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Testing U.S. Equity Anomalies Worldwide

Posted in Buybacks-Secondaries, Fundamental Valuation, Momentum Investing, Size Effect, Value Premium

Do widely acknowledged U.S. equity market anomalies exist in other stock markets? If so, why? In his November 2011 paper entitled “Equity Anomalies Around the World”, Steve Fan investigates whether a number of equity market anomalies found among U.S. stocks (asset growth, book-to-market ratio, investment-to-assets ratio, six-month momentum with skip-month, net stock issuance, size and total accruals) also occur in other equity markets and the degree to which such anomalies relate to stock-unique (idiosyncratic) risk. He measures raw anomaly strength based on gross returns from hedge (“zero-cost”) portfolios that are long and short equally weighted extreme quintiles of stocks ranked annually for each accounting variable and every six months for momentum (with overlapping momentum portfolios). To estimate alphas, he adjusts raw returns for the three Fama-French risk factors (market, book-to-market, size) or three alternative investment-based risk factors (market, investment, return on assets). Using monthly common stock return data and associated firm characteristics/accounting data for 43 country stock markets during 1989 through 2009, he finds that:

  • There are significant average monthly gross returns for hedge portfolios formed using:
    • High-minus-low book-to-market ratio, high-minus-low momentum and small-minus-large size in most countries (24 to 36 out of 43).
    • Low-minus-high asset growth, low-minus-high investment-to-assets ratio, low-minus-high net stock issuance and low-minus-high total accruals in some countries (10 to 18 out of 43).
  • Developed countries exhibit higher gross hedge returns for asset growth, momentum and net stock issuance, while emerging countries have higher returns for book-to-market ratio and investment-to-assets ratio.
  • Most of these anomalies persist after controlling for the risk factors from the Fama-French model and the alternative three-factor model.
  • Idiosyncratic volatility/risk (an indicator of the cost of trading) relates positively to abnormal returns for all of the anomalies, more weakly in developed than emerging countries. In other words:
    • Stocks with high (low) idiosyncratic risk tend to exhibit high (low) abnormal returns. Notably, abnormal returns for stocks with very low idiosyncratic risk are generally insignificant.
    • Investors take more risk to exploit anomalies in developed than emerging markets.

In summary, evidence from 43 country stock markets over two recent decades indicates that individual stock anomalies found in the U.S. exist at the gross level in some to many other countries, but costs of trading the anomalies may preclude profitable exploitation.

Cautions regarding findings include:

  • Reported returns are gross, not net. Including realistic trading frictions and shorting costs from hedge portfolio formation/reformation would reduce returns. Estimating and incorporating trading frictions would arguably be an alternative to idiosyncratic risk as a way of investigating limits to arbitrage for the anomalies.
  • As noted in the study, results are full-sample only, with no assessment of whether the anomalies weaken over time.
  • A sample size of 21 years may not be large with respect to number of economic cycles or secular economic trends (such as disinflation since the early 1980s).
  • Data quality may vary materially by market.
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