International Characteristic-Based Asset Pricing

Abstract

In this paper, we develop characteristic-based asset-pricing models for international stocks. We price stocks using benchmark portfolios created based on observable characteristics: market capitalization, book-to-market, prior-year return, growth of total assets, and operating profitability. Benchmark portfolios are created for each stock within each geographical region or country. As such, our approach allows for segmentation in characteristic-based asset pricing among regions. Using a resampling micro-portfolio approach recently introduced by Barras (2018), we find that market capitalization is the most powerful single characteristic in pricing international stocks, and that a three-characteristic model based on market capitalization, book-to-market, and prior-year return has the lowest pricing errors. Meanwhile, micro-portfolio tests and bootstrap simulation analysis also provide evidence that characteristic-based models perform significantly better than global or regional factor-based models in pricing international stocks. We further apply our characteristic-based models to the worldwide equity holdings of U.S.-domiciled mutual funds that mainly invest in international stocks. International equity index funds exhibit zero characteristic-based alphas, reinforcing that our characteristic-based model prices international stocks accurately. Further, we find strong evidence that actively managed funds that mainly invest in emerging markets or in international small/mid-cap stocks exhibit positive alphas. Our results indicate that U.S.-domiciled active managers are able to generate alphas in less-efficient sectors of international stock markets, when expected returns are measured using characteristic-based pricing.

Keywords: International asset pricing, Characteristic-based asset-pricing models, International mutual funds

JEL Classification: G12, G15, G23