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Structural Breaks and Portfolio Performance in Global Equity Markets Harry J Digital Commons @ George Fox University Faculty Publications - School of Business School of Business 2014 Structural Breaks and Portfolio Performance in Global Equity Markets Harry J. Turtle West Virginia University Chengping Zhang George Fox University, [email protected] Follow this and additional works at: http://digitalcommons.georgefox.edu/gfsb Part of the Business Commons Recommended Citation Turtle, Harry J. and Zhang, Chengping, "Structural Breaks and Portfolio Performance in Global Equity Markets" (2014). Faculty Publications - School of Business. Paper 52. http://digitalcommons.georgefox.edu/gfsb/52 This Article is brought to you for free and open access by the School of Business at Digital Commons @ George Fox University. It has been accepted for inclusion in Faculty Publications - School of Business by an authorized administrator of Digital Commons @ George Fox University. For more information, please contact [email protected]. © 2014 iStockphoto LP Structural breaks and portfolio performance in global equity markets HARRY J. TURTLE† and CHENGPING ZHANG‡* †College of Business and Economics, West Virginia University, Morgantown, WV, USA ‡College of Business, George Fox University, Newberg, OR, USA 1. Introduction of structural breaks in emerging equity markets due to increased world market integration. More recently, struc- Traditional asset pricing models such as the Capital Asset tural break analysis by Berger et al.(2011) find that pre- Pricing Model (CAPM) of Sharpe (1964), Lintner (1965), emerging or frontier, equity markets remained segregated and Mossin (1966); Merton’s(1973) Intertemporal Capital from other markets over time. Asset Pricing Model (ICAPM) and Fama and French’s In general, structural breaks produce erroneous inferences three-factor model (1992, 1993, 1996) often require the and portfolio decisions due to model misspecification. As a assumption of stationary return distributions. Unfortunately, simple example, a structural shift in second moments will the extant literature provides substantial evidence that finan- produce a change in asset betas that might result in a spuri- cial time series might display structural changes.§ For exam- ously significant Jensen’s alpha, even when the true model ple, using a long history of aggregate stock returns in a displays no marginal performance benefit within regimes. Bayesian framework that incorporates uncertainty about Hillebrand (2005) documents this issue and shows that the structural break timing, Pastor and Stambaugh (2001) find sum of estimated autoregressive parameters will be heavily that the equity premium exhibits a sharp decline during the biased towards one in a GARCH model if parameter shifts 1990s. With regard to most emerging markets, Garcia and are not considered. Andreou and Ghysels (2008) point out Ghysels (1998) find that the parameter estimates of a CAPM that ignoring the presence of structural breaks can have with world factors show significant structural instability. Be- costly effects on financial risk management and may kaert et al.(2002) also provide strong evidence produce faulty inferences regarding credit risk. Recently, Pettenuzzo and Timmermann (2011) find structural breaks *Corresponding author. Email: [email protected] cause model instability that impacts prediction, optimal xSee Andreou and Ghysels (2009) for an excellent review of struc- asset allocations and resultant investor utility. tural breaks in financial time series. Structural breaks can often be used to describe general investments improve the location of the tangency portfolio financial market conditions. For example, Meligkotsidou from January 1988 to March 1997, the minimum variance and Vrontos (2008) find structural breaks in the hedge portfolio from April 1997 to March 2003 and both the min- fund return series around the internet boom and the imum variance portfolio and the tangency portfolio from Long-Term Capital Management crisis. In addition, April 2003 to January 2010. Gerlach et al.(2006) document a structural shift in the Our analysis of structural breaks in global markets sug- integration of Asia-Pacific real estate markets due to the gests that disparate results observed in previous studies 1997 Asian financial crisis. The examination of structural might be due to differences in sample periods, the exclusion breaks in international financial markets remains impor- of particular markets, or both. We document the importance tant because studies by Hardouvelis et al.(2006), Carrieri of including even a small number of strongly performing et al.(2007), and Pukthuanthong and Roll (2009) find markets within a given sample and show that emerging evidence that integration of global stock markets has markets have not fully harmonized with other global mar- increased over time. kets. Unrecognized inclusion of multiple market regimes in The potential benefits of adding international investments previous studies might be the cause of recent findings of to a well-diversified US-based portfolio have been debated diminishing benefits to diversification. since the seminal work of Solnik (1974b). For example, Overall, we find a continued role for global diversifica- Harvey (1995) finds that including emerging market assets tion that does not uniformly diminish over time. Our in a mean-variance efficient portfolio significantly increases results suggest that multivariate return moments change expected returns and reduces volatility from March 1986 to over regimes, and that harmonization of global markets is June 1992. Bekaert and Urias (1996) show that, over a sim- not consistently demonstrated within regimes. For example, ilar timeframe, emerging market funds in the UK provide although US and emerging market sample means display diversification benefits whereas US emerging market funds similar patterns as we move from the first to second do not. De Santis and Gerard (1997) estimate that the regime, the third regime shows a dramatic increase in expected gain from international diversification is more than emerging market index returns as US market returns fall. 2% per year from 1970 to 1994. De Roon et al.(2001) find Intuitively, the positive relationship between means over strong evidence of diversification benefits from investing in the initial two regimes is consistent with integration of glo- global emerging markets when market frictions are not bal markets, whereas the final period may be more indica- taken into consideration, but the benefits largely diminish tive of a structural break in the relationship between the with short-sale constraints and transaction costs. In contrast, US and emerging markets. The difference is important for Li et al.(2003) show that international diversification bene- portfolio managers because integration suggests investment fits remain substantial for US investors even with short policy might be better structured solely within domestic selling constraints. Lewis (2007) finds that diversification markets, whereas a structural break interpretation suggests benefits, either from investing in foreign equities directly or global market diversification remains important for in American Depository Receipts (ADRs) traded in the US, asset allocation decisions. are diminishing due to increased world equity market The remainder of the paper is organized as follows. In integration. Section 2, we review the estimation and testing procedure In this paper, our goal is to specify an empirical model for unknown breaks in a multivariate regression model and that admits linkages in the structural relationships between describe our mean-variance spanning test procedure. The global equity markets. Using a general multivariate regres- data are described in Section 3. Section 4 presents our sion model with unknown structural breaks, we examine empirical results. Conclusions are stated in Section 5. the diversification benefits in international market portfolios when global markets are subject to common structural changes. We apply the spanning tests of Kan and Zhou 2. Econometric methodology (2012) to disentangle the portfolio benefits available from various asset classes. We consider potential structural breaks in global financial fi We nd two structural breaks (with three resultant markets comprised of US, developed and emerging markets. regimes) in global equity markets from January 1988 We examine the ability of regional emerging market returns through January 2010. These estimated breaks and their to improve the performance of a well-diversified portfolio fi 95% con dence intervals are comparable across multiple of US domestic holdings and developed market equities. beta risk models. We show that emerging markets provide We use the spanning tests of Kan and Zhou (2012) to ana- fi fi signi cant marginal portfolio performance bene ts to a lyse the potential of emerging markets to improve portfolio fi well-diversi ed global investor prior to 1997 and post 2003 performance. (post 2006 in our smallest model). We also find that emerging markets significantly improve the mean-variance frontier relative to a broad set of bench- 2.1. Structural break testing and estimation mark assets that include the Morgan Stanley Capital International (MSCI) US equity index, the MSCI developed The literature on testing, estimation and application of market index and US small, big, value and growth structural break models is voluminous. Initial tests of struc- portfolios. In particular, Latin American emerging market tural changes were restricted to the case of a single break in a univariate regression model
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