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Indexing, cointegration and equity market regimes

  • Carol Alexander

    (ISMA Centre, University of Reading, UK)

  • Anca Dimitriu

    (ISMA Centre, University of Reading, UK)

This paper examines, from a market efficiency perspective, the performance of a simple dynamic equity indexing strategy based on cointegration. A consistent 'abnormal' return in excess of the benchmark is demonstrated over different time horizons and in different real world and simulated stock markets. A measure of stock price dispersion is shown to be a leading indicator for the abnormal return and their relationship is modelled as a Markov switching process of two market regimes. We find that the entire abnormal return is associated with the high volatility regime as the indexing model implicitly adopts a strategic position that pays off during market crashes, whilst effectively tracking the benchmark in normal market circumstances. Therefore we find no evidence of market inefficiency. Nevertheless our results have implications for equity fund managers: we show how, without any stock selection, solely through a smart optimization that has an implicit element of market timing, the benchmark performance can be significantly enhanced. Copyright © 2005 John Wiley & Sons, Ltd.

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File URL: http://hdl.handle.net/10.1002/ijfe.261
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Article provided by John Wiley & Sons, Ltd. in its journal International Journal of Finance & Economics.

Volume (Year): 10 (2005)
Issue (Month): 3 ()
Pages: 213-231

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Handle: RePEc:ijf:ijfiec:v:10:y:2005:i:3:p:213-231
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  1. René Garcia, 1995. "Asymptotic Null Distribution of the Likelihood Ratio Test in Markov Switching Models," CIRANO Working Papers 95s-07, CIRANO.
  2. Clarida, Richard H. & Sarno, Lucio & Taylor, Mark P. & Valente, Giorgio, 2003. "The out-of-sample success of term structure models as exchange rate predictors: a step beyond," Journal of International Economics, Elsevier, vol. 60(1), pages 61-83, May.
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  8. Fama, Eugene F, 1970. "Efficient Capital Markets: A Review of Theory and Empirical Work," Journal of Finance, American Finance Association, vol. 25(2), pages 383-417, May.
  9. Pierre Collin-Dufresne, 2001. "The Determinants of Credit Spread Changes," Journal of Finance, American Finance Association, vol. 56(6), pages 2177-2207, December.
  10. Hamilton, James D, 1989. "A New Approach to the Economic Analysis of Nonstationary Time Series and the Business Cycle," Econometrica, Econometric Society, vol. 57(2), pages 357-84, March.
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