Sources of Over-Performance in Equity Markets: Mean Reversion, Common Trends and Herding

ISMA Centre Working Paper No. DP2003-08

31 Pages Posted: 27 Jul 2003

See all articles by Carol Alexander

Carol Alexander

University of Sussex Business School; Peking University HSBC Business School

Anca Dimitriu

University of Reading - ISMA Centre

Multiple version iconThere are 2 versions of this paper

Date Written: October 2003

Abstract

In the field of optimisation models for passive investments, we propose a general portfolio construction model based on principal component analysis. The portfolio is designed to replicate the first principal component of a group of stocks, instead of a traditional benchmark, thus capturing only the common trend in the stock returns. The main advantage of this approach is that the reduction of the noise present in stock returns facilitates the replication task considerably and the optimal portfolio structure is very stable. We analyse the portfolio performance over different time horizons and in different international equity markets. In the Dow Jones stock universe, the strategy over-performs both equally weighted and price weighted benchmarks, even after transaction costs. The decomposition of the strategy's over-performance into a market premium, a value premium and a volatility premium reveals a time-varying structure. Throughout most of the period studied, the value component dominated the other two, but during the volatile periods of the last years the strategy earned a significant volatility premium. A behavioural explanation for the mean reversion mechanism leads to the conclusion that the portfolio performance is influenced by the extent of investors' herding towards the common trend in stock returns.

Note: Previously titled "Optimising Passive Investments"

Keywords: indexing, value strategies, optimisation models, principal component analysis, abnormal returns

JEL Classification: C32, C51, G11, G23

Suggested Citation

Alexander, Carol and Dimitriu, Anca, Sources of Over-Performance in Equity Markets: Mean Reversion, Common Trends and Herding (October 2003). ISMA Centre Working Paper No. DP2003-08, Available at SSRN: https://ssrn.com/abstract=413780 or http://dx.doi.org/10.2139/ssrn.413780

Carol Alexander

University of Sussex Business School ( email )

Falmer, Brighton BN1 9SL
United Kingdom

HOME PAGE: http://www.coalexander.com

Peking University HSBC Business School ( email )

Anca Dimitriu (Contact Author)

University of Reading - ISMA Centre ( email )

Whiteknights Park
P.O. Box 242
Reading RG6 6BA
United Kingdom

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