Using a large sample of institutionally managed portfolios, we study the role of social trust in the equity allocations of 8,088 investors from 33 countries over the 2000-2017 period. The negative relation between social trust and foreign bias suggests that institutional investors from high-social trust countries are less prone to underinvesting in foreign equity. Our results provide credence to an information-based explanation, indicating that social trust reduces foreign bias by compensating the lack of information about foreign markets. The negative relation between social trust and foreign bias does not hold unconditionally, but only relates to host countries with weak formal institutional frameworks. The informal institution of social trust can offset the lack of formal country-level institutions in international portfolio decisions. Social trust helps investors accomplish greater cross-country portfolio diversification.
Nikos K. Nomikos
Tatjana Xenia Puhan
This paper uses a comprehensive set of variables from the five largest Eurozone countries to compare the performance of univariate and machine learning-based multivariate models in predicting stock market crashes. In terms of statistical predictive performance, a support vector machine-based prediction model outperforms a random classifier and is superior to the average univariate benchmark as well as a multivariate logistic regression. The ability to forecast stock market crashes out-of-sample translates into large value-added for active investors. Incorporating nonlinear and interactive effects is both imperative and foundation for the predictive performance of support vector machines compared to their linear benchmark. It enables identify and explain the complex relationships in the underlying economic conditions that precede large stock market declines. Our findings can help forecast financial fragility and deteriorating macroeconomic outcomes.
This paper evaluates the predictive performance of machine learning methods in forecasting European stock returns. Compared to a linear benchmark model, interactions and nonlinear effects help improve the predictive performance. But machine learning models must be adequately trained and tuned to overcome the high dimensionality problem and to avoid overfitting. Across all machine learning methods, the most important predictors are based on price trends and fundamental signals from valuation ratios. However, the models exhibit substantial variation in statistical predictive performance that translate into pronounced differences in economic profitability. The return and risk measures of long-only trading strategies indicate that machine learning models produce sizeable gains relative to our benchmark. Neural networks perform best, also after accounting for transaction costs. A classification-based portfolio formation, utilizing a support vector machine that avoids estimating stock-level expected returns, performs even better than the neural network architecture.
This paper evaluates the predictive performance of machine learning techniques in estimating time-varying betas of US stocks. Compared to established estimators, tree-based models and neural networks outperform from both a statistical and an economic perspective. Random forests perform the best overall. Machine learning-based estimators provide the lowest forecast errors. Moreover, unlike traditional approaches, they lead to truly ex-post market-neutral portfolios. The inherent model complexity is strongly time-varying. The most important predictors are various historical betas as well as fundamental turnover and size signals. Compared to linear regressions, interactions and nonlinear effects enhance the predictive performance substantially.
We analyze the performance of a comprehensive set of equity premium forecasting strategies. All strategies were found to outperform the mean in previous academic publications. However, using a multiple testing framework to account for data snooping, our findings support Welch and Goyal (2008) in that almost all equity premium forecasts fail to beat the mean out-of-sample. Only few forecasting strategies that are based on Ferreira and Santa-Clara’s (2011) sum-of-the-parts approach generate robust and statistically significant economic gains relative to the historical mean even after controlling for data snooping and accounting for transaction costs.
Factor‐based allocation embraces the idea of factors, as opposed to asset classes, as the ultimate building blocks of investment portfolios. We examine whether there is a superior way of combining factors in a portfolio and provide a comparison of factor‐based allocation strategies within a multiple testing framework. Factor‐based allocation is profitable beyond exploiting genuine risk premia, even when applying multiple testing corrections. Investment portfolios can be efficiently diversified using factor‐based allocation strategies, as demonstrated by robust economic performance over various economic scenarios. The naïve equally weighted factor portfolio, albeit simple and cost‐efficient, cannot be outperformed by more sophisticated allocation strategies.
We examine whether catastrophe bonds can serve as a hedge or a safe haven for global stock, bond, real estate, commodity, private equity, and infrastructure markets. Our findings indicate that catastrophe bonds are a poor hedge, but they act as an effective diversifier against other asset classes. Furthermore, catastrophe bonds serve as a strong safe haven against extreme price drops of the stock market only during the post-crisis period.
Embracing the concept of factor investing, we design a flexible framework for building out different factor completion strategies for traditional multi-asset allocations. Our notion of factor completion comprises a maximally diversified reference portfolio anchored in a multi-asset multi-factor risk model that acknowledges market factors such as equity, duration, and commodity, as well as style factors such as carry, value, momentum, and quality. The specific nature of a given factor completion strategy varies with investor preferences and constraints. We tailor a select set of factor completion strategies that include factor-based tail hedging, constrained factor completion, and a fully diversified multi-asset multi-factor proposition. Our framework is able to organically exploit tactical asset allocation signals while not sacrificing the notion of maximum diversification. To illustrate, we additionally embed the common trend style that permeates many asset classes, and we also include the notion of style factor momentum.