Risk return relationship is flat or negative
We examined the empirical relationship between risk and return in emerging equity markets and found that it is flat, or even negative. This is inconsistent with theoretical models such as the CAPM, which predict a positive relationship. However, our findings are consistent with the results of studies which have previously examined the empirical relationship between risk and return in the US and other developed equity markets.
These findings are stronger, when volatility instead of beta, is used to measure risk. Specifically, a monthly rebalanced top-minus-bottom quintile hedge portfolio based on the past three years volatility exhibits a negative raw return spread of -4.4 percent per annum over our 1989-2010 sample period. Adjusted for differences in market beta, this amounts to a statistically significant negative alpha spread of -8.8 percent. The alpha spread remains large and significant after also controlling for size, value and momentum effects. In line with other studies on the volatility effect, we observe that the negative alpha of the most volatile stocks is greater than the positive alpha of the least volatile stocks.
Findings robust across countries, large caps, longer holding periods
The paper shows that the findings are robust across countries. As well as reporting results for the broad emerging markets universe, we report results for individual countries. It is also evident in a universe of large-cap only stocks; for example, when the 50% of our sample containing the smallest stocks is excluded. The results of this robustness test remove concerns that the volatility effect is mainly concentrated in small illiquid stocks.
Furthermore, it is persistent and significant in longer holding periods. Although the alpha spread drops, it is still economically and statistically significant. Besides the one month holding period, we also looked at results for 6 months, 1,2,3,4 and 5 years. This disproves the theory that the volatility effect is only a short-term characteristic.
Together with the volatility factor premium, we looked at the presence of other factor premiums. We found clear evidence of size, value and momentum premiums in emerging markets.
Volatility effect strengthened over time
The volatility effect also appears to have strengthened over time, which might be related to the increase in the number of benchmark-driven investors. Participation has grown, because of the increased popularity of emerging-market investments and the liberalization of capital markets. International, benchmark-driven investors - unlike domestic investors - do not focus on absolute risk. Instead they focus on risk compared to a benchmark, such as the MSCI Emerging Markets. Specifically, the alpha spread amounts to 3.1 percent in the first half of our sample period (1989-1999), versus -14.4 percent during the second half of our sample period (2000-2010).
The results for emerging markets are in line with results for developed markets. And they also concur with the ‘limits to arbitrage’ hypothesis: due to restrictions that are placed on funds that would ordinarily be used by rational traders to away pricing inefficiencies, prices may remain in a non-equilibrium state for protracted periods of time.
Low correlation between volatility effects in emerging and developed markets
We find low correlations between the volatility effects in emerging and developed equity markets: 0.26 with the US, 0.19 with Europe and 0.24 with Japan. For investors, the practical implication of these correlation levels is that significant diversification benefits may be achieved by exploiting the volatility effect in multiple markets simultaneously.
These low correlations do not support a common-factor explanation: the possibility that the volatility effect might reflect a global systematic risk factor. This is something that cannot be eliminated through diversification and therefore commands returns in excess of the risk free rate.
At the end of each month between December 1988 and December 2010, emerging market stocks were sorted into five portfolios, according to volatility. The top quintile contained the stocks with the highest risk and the bottom quintile, the stocks with the lowest risk. The universe was defined as the equally-weighted portfolio of all stocks in the S&P/IFC Investable Emerging Markets Index. All portfolios were equally weighted and constructed in a country neutral manner. We next calculated portfolio returns in US dollars over the subsequent month and then repeated this process. After adjusting for market beta, the difference in returns between the top and the bottom ranked quintile portfolios is the alpha spread. A negative alpha spread means that less volatile stocks have higher risk-adjusted returns. Portfolios are also based on beta and other factors (size, value and momentum).