Post on 25-Dec-2015
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November 2011
Jon Wongswan
Phatra Securities
jon@phatrasecurities.com
What Influences U.S. International Equity Investment:
Equity or Currency Returns?
Stephanie Curcuru, Charles Thomas,
Frank Warnock, and Jon Wongswan
November 2011
Thammasat Finance Conference
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November 2011 Outline
I. Overview
II. Data Description
III. Empirical Results
IV. Conclusions
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November 2011 I. Overview
• This paper examines the relationship between U.S. investors’ international equity portfolio rebalancing (country level) and local-currency equity and currency returns.
Equity Return (USD) = Equity Return (Local Currency) + Currency Return
Portfolio Rebalancing
at time t
Equity Return (Local
Currency) at time …, t-1, t,
t+1, …
Currency Return
at time …, t-1, t, t+1, …
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November 2011 I. Overview (cont.)
• Earlier work by Curcuru, Thomas, Warnock, and Wongswan (2011 AER)—CTWW1—examines the portfolio rebalancing behavior of U.S. investors’ international equity portfolio in U.S. dollar term.
Portfolio Rebalancing
at time t
U.S. Dollar Equity Return
at time …, t-1,
t, t+1, …
U.S. investors do not exhibit return chasing behavior but tend to sell past winners.
U.S. investors rebalance portfolio into markets that subsequently have abnormal returns.
Contributions: Use portfolio holdings data and find results opposite to existing studies
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November 2011 I. Overview (cont.)
• Research question for this paper: Are the documented effects in CTWW1 coming from local-currency equity or/and currency returns?
• Findings of this paper: We find that the rebalancing of U.S. investors’ international equity portfolio is not related to past or future currency returns.
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November 2011
Motivation ...From the Practical to the Theoretical
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
0%
5%
10%
15%
20%
25%
30%
Cross-border equity claims / World market capitalization
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
50%
U.S. cross-border equity claims / Total cross-border equity
claims
Cross-border equity investment has become more important.
U.S. investors are a major participant.
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November 2011 Motivation (cont.)
• Empirical results have policy implications.
• Existing theoretical models imply different relationships between currency returns and international portfolio rebalancing. Adler and Dumas ( 1983 JF): No relationship (Hedge through other asset
classes)
Hau and Ray (2006 RFS): Negative relationship (Reduction in currency exposure)
Burnside, Eichenbuam, and Rebelo (2010 JEEA): Positive relationship (Carry trade)
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November 2011 II. Data Description
1. Portfolio Holdings
• U.S. investors’ country-level foreign equity holdings in 43 countries from January 1990 through December 2008 (monthly frequency).
• Portfolio holdings can not be directly infer from flows data because of the “Financial Center Bias” in the capital flows data.
To correct for the Financial Center Bias, we use:
• Infrequent comprehensive (security-level) surveys of cross-border holdings as fixed points.
• To interpolate positions between survey dates, we use monthly capital flows data (TIC) and country price returns.
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November 2011 Estimating Portfolio Holdings Data
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TTT nhbhgap
)()1(1 tTttttt adjgapgsgprhh
• Form naïve holdings estimates
• Doing so will result in a “gap” at time T of a benchmark
• Solve for an adjustment factor (adj) such that at T estimated holdings (h) = benchmark holdings (bh)
• This methodology is originally implemented in Thomas, Warnock, and Wongswan (2004 IFDP) and improved upon and updated by Bertaut and Tryon (2007 IFDP).
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November 2011
U.S. Holdings of Foreign Equities: U.K.
0
100
200
300
400
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Bill
ion
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Survey Date Benchmark-consistent Naive
Example: U.S. Holdings of U.K. Equities
Security-Level Benchmark Survey
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November 2011 II. Data Description (cont.)
2. Country Returns
We use MSCI country-level total return index for each country.
• Assume that U.S. investors’ holdings composition within each country is similar to that of MSCI country index.
At the end of 1997, the cross-sectional correlation between firm-weights in the MSCI world (excluding the U.S.) and firm-weights in U.S. investors’ international portfolios is 0.77.
• Adjust for the share outstanding availability for the public (float adjustment).
• Adjust for foreign ownership restrictions.
3. Currency Returns
We use monthly exchange rate against USD data from the Federal Reserve Board.
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November 2011 III. Empirical Results
We apply well-established techniques from the finance literature to characterize the relationship between portfolio reallocations and equity and currency returns.
1. Portfolio reallocations and past returns
Lag Momentum (LM): Grinblatt, Titman, and Wermers (1995 AER)
2. Portfolio reallocations and future returns
Conditional Weight Measure (CWM): Eckbo and Smith (1998 JF) and Ferson and Khang (2002 JFE)
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November 2011
1. Portfolio Reallocations and Past Returns
• Goal: Measure the relationship between portfolio reallocations and past returns.
• Momentum behavior: Actively reallocate more (less) investment into the country that has relatively higher (lower) past return.
• Contrarian behavior: Actively reallocate more (less) investment into the country that has relatively lower (higher) past return.
• We use Lag Momentum (LM) measure of Grinblatt, Titman, and Wermers (1995 AER) to measure this relationship.
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November 2011
1. Portfolio Reallocations and Past Returns (cont.)
Portfolio reallocation
• Definition: Active changes in portfolio holdings net of valuation effect (Xi,t)
• Calculation:
• Xi,t equals to zero for a buy-and-hold portfolio.
tp
titititi r
rwwX
,
,1,,, 1
1
Implied New Weight due to Valuation EffectActual New Weight
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November 2011
Example of Active Weight Change (Xi,t) for a Buy-and-Hold Portfolio
A buy-and-hold portfolio weights in period 2 are WA,2 = 48% and WB,2 = 52%,
XA,2 = 0.48 – 0.50*[(1+0.2)/(1+0.25)] = 0.48 – 0.48 = 0
XB,2 = 0.52 – 0.50*[(1+0.3)/(1+0.25)] = 0.52 – 0.52 = 0
Period 2
Country Return (1->2) Holdings Value Weight
A 20% $200*(1+0.2) = $240 240/ (240+260) = 48%
B 30% $200*(1+0.3) = $260 260/ (240+260) = 52%
Period 1
Country Holdings Value Weight
A $200 50%
B $200 50%
Portfolio return = (0.5 * 0.2) + (0.5 * 0.3) = 25%
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November 2011
1. Portfolio Reallocations and Past Returns (cont.)
• LM is based on the covariance between Xit and relative returns in country i at lag k:
• LM > 0 Momentum trading behavior
• LM < 0 Contrarian trading behavior
• LM can also be computed for buy or sell only, limiting observations to only times in which Xit is positive (BM) or negative (SM).
T
t
N
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T
rrXT
LM1 1
,,, )(1 Relative Past
Return
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November 2011
Portfolio Reallocations and Past Returns
U.S. Dollar Equity ReturnsLocal-Currency Equity Returns
Currency Returns
Lag 1 Lag 2 Lag 3 Lag 1 Lag 2 Lag 3 Lag 1 Lag 2 Lag 3
LM (Buy and Sell)
0.005 (0.144)
-0.169 (0.152)
-0.179(0.146)
0.146 0.132)
-0.059(0.135)
-0.135(0.145)
-0.122(0.064)
-0.082(0.071)
-0.027(0.069)
BM (Buy Only)
0.159(0.123)
0.064(0.114)
0.036(0.103)
0.249* (0.107)
0.147(0.099)
0.082(0.107)
-0.084(0.052)
-0.067(0.051)
-0.039(0.051)
SM (Sell Only)
-0.154*(0.056)
-0.232*(0.065)
-0.215*(0.065)
-0.103* (0.055)
-0.207*(0.057)
-0.217*(0.060)
-0.039(0.027)
-0.016(0.035)
0.012(0.029)
Newey and West (1987) standard errors are in parentheses.* Statistically significant at the 5 percent level.
• U.S. investors can be characterized as selling past winners.
• No evidence of relationship between portfolio reallocations and currency returns.
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November 2011
2. Portfolio Reallocations and Future Returns
• Goal: Measure portfolio reallocations and future abnormal returns.
• Good portfolio reallocation: Actively rebalance the portfolio into (out of) a country that subsequently earns positive (negative) abnormal return.
• Abnormal return: Return component that cannot be predicted from using public information.
• We use the Conditional Weight Measure (CWM) of Eckbo and Smith (1998 JF) and Ferson and Khang (2002 JFE) to measure this relationship.
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November 2011
2. Portfolio Reallocation and Future Returns (cont.)
• The measure is based on the conditional covariances between changes in portfolio weights and future abnormal returns.
where the buy-and-hold benchmark holding is:
• CWM > 0 Good country reallocation ability
TN
itttiti
btitik rErwwECWM
11,1,,, ||
t
ktp
i
r
rkti
bti ww 1
,
,
1
1,,
Abnormal ReturnActive Reallocation
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November 2011
Portfolio Reallocations and Future Returns
k=1 k=2 k=3
U.S. Dollar Equity Returns 0.369*(0.147)
0.649*(0.211)
0.735*(0.274)
Local Currency Equity Returns
0.037(0.065)
0.037(0.201)
0.037(0.276)
Currency Returns 1.122*(0.382)
1.122*(0.575)
1.122*(0.747)
Newey and West (1987) standard errors are in parentheses.* Statistically significant at the 5 percent level.
• U.S. investors switch into markets that subsequently have abnormal returns.
• No evidence of U.S. investors switching into currencies that subsequently have abnormal returns.
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November 2011 IV. Conclusions
• Using portfolio holdings data, we do not find significant evidence of the relationship between portfolio reallocations and currency returns (past or future).
• Academic perspective: Results are consistent with existing studies on return predictabilities- Well-documented predictabilities in country-level equity returns (Harvey JF
1991; Ferson and Harvey JF 1993; Ang and Bakeart RFS 2007)
- Limited predictabilities in currency returns (Meese and Rogoff JIE 1983)
• Practitioner perspective: Majority of international equity funds do not make investment decisions based on views on currency movements because- Low ability to predict future currency movements
- Hard to know each firm’s total exposure to currency
- Hard to know each firm’s currency hedging positions and policy
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November 2011 IV. Conclusions
• The findings do not imply that investors are not concerned about currency movements because- Investors may have hedged the exposure in other asset classes
- Investors may want to take on an exposure as a source of portfolio diversification
• To fully understand the role of currency returns, we may need to examine investors’ overall portfolio across different asset classes.