Price-Based Investment Strategies by Adam Zaremba & Jacob “Koby” Shemer

Author:Adam Zaremba & Jacob “Koby” Shemer
Language: eng
Format: epub
ISBN: 9783319915302
Publisher: Springer International Publishing

Non-price Risks

Concentrating on price-based investing, we have now discussed predominantly the risk measures that could be obtained based on prices and returns. Some investors, however, may also want to take a broader look including the non-price risks, at least for robustness purposes, to investigate the extent the risk-return relationships hold under different measures. Can the low-risk anomaly—heretofore emerging as one of the dominant forces shaping the future returns—be proxied with non-price indicators? It can be done.

Looking at the discussion of “quality investing” within the framework of fundamental investing, we can see the highlighted relation between the fundamental quality of a company and its future stock market performance. At first, it seems only rational to assume that investors should be willing to pay more for companies displaying higher quality characteristics. Consequently, higher prices should imply lower expected returns. To put it simply: the higher the quality, the lower the returns.

Still, a substantial part of recent publications seems to indicate that quality is not fully priced in, proving that historically quality stocks outperformed low-quality securities. This counterintuitive phenomenon has been confirmed by many studies and led to many ways of understanding quality through, for example, credit standing, leverage, growth, accruals, or profitability.22 Furthermore, the synthesized measures of quality, which integrate a range of various metrics, appear to be positively correlated with future returns.

Interestingly, at the level of countries, the relationship between returns and “fundamental risks” appear more “traditional”—when allocating asset across countries, investors are exposed to various risks and “shocks” related to currency devaluation, coups, expropriation, or regulatory changes (Bekaert et al. 1996; Dahlquist and Bansal 2002a, b), which seem particularly timely nowadays when the global financial turmoil has forced many governments to seize the assets of its citizens, and military conflicts and political instability spread chaos across numerous countries in Africa, Europe, and the Middle East.

What is then the role of these alternative risks in the international portfolio? If posing real threats to the investor’s wealth should also be rewarded with additional payoffs. Indeed, according to many researchers, these political , financial, and economic risks are priced in at the country level, making investments in riskier countries associated with higher expected returns. This phenomenon was investigated in an article by Erb et al. published in 1995. Having examined the impact of country credit risk, the authors proved it a powerful predictor of future returns, especially within emerging markets. After forming quartile portfolios based on the Institutional Investor’s semiannual surveys, the researchers calculated mean returns in the 1980–1993 period, having based their analysis on 40 markets, both developed and emerging. As a result, the quartile portfolio of the riskiest countries delivered returns on average 11.6 percentage points higher per annum than the safe markets. Still, across the developed markets the differences in returns were relatively small being driven predominantly 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 a very similar level of volatility for both portfolios.

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