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The Dogs of the Dow in China

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The Dogs of the Dow in China International Journal of Business and Social Science Vol. 2 No. 18; October 2011 The Dogs of the Dow in China Carol Wang James E. Larsen M. Fall Ainina Marlena L. Akhbari Nicolas Gressis Department of Finance and Financial Services Raj Soin College of Business, Wright State University 3640 Colonel Glenn Highway Dayton, OH 45435 United States of America Abstract The unique institutional environment of China‟s stock markets provides a rich setting to study the relationship between investors‟ behavior and market returns in the case of information inefficiency. This study extends the well documented Dogs of the Dow (Dow Dogs) strategy to China‟s A share stock market. We find that Dow Dogs portfolios significantly outperform the market benchmark for the period of 1994 to 2009 in China‟s markets. Further analysis indicates that (1) The fewer Dogs included in the portfolio, the greater the portfolio abnormal returns; (2) In general, the shorter holding period (in months), the greater the portfolio abnormal returns. These findings are robust even after adjusting for transaction costs and taxes. Our study contributes to the behavioral finance literature by providing new empirical evidence of the market anomaly. JEL Classification: G14, G15 Keywords: Dogs of the Dow, China stock market, Market efficiency, Anomaly. 1. Introduction The Dogs of the Dow strategy is a portfolio screening method which prescribes purchasing the ten Dow stocks with the highest dividend yield. Since its advent in 1988, this trading rule has gained great popularity in the investment community and has been studied extensively by academia. However, this investment strategy has never been investigated using Chinese stocks. The purpose of the present study is to begin filling this gap in the literature. Our results suggest that the portfolios following the Dow Dogs strategy provides superior performance over the market benchmark for various holding periods before rebalancing, ranging from one, up to twelve months. These results persist regardless of the number of stocks, up to 50, in the portfolio. In addition, we find that the raw returns are negatively related to the number of companies included the portfolio. On the other hand, including more stocks and holding longer time period (in months), or equivalently rebalancing less frequently significantly improve the risk adjusted return of the portfolio. This study contributes to the literature in the following dimensions. First, it extends the well-documented Dow Dogs strategy in the U.S to the Chinese stock markets and provides empirical evidence for the strong predictive power of the Dow Dogs strategy in China markets. Second, this study explores various versions of the Dow Dogs strategy in terms of the number of components and rebalancing frequency. The result helps to identify the new trading rules that capture the various strengths of the Dow Dogs strategy. Third, given the unique speculative atmosphere in China‟s stock markets, the findings of this study provide practical references for the financial services community and important implications for the theoretical understanding of the Dow Dogs anomaly in a setting where highly ebullient behaviors of investors are present. The remainder of this paper is organized as follows. Section 2 provides a description of the Chinese stock markets. Section 3 contains a brief review of the Dogs of the Dow literature. Section 4 describes the data. Section 5 explains the methodology. The results are presented in Section 6. The paper ends with a summary and our conclusions in Section 7. 2. The Development of China’s Stock Markets Over the past two decades, China has experienced impressive economic growth and become the world‟s second largest economy. 70 © Centre for Promoting Ideas, USA www.ijbssnet.com The evolution of its capital markets has played a critical role in China‟s dynamic transition from a centrally planned system to a market economy and provides an important channel for investor wealth allocation. Given the increasing globalization of the economy, astute investors recognize the importance of an internationally diversified portfolio. The unique characteristics of China‟s stock markets and institutional setting have attracted a considerable amount of investment interest and academic attention from around the world. Currently there are two stock exchanges in mainland China, the Shanghai Stock Exchange (SHSE) and the Shenzhen Stock Exchange (SZSE), which were established in 1990 and 1991, respectively. At the end of 2009, they were the third and fifth largest stock exchanges in the world based on total value of shares traded (World Federation of Exchanges, 2009). By the end of 2009, total market capitalization of the 902 stocks listed on the SHSE amounted to $2,800 billion and the shares of the 830 firms listed on the SZSE were valued at $839 billion. Table 1 reports the annual number of listed companies, total market capitalization, and total value of shares trading over time. Figure 1 provides the graphic illustration of the evolution of the stock exchanges in China. Insert Table (1) about here Insert Figure (1) about here The majority of Chinese companies issue A class shares that are quoted in Chinese Yuan and can be purchased only by domestic investors and selected foreign institutional investors. About 6 percent of all listed companies issue both A class and B class shares, or B class shares only. B class shares are quoted in foreign currencies and historically have been restricted to foreign investors, but starting in March 2001, Chinese investors can also trade B shares with legal foreign currency accounts. This study focuses on A class stocks only. Several institutional characteristics make the Chinese market a unique environment in which to test the Dogs of the Dow strategy. First, the investor body is dominated by individual investors who normally have less expertise and resources than institutional investors. Second, the security legal system is still underdeveloped and compared to American securities markets information transparency is less reinforced in China‟s market. Both of these factors may contribute to a higher level of speculative behaviors. Third, the financial market in China is relatively young. The number of investment vehicles and the number of listed stocks are limited and cannot meet the growing investment demand of public investors. It has been argued, therefore, that the A share market is likely to be plagued by speculative forces. These limits and the special features of the investment environment in China, however, afford us the opportunity to observe the effect of the Dow Dogs strategy that would be difficult to accomplish in more developed markets. 3. Literature Review The world was introduced to the Dogs of the Dow strategy in a 1988 Wall Street Journal article (Dorfman, 1988). In this article, John Slatter, a financial analyst, states that the annual return for the ten highest yielding DJIA stocks beat the DJIA by 7.6 percent, on average, for the period 1972 to 1987. The success of the strategy is confirmed in studies conducted by Knowles and Petty (1992) and O'Higgins and Downes (1992), both of which investigate longer sample periods. Obviously, the success of the Dogs of the Dow challenges the classic efficient market hypothesis (Fama, 1970). The effectiveness of the Dow Dogs has been constantly debated among academics ever since and various explanations behind the effect have been proposed. The literature mainly can be classified into two streams. One is based on implications of the traditional efficient market hypothesis. The other is based on the recently emerging behavioral hypothesis that allows for irrational behavior on the part of investors. Originally, it is suggested that dividends represent the true measure of value of the company. The Dow Dogs strategy happens to select the undervalued stocks that tend to climb up when the market conditions become favorable. O'Higgins and Downes (1992) claim that window dressing along with the rise of institutional investors during the 1970s are important explanatory factors for the Dogs‟ superior performance. Nevertheless, some studies report inconsistent performance for the Dow Dogs strategy. For example, McQueen et. al. (1997) test the Dogs method using a 50-year sample period between 1946 and 1995. They find that the top 10 Dogs‟ annual returns beat the DJIA statistically but not economically if adjusting for risk, taxes and rebalancing costs. They believe that the Dogs technique may disappear after it becomes widely known by investors. Keating (1998) finds that the Dogs have lost their bite since 1995. He posits that the growing knowledge about the Dogs strategy among investors prompts them to capitalize on the opportunity and, therefore, arbitrages away the abnormal profits associated with the Dogs. 71 International Journal of Business and Social Science Vol. 2 No. 18; October 2011 Domian et. al. (1998) examine the connections among past returns, dividend yields, and future returns during, before, and after the 1987 market crash. Their results demonstrate that the Dogs effect is a loser-winner effect during the pre-crash period. But, during the post-crash period the past returns of the selected Dogs based on dividend yields outperform S&P500 and are not real “Dogs” any more. Hough (2007) draws a similar conclusion about the declining Dogs effect since 1996 and argues that the increasing use of share repurchase as an alternative to dividend payment causes the disappearance of the Dogs in the 1990s. Hirschey (2000) reexamines the Dow Dogs strategy and argues that the previously documented outperformance of the Dogs is attributable to data errors and data mining. Therefore, the Dow Dogs effect still conforms to the traditional asset pricing model. However, Prather and Webb (2002) replicate the Dow Dogs approach and conjecture that the success of this strategy is not caused by data errors nor data mining problem, and also reject the window dressing of the institutional investment hypotheses raised by O'Higgins and Downes (1992).
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