Sources of Over-performance in Equity Markets: Mean Reversion, Common Trends and Herding
In the field of optimisation models for passive investments, we propose a general portfolio construction model based on principal component analysis. The portfolio is designed to replicate the first principal component of a group of stocks, instead of a traditional benchmark, thus capturing only the common trend in the stock returns. The main advantage of this approach is that the reduction of the noise present in stock returns facilitates the replication task considerably and the optimal portfolio structure is very stable. We analyse the portfolio performance over different time horizons and in different international equity markets. The strategy over-performs both equally weighted and price weighted benchmarks, even after transaction costs. A market premium, a value premium associated with mean reversion in stock returns, and a volatility premium which give the strategy characteristics of a benchmark enhancer, all explain the over-performance, but have time-varying contributions to it. A behavioural explanation for the mean reversion mechanism leads to the conclusion that the portfolio performance is influenced by the extent of investors herding towards the common trend in stock returns.
|Date of creation:||May 2003|
|Date of revision:||Oct 2003|
|Publication status:||Published in Journal of Portfolio Management 2004, 30:4, 170-185|
|Contact details of provider:|| Postal: PO Box 218, Whiteknights, Reading, Berks, RG6 6AA|
Phone: +44 (0) 118 378 8226
Fax: +44 (0) 118 975 0236
Web page: http://www.henley.reading.ac.uk/
More information through EDIRC
When requesting a correction, please mention this item's handle: RePEc:rdg:icmadp:icma-dp2003-08. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Marie Pearson)
If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.
If references are entirely missing, you can add them using this form.
If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.
If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.
Please note that corrections may take a couple of weeks to filter through the various RePEc services.