Bridge over ocean
1 September 2015 CFA Institute Journal Review

Do “Dogs of the World” Bark or Bite? Evidence from Single-Country ETFs (Digest Summary)

  1. Jakub M. Szudejko, CFA

The authors describe an investment strategy based on a mean-reversion concept that assumes that asset returns trend toward their long-term means. They explain how a simple strategy of betting on recently underperforming assets (i.e., “the dogs”) can produce returns that exceed index returns.

What’s Inside?

The authors investigate the performance of a strategy based on a mean-reversion concept that focuses on mean-reversion opportunities in national equity markets. Based on an analysis of historical returns, the authors conclude that this strategy may produce returns that exceed index returns on a risk-adjusted basis. They note that implementation through single-country exchange-traded funds (ETFs) is simple and cost efficient.

How Is This Research Useful to Practitioners?

Reversion of returns to the long-term mean is a contrarian strategy that intends to exploit the market tendency to overreact to new information, which is well documented across asset classes, national markets, and industry sectors. It is based on the assumption that in a crisis, the national stock index may become deeply undervalued and be traded below its fair value, which makes it an attractive buy.

The authors propose an investment strategy known as “dogs of the world,” which requires investment each year in the five national equity markets that were the previous year’s worst underperformers in US dollar terms.

The study simulates the results of pursuing this strategy between 1971 and 2012 by taking positions in the previous year’s five worst-performing markets chosen from 45 national developed and emerging markets. Assuming a five-year holding period, such a portfolio would have produced compounded annual returns of 10.39%. This result exceeds the global MSCI benchmark index by 0.94%, and despite higher volatility, it is justified on a risk-adjusted basis.

The strategy may be implemented through passive exposure to foreign equity markets using single-country ETFs, available for most of the analyzed countries. Over the analysis period of 1997–2012, the return from a simulated portfolio consisting of ETFs of the worst-performing markets exceeds the return of the MSCI All Country World Index (MSCI ACWI) by 246 bps, and it has a higher Sharpe ratio, net of ETF expenses.

The authors suggest that this strategy is quite effective (the strategy would be in the top quartile) when compared with actively managed funds because of better performance on a risk-adjusted basis and lower costs as a result of the use of ETFs.

How Did the Authors Conduct This Research?

The study is based on monthly return data for 45 developed and emerging national equity market indexes from the global MSCI ACWI Equity Indexes Database between 1970 and 2012. All returns are measured from the perspective of a US resident and in US dollars. The strategy uses single-country unhedged ETF returns originated from Morningstar Direct.

The authors build an equally weighted stock portfolio that consists of the top five worst-performing markets in the previous period with a five-year holding period. Therefore, the model assumes that each year the hypothetical investor allocates 20% of the portfolio to the worst-performing country equity markets from the previous year. The authors note that the portfolio may be biased toward small markets compared with the MSCI ACWI, which is a market-value-weighted index.

The authors examine the extent to which the indexes’ returns revert to long-term means by using an autoregressive time-series model. Mean reversions are represented by negative slope coefficients and are subsequently tested for significance using a t-test.

They ensure the validity of their results with robustness checks in which they measure the significance of key assumptions and confirm the optimal holding period and number of dogs added to the portfolio each year. The authors also confirm the occurrence of price reversals on a local-currency basis.

Abstractor’s Viewpoint

The proposed strategy is designed to capitalize on behavioral flaws often visible when markets crash. Investors overreact, sell off, and are reluctant to buy back in the future, which clearly creates an investment opportunity for contrarians. The strategy applies a rebalancing rule on a yearly basis that may not be particularly effective in capturing long, gradual declines attributable to fundamental factors. For example, the Greek equity market is mentioned as a top five worst market (i.e., as a possible buy) in four consecutive years (2008–2011) but did even worse in subsequent years. The study may be useful for investors who are looking for a simple contrarian strategy to enhance returns. It is comprehensive, and the addition of a more complex and frequent rebalancing schedule would make the study even more relevant.

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