J. Christopher Hughen

How Effective Is Arbitrage of Foreign Stocks? The Case of the Malaysia Exchange‐Traded Fund

Unlike closed‐end country funds that usually trade at large premiums to the values of their portfolios, exchange‐traded funds facilitate arbitrage to prevent their prices from deviating from their underlying values. However, such arbitrage can involve significant transaction costs, which have caused some to question the ability of this arbitrage to reduce premiums. This study examines the premiums on the iShares Malaysia Fund, which is the only exchange‐traded fund that has experienced an extended suspension of arbitrage. The results illustrate the importance of arbitrage in providing the full benefits of international diversification associated with exchange‐traded funds that invest in foreign securities.

The Efficiency of International Information Flow: Evidence from the ETF and CEF Prices

While similar in their trading and organization, closed-end funds (CEFs) and exchange-traded funds (ETFs) differ in their liquidity and ease of arbitrage. We compare their price transmission dynamics using a sample of funds that invest in foreign securities and are most likely to show the deficiencies in the manner in which they process information. Our analysis shows that ETF returns are more closely related to their portfolio returns than are CEF returns. However, both fund types underreact to portfolio returns but overreact to domestic stock market returns. A simple trading strategy using these results is profitable with roundtrip trading costs less than 1.38% for CEFs and 0.71% for ETFs.

Portfolio Allocations Using Fundamental Ratios: Are Profitability Measures Effective in Selecting Firms and Sectors?

Our study assesses the performance of portfolios formed using out-of-sample sector forecasts and past firm fundamental ratios. Portfolio allocations based on profitability measures—gross profit, operating profit, and earnings before interest, taxes, depreciation, and amortization (EBITDA)—generate substantially better performance than the benchmark. Long/short portfolio allocations using these fundamentals possess alphas over 14% and increase Sharpe ratios by over 60%. A composite variable provides the highest payoff for firm allocations, whereas EBITDA produces the most profitable out-of-sample sector allocations. Profitability metrics are superior indicators of sustainable economic performance because these ratios are more strongly linked to future returns and cash flows than net income.

Identifying Regime Changes in Closed-End Fund Discounts

In seeming contradiction of the efficient markets hypothesis, closed-end fund shares typically trade at discounts to their portfolio values. We find that about half of these discounts are nonstationary. Focusing only on those funds that have stationary discounts, this study applies the Bai and Perron (1998, 2003a,b) methodology to test for structural breaks in the mean discounts. Virtually all have structural breaks, and our findings contradict previous studies that indicate closed-end fund discounts revert to a long-term mean value. The data indicate that closed-end fund trading strategies are more risky than they superficially appear. As structural breaks in mean discounts do not occur together, our analysis does not find support for a common factor (possibly investor sentiment) causing these breaks.

Chasing Two Rabbits: Challenges in Benchmarking Liquid Alternatives

Liquid alternatives are required to compare their performance to a broad-based market index. Despite their objective to offer low correlations with equity returns, these funds provide traditional equity indexes as benchmarks two and a half times more than any other benchmark category. By pursuing strategies unrelated to their primary benchmarks, liquid alternatives can generate significant tracking errors, which cause biased information ratios. We review the challenges of benchmarking liquid alternatives and recommend use of the downside deviation or maximum drawdown. This issue is important, as research shows how performance relative to even a mismatched benchmark is a significant determinant of fund flows.

Stock returns and the US dollar: the importance of monetary policy

The relation between the dollar’s value and stock prices is controversial. Our analysis shows that returns were 2.6 times higher when the dollar was trending up versus down. Our key insight is that dollar trends should be evaluated in light of monetary policy. While stocks returns have been relatively high when the dollar was appreciating, the difference in returns under tight and loose monetary policies was 9%. When the dollar was in a downtrend, the difference in stocks returns under different monetary policies was 17%.