Editor’s Introduction to the Special Issue on Investing in Non-US Financial Markets

INTRODUCTION

US-based investors, as well as international investors, can learn from studying non-US market returns, which is one of the principal motivations for having this special issue on investing in non-US financial markets and the purpose of the lead article, “American Exceptionalism: The Long-Term Evidence,” by Elroy Dimson, Paul Marsh, and Mike Staunton. They report the returns since 1900 on the world excluding the United States, an index that starts off with 22 non-US countries in 1900 and ends up at year end-2020 with 89 non-US countries. The authors include more non-US financial markets than any previous studies of long-term performance. Most of their evidence relates to non-US markets. Over the long run, equity returns have systematically exceeded the investment performance of government bonds and Treasury bills. Dimson, Marsh, and Staunton show that the United States is the exception in terms of historical returns, not the rule. Moreover, the United States continued to outperform non-US stock markets by a significant margin despite the expectations and views of many equity investors at the start of the 21st century.

The United States is arguably the anchor economy for the global economic system. Therefore, it is reasonable to expect that the dynamics of the US economy influence investment strategies in emerging markets. Anna Martirosyan and Joseph Simonian in their article “Emerging Market Stock Momentum Returns during US Economic Regimes” empirically investigate the momentum behavior of stock markets in emerging market countries during expansionary and contractionary regimes in the US economy. For the eight stock markets (Brazil, Russia, India, China, Mexico, South Africa, Poland, and Qatar) in their study, three-month and six-month momentum strategies were evaluated in expansionary and contractionary growth regimes by applying a well-known regime-switching model. Markets were categorized as winners and losers based on past performance, and long–short portfolios were constructed, buying winners, and selling losers. Two key findings reported by Martirosyan and Simonian are that momentum profits in emerging markets (1) vary widely across US macroeconomic regimes and (2) are generally, but not always, higher in expansionary regimes. The authors find that differences in volatility help explain the varying performance of momentum in different emerging markets.

In the United States, the relation between overnight returns and market performance in the last half hour before the close of the next day has been well documented in one study. The finding contradicts the efficient market hypothesis because it implies that overnight information is not fully reflected in prices immediately at or shortly after the market open. In “Overnight Return Momentum: Evidence from European Markets,” Arik Ben Dor and Xiaming Zeng hypothesize that this predictability is related to a key dynamic in financial markets over the past two decades because it is consistent with the increased role played by passive investors. This role played by passive investors has led to a dramatic shift in stock trading as more and more of the intraday volume has shifted to or near market close, as passive investors attempt to minimize tracking errors that are typically calculated based on closing prices. Ben Dor and Zeng find that for several major European markets, the last half-hour of stock returns can be predicted by overnight returns at the market level. Since 2000, market-timing strategies based on overnight returns produced sizable economic gains across European countries relative to benchmarks after adjusting for transaction costs and across different subsamples and market conditions. These findings cannot be explained by calendar effects or other risk factors.

The analysis of the dynamics of analysts’ estimates of Euro Stoxx 50 dividends and dividend futures prices is provided by Arik Ben Dor and Stephan Florig. In their article, “Euro Stoxx 50 Dividends—Reconciling Analyst Estimates and Dividend Future Prices,” they use these estimates to decompose fluctuations in the equity market into fundamental expectations and discount rate adjustments. Although analysts tend to be overly optimistic about dividends paid over short horizons, Ben Dor and Florig find evidence that (1) analysts possess skill regarding the direction of future dividend growth and (2) prices of dividend futures are driven more by hedging activity than fundamental views or uncertainty around future cash flows, leading prices to drop significantly below analysts’ expectations and subsequent realized payoffs in times of increased equity market volatility. Investigating the impact of the outbreak of COVID-19 and the subsequent crash of the Euro Stoxx 50, they find that most of the drop in the equity index was attributable to discount rate adjustments, not fundamental views. Investors can apply the methodology proposed by the authors to formulate an alternative view on the drivers behind future market swings.

European equity and bond markets have undergone tremendous changes since the launch of the European Monetary Union (EMU) in 2000. Since that time, European equity markets have been less attractive than European bond markets due to their poor performance. As a result, institutional investor allocation to European bonds has dominated the equity allocation. Gueorgui S. Konstantinov in his article “What Portfolio in Europe Makes Sense?” looks at European bond and equity portfolios, focusing on the relevance of balanced portfolios. The tremendous volatility and low returns involved in European equity markets are a possible explanation for why investors prefer bonds that show Sharpe ratios in excess of one. Accounting for five-year realized inflation, as well as strong bond market performance in the past 20 years with yields in the negative territory, Konstantinov finds evidence suggesting that the low/negative expected bond returns no longer justify large bond exposure in balanced funds. There are two challenging issues for European portfolio allocation. The first reflects the future of bond exposure in a balanced mandate. The second involves meaningful allocation to equity markets in a balanced portfolio.

Exchange-traded funds (ETFs) were introduced into the US market in 1989 and then Europe in 2000. As of year-end 2020, US ETFs were more numerous than European ETFs, and they were larger in size as measured by assets under management (AUM) with a multiple of 1.23 in terms of number and a multiple of 4.45 in terms of AUM. In “The European ETF Market: Growth, Trends, and Impact on Underlying Instruments,” Véronique Le Sourd and Shahyar Safaee present some key statistical facts about the European market for ETFs based on a 2021 European ETF investor survey. The survey focused on the growth of the European ETF market, key trends in the market, and the impact on underlying instruments. ETF ownership of European stocks is roughly half that of US stocks. The survey also reveals a particularly strong appetite for environmental, social, and governance (ESG)-themed funds, and ETFs appear to be a useful instrument for integrating an ESG component into investment decisions. Le Sourd and Safaee report that in terms of AUM and the number of products, ESG-themed funds exceed that found in the US market, although the incremental AUM is now almost on par. European investors have shown great interest in ESG-themed investments, with 55% of ETF users already investing in such products in 2021. Moreover, 68% of those who have not yet done so are considering integrating ESG into their portfolios in the near future.

In multiclass portfolio construction, real estate investing is recognized as a source of diversification and added value. However, in practice the challenge is achieving efficient real estate exposure due to the idiosyncratic features of this asset class. Because of these features, which include high unit value (indivisibility), heterogeneity, fixed (location-specific) nature, and the need for day-to-day property management, a variety of real estate investment vehicles have been designed to match investors’ needs and provide solutions to some or all of the identified challenges that are typical of direct investing in real estate. While private vehicles—such as private companies or private equity-like funds—enhance the direct physical investment approach by allowing for diversification and optimization of property management, they are not designed for investors with strong liquidity requirements. Publicly registered exchange-traded vehicles (e.g., real estate operating companies and real estate investment trusts) provide investors with a liquid way of accessing property ownership with a small unit investment value. Yet, for most investors the liquidity of publicly registered exchanged vehicles comes at a cost and indirectly results in unwanted short-term volatility and a strong short-term correlation with equity markets that can seriously impact the diversification benefits sought by investors. Using a unique dataset from Sociétés Civiles de Placement Immobilier, Béatrice Guedj, Lionel Martellini, and Shahyar Safaee, in their article “Benefits of Open Architecture and Multi-Management in Real Estate Markets—Evidence From French Nonlisted Investment Trusts,” provide evidence that the French nonlisted real estate investment funds market exhibits a substantial level of dispersion in risk and return characteristics. They find that open architecture and multi-management are untapped sources of added value in the French unlisted real estate fund market and that by making suitable selection and diversification decisions, investors in French real estate funds can achieve substantially higher risk-adjusted performance.

A-shares refer to the shares of Chinese companies trading in Chinese yuan on the stock exchanges in Shanghai and Shenzhen, whereas B-shares trade in foreign currency and H-shares trade on the stock exchange in Hong Kong. The A-share market, the second largest stock market in the world, has recently opened up, and index providers have started to partially include this market in their flagship indexes. In “China A-Shares: Strategic Allocation to Market and Factor Premiums,” Wilma de Groot, Laurens Swinkels, and Weili Zhou investigate three important questions regarding A-shares. First, they examine the consequences of including A-shares on a portfolio’s risk and return. Second, the authors assess the impact on a portfolio’s risk and return if investors decide to strategically allocate to factor premiums in the A-shares market. Since factor premiums in the A-share market may be even less correlated with factor premiums in the rest of the world, their diversification benefits may be even greater than allocating based on diversification benefits at the market index level. The third question is whether factor premiums in A-shares are still profitable after adjusting for transaction costs. The authors report the following. First, their long-term analysis shows that Sharpe ratios increase when A-shares are added to a strategic allocation of 60% equities and 40% bonds. Second, value, momentum, and quality premiums have statistically significant and economically large return premiums relative to a market-capitalization-weighted portfolio in A-shares, similar to developed and emerging markets. Finally, they observe that trading costs have a marginal impact on investors’ returns when trading wisely.

Although the cash flows and shareholder rights for stocks dual-listed in mainland China (A-shares) and Hong Kong (H-shares) are identical, the price of A-shares is generally higher than the price of H-shares. In “The Revealed Inefficiencies of the China A-H Premium,” Fujun Li, Xiaoyang Liu, and Vivek Viswanathan argue that the A-H premium contains unique information about future A-share price movements. They find that A-shares are generally priced less efficiently than their H-share counterparts, with A-share prices converging to H-share prices more strongly than the other way around. They argue that the A-H premium is driven primarily by inefficiencies in the pricing of A-shares due to specific retail preferences from the largely retail A-share market. A strategy that buys stocks with a low A-H premium and sells stocks with a high A-H premium generates a 28.0% capitalization-weighted annualized return, with significant positive alpha over the Fama–French three-factor model.

In “Analyzing Markets with a Large Public Company: The Case of South Korea,” I along with Jang Ho Kim, Taehyeon Kang, and Jaeyong Yu look at the impact of the largest public firm in a country, with a focus on the case of the South Korean market, where the largest firm is an outlier in terms of market capitalization. Using statistical and fundamental factors, we perform factor analysis with the largest firm as one of the factors. Our intent is not to propose the direct use of the largest firm as a factor, even in the case of South Korea. Instead, our approach for using the largest firm as an independent factor is only to demonstrate such firms’ unique value in risk analysis. We believe understanding key factors representing the overall structure of markets is important because factors are critical for systematic investments, risk analysis, and understanding markets globally. We find that a market with a massive firm, in terms of market capitalization, has a distinct structure, and distinguishing the effect of the largest firm can be effective in modeling the market.

Since early 2020, there has been a surge in the number of retail investors in the South Korean market. Retail investors have shown a preference for investing directly in stocks rather than indirectly via collective investment vehicles such as mutual funds. Consequently, although investing by individuals has increased sharply, the trend is not reflected in indirect investments. While there are several reasons for this investment behavior that are unique to the South Korean market, the overall trend maybe more relevant to the global market. In “Recent Trends and Perspectives on the Korean Asset Management Industry,” Jang Ho Kim, Yongjae Lee, Jaekyu Bae, and Woo Chang Kim discuss the recent movement by retail investors in South Korea and its possible causes. They then explain its impact on the South Korean asset management industry and how asset management firms can adapt to these changes. The authors also provide insights from industry leaders who shared their views of the South Korean asset management industry.

A good number of studies have investigated the relative performance of professional and retail investors. Given the typical use of infrequently sampled data on portfolio holdings and returns, these studies find it difficult to distinguish between skill and luck, let alone between superior security selection and market timing ability. In “Market Timing Skill and Trading Activity in Taiwan’s Retail-Dominated Futures Market,” Shean-Bii Chiu, Jason Hsu, Hsing-Kuo Lai, and Phillip Wool employ comprehensive data on 61 million individual trades made by investors in Taiwan’s financial futures market over a 10-year period to confirm that behaviorally biased retail investors consistently lose to institutional investors. They find performance persistence and a nonlinear relationship between past trading volume and future performance, characterized by overconfidence on the part of a vast majority of traders and rational learning about skill by the most active traders. Moreover, the authors introduce a new measure for assessing high-frequency trading skill. Their findings validate the intuition that significant alpha can be harvested by active investors in retail-dominated markets.

Frank J. Fabozzi

Editor