Elroy Dimson

Risk measurement when shares are subject to infrequent trading

Abstract When shares are traded infrequently, beta estimates are often severely biased. This paper reviews the problems introduced by infrequent trading, and presents a method for measuring beta when share price data suffer from this problem. The method is used with monthly returns for a one-in-three random sample of all U.K. Stock Exchange shares from 1955 to 1974. Most of the bias in conventional beta estimates is eliminated when the proposed estimators are used in their place.

Event study methodologies and the size effect: The case of UK press recommendations

Abstract This study of 862 press recommendations demonstrates that the size effect can distort longer-term performance measures, and hence event studies. Relative to similar sized companies, post-publication performance is neutral. However, market adjustments, the CAPM and Market Model, with equally or capitalization weighted indexes, all produce biased results. Event studies are most exposed to such bias when the measurement interval is long, event securities differ systematically in size or weighting from the index constituents, the size effect is large and/or volatile, and when CAPM-type methodologies are used. These distortions are avoided by explicitly controlling for size.

The Worldwide Equity Premium: A Smaller Puzzle

We use a new database of long-run stock, bond, bill, inflation, and currency returns to estimate the equity risk premium for 17 countries and a world index over a 106-year interval. Taking U.S. Treasury bills (government bonds) as the risk-free asset, the annualised equity premium for the world index was 4.7% (4.0%). We report the historical equity premium for each market in local currency and US dollars, and decompose the premium into dividend growth, multiple expansion, the dividend yield, and changes in the real exchange rate. We infer that investors expect a premium on the world index of around 3-3 1/2% on a geometric mean basis, or approximately 4 1/2-5% on an arithmetic basis.

Global Evidence on the Equity Risk Premium

The size of the equity risk premium—the incremental return that shareholders require to hold risky equities rather than risk‐free securities—is a key issue in corporate finance. Financial economists generally measure the equity premium over long periods of time in order to obtain reliable estimates. These estimates are widely used by investors, finance professionals, corporate executives, regulators, lawyers, and consultants. But because the 20th century proved to be a period of such remarkable growth in the U.S. economy, estimates of the risk premium that rely on past market performance may be too high to serve as a reliable guide to the future. The authors analyze a 103‐year history of risk premiums in 16 countries and conclude that the U.S. risk premium relative to Treasury bills was 5.3% for that period—lower than previous studies suggest—as compared to 4.2% for the U.K. and 4.5% for a world index. But the article goes on to observe that the historical record may still overstate expectations of the future risk premium, partly because market volatility in the future may be lower than in the past, and partly because of a general decline in risk resulting from new technological advances and increased diversification opportunities for investors. After adjusting for the expected impact of these factors, the authors calculate forward‐looking equity risk premiums of 4.3% for the U.S., 3.9% for the U.K., and 3.5% for the world index. At the same time, however, they caution that the risk premium can fluctuate over time and that managers should make appropriate adjustments when there are compelling economic reasons to think that expected premiums are unusually high or low.

A brief history of market efficiency

Every finance professional employs the concept of market efficiency. The theory, evidence and counterevidence focus on a couple of dozen highly influential articles published during the twentieth century. We summarise the origins of and interlinkages between these contributions to the history of finance.

Capturing the Value Premium in the United Kingdom

Using a new data set of accounting information merged with share price data, we found a strong value premium in the United Kingdom for the period 1955–2001. It existed among small-capitalization and large-capitalization stocks. But small-cap stock managers who wish to capture the higher expected returns face some challenges. We show that rebalancing-induced portfolio turnover for indexed small-cap value strategies can be substantial. Coupled with the relative illiquidity of the U.K. market for small-cap value stocks, such high turnover calls for strategies that sacrifice tracking accuracy in favor of reducing trading needs and lowering trading costs. Value stocks appear to earn a premium in many markets around the world. Investigations of the value premium outside the United States have so far been hampered, however, by lack of data. Existing studies tend to focus on relatively large-capitalization stocks and recent time periods. In this study, we analyzed the U.K. evidence and addressed some of these problems. We used a new data set of accounting information that covers virtually all U.K. firms ever listed on the London Stock Exchange going back to the 1950s. Unlike many previously existing databases, this set of data is free of survivor bias. Using book value of equity to market value of equity (BE/ME) as the measure of value, we found a strong value premium in the United Kingdom for the 1955–2001 period. The return spread we found between our high-BE/ME and low-BE/ME portfolios (averaged across large- and small-cap stocks) is about 0.5 percent a month. The value premium was particularly strong among small-cap stocks, and it was surprisingly stable until the mid-1970s. In recent years, the spread between high-BE/ME and low-BE/ME stocks has been highly volatile. We also show that returns on value strategies based on dividend yield move closely with returns on BE/ME strategies. The premium earned by dividend yield strategies is smaller, but the results suggest that dividend yield may be a useful auxiliary measure of value when BE/ME data deliver doubtful results. Although the historical returns seem impressive, implementation of strategies designed to capture the value premium is potentially costly, particularly within the small-cap segment. Stocks migrating in and out of the small-cap value universe, dividends, and delistings—all give rise to trading needs, even for a passive manager. We found rebalancing-induced portfolio turnover for a passive small-cap value strategy to be approximately 40 percent a year. In a high-trading-cost environment, this mechanical trading strategy could easily cut several percentage points off annual performance. We show that high trading costs are an important concern in the U.K. market. Even today, the equity market for small-cap value stocks in the United Kingdom is substantially less liquid than the market for large-cap stocks. The typical small-cap value stock tends to trade only every other day. This illiquidity implies that traders who demand immediacy of execution are likely to face substantial trading costs. Patient investors, however, may find opportunities to earn a premium by supplying liquidity to less patient traders. Rebalancing strategies and trading costs are, therefore, an important determinant of achievable returns in the small-cap value segment. Pure indexing strategies designed to minimize benchmark tracking error require immediate execution of trading needs because of inflows and outflows or because of benchmark rebalancing. Rebalancing needs can be reduced by sacrificing tracking accuracy, however, by, for example, using a flexible definition of portfolio eligibility. Passive managers are likely to benefit from a patient approach to trading; active managers will need to incorporate trading costs (and possibly slow execution) into their assessments of prospective excess returns. Clever management of the trade-off between tracking accuracy and trading cost can thus be a source of substantial competitive advantage for small-cap value managers. Furthermore, small-cap value stocks in the United Kingdom may be most suitable for the managers who are less subject to daily inflows and outflows and the trading needs they cause. Finally, the concerns our results raise for the U.K. equity market may be even more relevant for other non-U.S. markets, where liquidity is likely to be even lower than in the United Kingdom.

Volatility forecasting without data-snooping

Abstract Data-snooping arises when the properties of a data series influence the researchers choice of model specification. When data has been snooped, tests undertaken using the same series are likely to be misleading. This study seeks to predict equity market volatility, using daily data on U.K. stock market returns over the period 1955–1989. We find that even apparently innocuous forms of data-snooping significantly enhance reported forecast quality, and that relatively sophisticated forecasting methods operated without data-snooping often perform worse than naive benchmarks. For predicting stock market volatility, we therefore recommend two alternative models, both of which are extremely simple.

U.K. Financial Market Returns, 1955-2000

We present and analyze new monthly index series for U.K. financial assets, covering equities, bonds, bills, and inflation. The data are consistent with the CRSP/Ibbotson series for the United States. We use our indices to estimate equity and bond premia and to make international comparisons, especially with the United States, Germany, and Japan. We illustrate potential uses of the new series by investigating stock market seasonality, inflation-linked bonds, real dividend growth rates, and the small-firm effect. While some of our findings resemble U.S. results, we also report differences between U.K. and U.S. stock market behavior. Copyright 2001 by University of Chicago Press.

Three Centuries of Asset Pricing

Theory on the pricing of financial assets can be traced back to Bernoullis famous St. Petersburg paper of 1738. Since then, research into asset pricing and derivative valuation has been influenced by a couple of dozen major contributions published during the twentieth century. These seminal works have underpinned the key ideas of mean-variance optimisation, equilibrium analysis and no-arbitrage arguments. This paper presents a historical review of these important contributions to finance.

The Norway Model

The Norwegian Government Pension Fund Global was recently ranked the largest fund on the planet. It is also highly rated for its professional, low-cost, transparent, and socially responsible approach to asset management. Investment professionals increasingly refer to Norway as a model for managing financial assets. We present and evaluate the strategies followed by the Fund, review long-term performance, and describe how it responded to the financial crisis. We conclude with some lessons that investors can draw from Norway’s approach to asset management, contrasting the Norway Model with the Yale Model.