_in_the_Factor_Zoo.aspx
Iqbal, J., Azher, S., & Ijaz, A. (2013). Predictive ability of value-at-risk methods:
Evidence from the Karachi Stock Exchange-100 Index. IUP Journal of
Financial Risk Management, 10(1), 26–40.
Jegadeesh, N., & Titman, S. (1995a). Short-horizon return reversals and the bid-
ask spread. Journal of Financial Intermediation, 4, 116–132.
Jegadeesh, N., & Titman, S. (1995b). Overreaction, delayed reaction, and con-
trarian profits. Review of Financial Studies, 8(4), 973–993.
Keim, D. B. (1983a). Size-related anomalies and stock return seasonality: Further
empirical evidence. Journal of Financial Economics, 12, 13–32.
Keim, D. (1983b). Stock return seasonality and the size effect. Journal of Financial
Keller, W. J., & van Putten, H. S. (2012). Generalized momentum and flexible
asset allocation (faa): An heuristic approach. Retrieved October 21, 2015, from
ssrn.2193735
LaFond, R. (2005). Is the accrual anomaly a global anomaly? MIT Sloan Research
Paper No. 4555-05. Retrieved November 6, 2015, from SSRN: http://ssrn.
Lefevre, E. (2010). Reminiscences of a stock operator: With new commentary snoop-
ing and the global accrual an and insights on the life and times of Jesse LIvermore.
Hoboken, NJ: Wiley.
Leippold, M., & Harald, L. (2010). Data snooping and the global accrual anomaly.
EFA 2007 Ljubljana Meetings Paper. Retrieved November 6, 2015, from SSRN:
http://ssrn.com/abstract=962867 or http://dx.doi.org/10.2139/ssrn.962867
Lev, B., & Nissim, D. (2006). The persistence of the accruals anomaly.
Contemporary Accounting Research, 23(1), 193–226.
Levy, R. A. (1967). Relative strength as a criterion for investment selection.
Lochridge, R. (1981). Strategy in the 1980s. Retrieved November 3, 2015, from
https://www.bcgperspectives.com/content/classics/strategy_strategy_in_
the_1980s/
Loughran, T., & Wellman, J. W. (2011). New evidence on the relation between
the enterprise multiple and average stock returns. Journal of Financial and
Quantitative Analysis, 46, 1629–1650.
Marshall, B. R., Nguyen, N. H., & Visaltanachoti, N. (2014). Time-series momen-
tum versus moving average trading rules. Working paper. Retrieved October 18,
REFERENCES 257

org/10.2139/ssrn.2225551
Mesale, A. J. (2008b). Measuring effectiveness of quantitative equity portfolio man-
agement methods. Senior Capstone Project. Retrieved October 12, 2015, from
http://www.master272.com/finance/longshort/alphadrivers.pdf
Miller, E. M. (1977). Risk, uncertainty, and divergence of opinion. Journal of
Finance, 32(4), 1151–1168.
MSCI. (2014c). MSCI quality indexes methodology. MSCI white paper. Retrieved
November 4, 2015, from https://www.msci.com/eqb/methodology/meth_
docs/MSCI_Quality_Indexes_Meth_Aug14.pdf
MSCI. (2015a). Exchange traded products based on MSCI indices Q3 2013.
Retrieved October 14, 2015, from https://www.msci.com/resources/pdfs/
Exchange_Traded_Products_Based_on_MSCI_Indices.pdf
MSCI. (2015b). MSCI ACWI (USD). Index fact sheet. Retrieved November 30,
2015, from https://www.msci.com/resources/factsheets/index_fact_sheet/
msci-acwi.pdf
Novy-Marx, R. (2012a). Is momentum really momentum? Journal of Financial
Economics, 103, 429–453.
Novy-Marx, R. (2012b). Quality investing. Retrieved October 29, 2015, from
http://rnm.simon.rochester.edu/research/QDoVI.pdf
Odean, T. (1998a). Are investors reluctant to realize their losses? Journal of
Finance, 53(5), 1775–1798.
Odean, T. (1998b). Volume, volatility, price, and profit when all traders are above
average. Journal of Finance, 53(6), 1887–1934.
O’Neill, J., Stupnytska, A., & Wrisdale, J. (2011). Linking GDP growth and equity
returns. Goldman Sachs Asset Management Monthly Insights. Retrieved
November 29, 2015, from http://s3.amazonaws.com/zanran_storage/
www2.goldmansachs.com/ContentPages/2509459477.pdf
O’Shaughnessy, J. (2011). What works on wall street, fourth edition: The classic
guide to the best-performing investment strategies of all time. New York: McGraw-
Hill Education.
Pouget, S., & Villeneuve, S. (2008). Price formation with confirmation bias. Retrieved
October 24, 2015, from http://www.creedexperiment.nl/enable2008/pouget.
pdf
Reinganum, M. R. (1981). Misspecification of asset pricing: Empirical anomalies
based on earnings’ yields and market values. Journal of Financial Economics, 9,
19–46.
Richard, E. (1974). Does economic growth improve the human lot? Some empiri-
cal evidence. In P. David & M. Reder (Eds.), Nations and households in eco-
nomic growth: Essays in honour of Moses Abramovitz. New York: Academic Press.
Richardson, S. A., & Sloan, R. G. (2005). External financing and future stock
returns. Working paper. Retrieved November 5, 2015, from http://web.mit.
edu/lewellen/www/Documents/Richardson%20Sloan.pdf
258 REFERENCES
Ritter, J. R. (2012). Is economic growth good for investors? Journal of Applied
Corporate Finance, 24(3), 8–18. Retrieved November 29, 2015, from http://
bear.warrington.ufl.edu/ritter/JACF_2012.pdf
Rosenberg, B., Reid, K., & Lanstein, R. (1985). Persuasive evidence of market
inefficiency. Journal of Portfolio Management, 11, 9–17.
Rubio, G. (1988). Further international evidence on asset pricing: The case of the
Spanish capital market. Journal of Banking and Finance, 12, 221–242.
Umutlu, M. (2015). Idiosyncratic volatility and expected returns at the global
level. Financial Analyst Journal, 71(6), 58–71.
Vinod, H. D., & Morey, M. R. (1999). A double Sharpe ratio. Working paper.
Retrieved October 16, 2015, from SSRN: http://papers.ssrn.com/sol3/
papers.cfm?abstract_id=168748
Zaremba, A. (2014b). Strategies based on momentum and term structure in finan-
cialized commodity markets. Retrieved October 21, 2015, from SSRN: http://
Zaremba, A., & Konieczka, P. (2014). The role of dividend yields in portfolio opti-
mization - Evidence from the CEE market. Retrieved October 10, 2015, from
ssrn.2521051
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

DOI 10.1057/978-1-137-59191-3
260 INDEX
D ETFs. See Exchange Traded Funds

Darvas, Nicolas, 41 (ETFs)
data mining, 24–6, 43, 46, 74, 95, 243 EV/sales ratio (EV/S ratio), 17, 18
delisting bias, 70–1 EV-to-EBITDA, 19
Dennis, Richard, 41 EV-to-EBITDA ratio, 10, 18
Dimensional Fund Advisors, 109 EV-to-revenue ratio, 17
disposition effect, 48–9 Exchange Traded Funds (ETFs), 1–3,
distress risk, 20, 111, 115, 209–13 124, 142, 243
divergence of opinions, 20, 21 expropriation, 21, 90, 155, 188, 202
diversification, 2, 86, 126, 128, 225 extrapolation bias, 21
diversification across strategies, 226–30
dividend initiation, 16
dividend resumption, 16 F
dividend yield, 14–16, 21, 27n6, 141, feedback trading, 49, 54n11
143, 144, 146–9, 155 financial distress, 19, 70, 111–12
DJIA. See Dow Jones Industrial financial leverage, 19, 109, 210
Average (DJIA) four-factor model, 68
Dogs of the Dow, 15, 27n7–8 F-score, 109, 111
Donchian, Richard, 41 fundamental ratios, 10, 11
Dow Jones, 124
Dow Jones Industrial
Average (DJIA), 15 G
downside risk, 82, 185 GDP growth, 2
Graham, Benjamin, 9, 11, 106,
107, 142
E greed and envy, 93
earnings stability, 110, 112 gross margins, 109, 213–16
earnings-to-price ratio, 11–12, 14, growth activities, 110
143–9, 234, 235 growth in margins, 110, 111
earnings yield, 11, 12, 26n3, 141, growth in profitability, 110, 111
149, 155, 156
EBITDA-to-EV ratio, 18–19, 150–4,
157, 226, 227, 229, 231, 234, H
235, 243 herd behavior, 49
EBITDA-to-price ratio, 14, 18,
234, 235
echo, 52 I
efficient market hypothesis, 45 idiosyncratic risk, 53, 81, 86, 87, 89,
EIU country risk, 227, 229, 231 91, 156
enterprise multiples, 10, 143, 151, 152 idiosyncratic volatility, 81, 86–8, 90,
E/P ratio, 11, 12, 144, 148, 149 96n12, 168, 170, 172–4, 180,
equity issuance, 109 195–197, 199, 200, 206, 244
equity multiples, 10, 143–5, 150 information risk, 72, 73, 188
INDEX 261
initial public offering, 112, 217 momentum, 3, 4, 15, 19, 39–55,

intermediate momentum, 68, 92, 115, 124, 157n5,
52, 162, 164–7 161–82, 225–33, 236–7,
international equity investing, 4, 137–40 239n7–9, 243, 244
investor sentiment, 22, 23, 115, 217, momentum across strategies, 236–7
233, 238n3 MSCI All Country World Total Return
investor sentiment index, 232, 238n3 Index, 138–9
IPO, 112, 116n8, 217–20, 238n3 MSCI index, 124, 185
issuance, 14, 109, 110, 112, 115, 116, MSCI Quality Indices, 109
209, 217–20
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
Q standard deviation, 14, 52, 83–4, 88,

quality investing, 4, 105–17, 209, 90, 106, 127, 131n6, 138, 144,
223, 223n2, 244 147, 153, 154, 157, 165, 166,
quality of earnings, 109, 114 168, 173, 176, 178, 186, 187,
191, 195–9, 201, 203, 205, 206,
211, 215, 219, 221
R standard momentum, 51, 53
regulatory constraints, 94, 95 statistical significance, 129–30, 235
relative momentum, 40, 51, 53, 174 stock issuance, 115, 116, 217–23
relative strength, 42 stock market capitalization, 10, 11, 17,
representativeness, 49–51, 55n13, 92 67, 74, 87, 124, 126, 166, 173,
return on assets (ROA), 105, 109–11, 174, 187–9, 191, 192, 207,
156, 213–16 217–20
return on equity (ROE), 105, 110 stop-loss orders, 44
revenue multiples, 16–18 STOXX, 124
revenue-to-EV ratio, 17 survivorship bias, 23–4, 124
ROA. See return on assets (ROA) systematic risk, 84–6, 93, 128,
132n11, 200
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

Country Asset Allocation Quantitative Country Selection Strategies in Global Factor Investing

Încărcat de

Informații document

Drepturi de autor

Formate disponibile

Partajați acest document

Partajați sau inserați document

Opțiuni de partajare

Vi se pare util acest document?

Este necorespunzător acest conținut?

Drepturi de autor:

Formate disponibile

Country Asset Allocation Quantitative Country Selection Strategies in Global Factor Investing

Încărcat de

Drepturi de autor:

Formate disponibile

COUNTRY ASSET ALLOCATION

Quantitative Country Selection

ADAM ZAREMBA AND JACOB SHEMER

ISBN 978-1-137-59190-6 ISBN 978-1-137-59191-3 (eBook)

Library of Congress Control Number: 2016956112

© The Editor(s) (if applicable) and The Author(s) 2017

Cover image © JamieB / Getty Images

Printed on acid-free paper

This Palgrave Macmillan imprint is published by Springer Nature

PRAISE FOR COUNTRY ASSET ALLOCATION: QUANTITATIVE

We thank Professor Waldemar Fra ̨ckowiak from the Poznan University

2 Value Versus Growth: Is Buying Cheap Always a Bargain? 9

3 Trend Is Your Friend: Momentum Investing 39

4 Is Small Beautiful? Size Effect in Stock Markets 67

5 Is Risk Always Rewarded? Low-Volatility Anomalies 81

6 Is Good Company a Good Investment? Quality Investing 105

7 Testing the Country Allocation Strategies 123

8 A Short Primer on International Equity Investing 137

9 Value-Oriented Country Selection 141

10 Momentum Effect Across Countries 161

11 Small-Country Effect 183

12 Risk-Based Country Asset Allocation 193

13 Country Selection Based on Quality 207

14 What Next? Combining and Improving Country

Fig. 3.1 Life cycle of a trend 47

Fig. 10.3 Cumulative excess returns on enhanced momentum strategies 171

Table 3.1 Studies of momentum in international stock markets 43

Table 14.1 Correlation across the country-level strategies 225

© The Author(s) 2017 1

in the USA with combined assets of $2.1 trillion (Investment Company

to behavioral errors. The work under the traditional approach is immense,

a certain characteristic; for example, the valuation ratios, capitalization,

Investment Company Institute. (2015). Exchange-traded funds: October 2015. ICI

Value Versus Growth: Is Buying Cheap

© The Author(s) 2017 9

IMPLEMENTATION AND TESTS OF VALUE STRATEGIES

Although these defects by no means disqualify the usefulness of the

Cash flow-to-price ratio. This measure represents another attempt to

sometimes used by market practitioners (for example, Mesale 2008b), but

1. Sales-to-price ratio, i.e. the reciprocal of the price-to-sales ratio (P/S

1. EBITDA-to-EV ratio, i.e. the reciprocal of the EV-to-EBITDA

Although the EBITDA multiples are not as popular as the metrics

WHY DOES VALUE OUTPERFORM GROWTH?

Another interpretation of the non-market risk was offered by Doukas

The behavioral explanation of stock market anomalies brings another

Cooper, I. (2006). Asset pricing implications of non-convex adjustment costs and

Trend Is Your Friend: Momentum Investing

Momentum investing is well-poised to be the holy grail of the financial

© The Author(s) 2017 39

The first type is relative momentum, or simply momentum—a clas-

DOES MOMENTUM WORK?

trend-following system based on 5-day and 20-day moving averages. This

Table 3.1 Studies of momentum in international stock markets

Griffin et al. (2003) 1926–2000 39

and demonstrated that momentum has been at work in the US equity

technical trading strategies generate consistent economic profits in a vari-

WHY DOES MOMENTUM WORK?

nutshell, some investors may deliberately choose not to invest based on a

and data mining create a significant risk. In effect, behavioral advocates

3. The trend continues

2. The trend begins

Fig. 3.1 Life cycle of a trend

Kahneman and Tversky in their article of 1974. In their experiment the

any contradictory evidence. As a result, the perception of the company in