The authors observe higher average returns of value stocks relative to those of growth stocks in four regions (Asia Pacific, Japan, Europe, and North America). The value premiums decrease as stocks increase in market capitalization (size). Momentum is also present in every region (except Japan), and it decreases with increases in size.
What’s Inside?
The authors’ goal is to determine whether empirical asset pricing models capture the value and momentum patterns in international average returns and the extent to which asset pricing is integrated across markets. Most previous work on international returns has focused on large stocks. The authors use a sample covering all size groups, including microcaps. They conduct asset pricing tests using the capital asset pricing model (CAPM), a three-factor model, and a four-factor model to capture returns for international portfolios.
How Is This Research Useful to Practitioners?
The authors examine international stock returns to determine the value, size, and momentum patterns in average returns for developed markets. The findings indicate no size premium in any region during the last 20+ years. Observations of small stock portfolios indicate lower average returns than in big stock portfolios—a reverse size effect. But there are value premiums in all regions, and there are larger value premiums for smaller stocks. Strong momentum returns exist everywhere except Japan.
According to the authors, a four-factor model can be used to explain the returns on an international portfolio as long as the portfolio does not have a strong tilt toward microcaps or stocks of a particular region. Unfortunately, these models do not explain returns well on regional size–book/market or size–momentum portfolios, which suggests shortcomings in integrated pricing across the four regions. The authors recommend that global models not be used to explain regional portfolio returns.
Local four-factor models are successful in capturing average returns on local size–book/market portfolios. But the models have problems with momentum and fail with portfolios that have extreme momentum tilts. Currently, few mutual funds have extreme momentum tilts, so this issue may not be a serious consideration for some funds.
How Did the Authors Conduct This Research?
The authors use stock returns and data from Bloomberg, Datastream, and Worldscope from November 1989 to March 2011. They examine 23 countries (developed markets) and combine them into four regions: North America, Japan, Asia Pacific (excluding Japan), and Europe. Market integration is a reasonable assumption in these regions.
For each region, stocks are sorted based on (1) size and book/market (B/M) and (2) size and momentum. Big stocks are in the top 90% of market capitalization for the region, and small stocks are in the bottom 10%. The B/M and momentum breakpoints are the 30th and 70th percentiles for the regions.
Monthly weighted returns are calculated, and at the end of June each year, the stocks in a region are sorted according to breakpoints. For the size and B/M analysis, the authors use the CAPM, three-factor model, and four-factor model in a regression with global or local factors to explain the returns on a global portfolio and for each of the four regions.
With respect to size and momentum, previous studies have revealed that the CAPM and three-factor model perform poorly, so only the results of the four-factor model are included. Microcaps are dropped to improve the performance of the models. The authors’ regression analysis uses global and local factors to explain the excess returns on the global and four regional portfolios.
Abstractor’s Viewpoint
The authors’ findings should be considered by pension plans, endowment funds, and long-term investors because they help explain the dominance of past performance by value patterns. The findings may also help such investors evaluate where we presently are in long-term value cycles and assist them in deciphering trends and positioning portfolios. The authors ignore exchange rate risk in their test of the international asset pricing model. Exchange rate volatility poses issues for investors, many of whom may choose to put in place currency hedging or overlay strategies, and it would be helpful to incorporate these risks into future research.