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Andrew F. Siegel, University of Washington

Presented by

Deepan Kumar Das

Introduction

implications for portfolio efficiency with conditioning information in

the form of lagged instruments.

▪ A model identifies a portfolio that should be minimum variance

efficient with respect to the conditioning information.

▪ The research framework refines tests of portfolio efficiency by using

the given conditioning information optimally.

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Context and Motivation

theories in the presence of conditioning information.

▪ The framework uses “unconditional” efficiency as defined by

Hansen and Richard (1987).

– An unconditionally efficient portfolio uses the conditioning information in the

portfolio weight function, to minimize the unconditional variance of return

for its unconditional mean.

respect to the information, Z .

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Context and Motivation

respect to Z, the conditioning information was used “optimally,” by

allowing for nonlinear functions of the information.

▪ The basic logic for the approach is that a model of expected returns implies

that for the right stochastic discount factor, m, 𝐸 𝑚𝑅 𝑍 = 1, where Z are

observable lagged instruments and R is the vector of gross (i.e., one plus

the rate of) returns. Any specification for m implies that particular

portfolio(s) should be efficient with respect to Z.

▪ Last but not least, previous studies such as Shanken (1990), Hansen and

Jagannathan (1991), Cochrane (1996), Jagannathan and Wang (1996) or

Ferson and Schadt (1996) dealt with conditioning information in the form of

lagged instruments to test the returns of the portfolios.

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Research Questions

fundamental valuation equation: 𝐸 𝑚𝑡+1 𝑅𝑡+1 𝑍𝑡 = 1,

where 𝑅𝑡+1 is an N-vector of test asset gross returns, 𝑍𝑡 is the

conditioning information, a vector of observable variables at

time t, 𝑚𝑡+1 is the stochastic discount factor (SDF) implied by

the model and 1 is an N-vector of ones,

This study sought to find the right functions of 𝑍𝑡 because

otherwise the study would result in loss of power.

This study used the following version of the equation:

𝐸 𝑚𝑡+1 𝑥 ′ 𝑍𝑡 𝑅𝑡+1 = 1, ∀𝑥 𝑍𝑡 : 𝑥′ 𝑍𝑡 1 = 1

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Research Questions

defined to be efficient with respect to the information 𝑍𝑡 , when

it is on this mean standard deviation frontier.

3. How to make 𝐸 𝑚𝑡+1 𝑥 ′ 𝑍𝑡 𝑅𝑡+1 = 1, ∀𝑥 𝑍𝑡 : 𝑥′ 𝑍𝑡 1 = 1 with a

particular specification for SDF (𝑚𝑡+1 ) equivalent to the efficiency

of a particular portfolio with respect to Z?

4. Testing conditional efficiency. The research tested conditional

efficiency by constructing the maximum correlation portfolio for

the indicated m with respect to Z.

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Contributions & Research Models

system of time-series regressions. If 𝑟𝑡 is the vector of N excess

returns at time t, measured in excess of a risk-free or zero-beta

return, and 𝑟𝑝,𝑡 is the excess return on the tested portfolio, the

regression is:

𝑟𝑡 = 𝛼 + 𝛽𝑟𝑝,𝑡 + 𝑢𝑡 ; 𝑡 = 1,2,3 … 𝑇

where T is the number of time-series observations, β is the N-

vector of betas and α is the N vector of alphas. The portfolio

𝑟𝑝 is minimum-variance efficient and has the given zero-beta

return only if α=0.

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Contributions & Research Models

converges to a normal random vector with mean zero and

covariance matrix, Cov(𝛼).

ො

▪ The term 𝑆መ 2 (𝑟𝑝 )is the sample value of the squared Sharpe ratio of 𝑟𝑝 ,

defined by:

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Contributions & Research Models

▪ The term 𝑆መ 2 (𝑟) is the sample value of the maximum squared Sharpe

ratio that can be obtained by portfolios of the assets in r (including

𝑟𝑝 ):

the squared Sharpe ratio over all portfolio weight functions, x(Z) , thus

achieving higher ratios on the expanded boundary.

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Contributions & Research Models

information, the multiplicative approach, and the efficient use of the

information.

▪ When the efficiency of a given portfolio, 𝑅𝑝 , was tested, then 𝑆መ 2 (𝑅𝑝 )

in the test statistic is formed using the normal maximum likelihood

estimators of the mean and variance. The one-month US Treasury bill

return was used as the risk-free or zero-beta rate.

▪ When there is no conditioning information the researchers used the

fixed-weight solution to evaluated at the ML

estimates.

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Contributions & Research Models

get returns:

▪ When the information is used efficiently, 𝑆መ 2 (𝑅) is formed using the

sample mean and variance of 𝑥ො ′ 𝑍 𝑅 where 𝑥ො 𝑍 is the sample

version of the efficient-with-respect-to-Z portfolio weight.

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Contributions & Research Models

▪ The tests are evaluated using simulations. To generate data consistent with

the null hypothesis that a portfolio is efficient, the authors either restricted

the return generating process to guarantee the portfolio’s efficiency, or

replaced its return with a portfolio that was efficient, based on the

specification of the asset-return moments. They constructed the null

distribution of the test statistic by using the artificial data in the same way

that they used the actual data to get the sample value of the statistic.

▪ Last but not least, they conducted experiments to assess the accuracy of

the empirical p-values. With no lagged instruments and normality the exact

finite sample p-values are known from the F distribution. They generated a

random sample of normal returns from a population with mean and

covariance matrix equal to our ML sample estimates.

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Contributions & Research Models

were used.

▪ The lagged instruments include: (1) the lagged value of a one-month

Treasury bill yield; (2) the dividend yield of the market index; (3) the

spread between Moody's Baa and Aaa corporate bond yields; (4) the

spread between ten-year and one-year constant maturity Treasury

bond yields; and (5) the difference between the one-month lagged

returns of a three-month and a one-month Treasury bill.

▪ Twenty five value-weighted industry portfolios (from Harvey and

Kirby, 1996) are used for the period February, 1963 to December,

1994.

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Obtained Results: Inefficiency of the

SP500 Relative to Industry Portfolios

where the tested portfolio, Rp , is the SP500. Referring to

the asymptotic distribution, the right-tail p-value is 0.48

for 1963-94 and 0.14 - 0.39 in the ten-year subperiods.

These tests produce little evidence to reject the null

hypothesis. During 1995-2002 the maximum Sharpe ratio

is substantially higher, and so is the value of the test

statistic. The asymptotic p-value is 0.001.

empirical p-values based on Monte Carlo simulation

assuming normality, and based on a resampling approach

that does not assume normality. The Monte Carlo and

bootstrapped p-values are close to each other in every

subperiod, suggesting that the departure from normality

of the monthly industry returns is not severe.

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Obtained Results: Inefficiency of the

SP500 Relative to Industry Portfolios

“multiplicative” returns. With 25 industry portfolios, the

market return and five instruments plus a constant (L=6),

there are 156 “returns.” One disadvantage of the

multiplicative approach is that the size of the system quickly

becomes unwieldy. It is not possible to construct the Wald

Test for the ten year subperiods, as the sample covariance

matrix is singular.

Over the 1963-94 period the Wald Test statistic using the

multiplicative returns is 348.6. The asymptotic p-value is

close to zero. The empirical p-values reject efficiency at

either the 2% (Monte Carlo) or 44% (resampling) levels. The

results in the multiplicative case are sensitive to the data

generating process. This makes sense, because even if Rt is

approximately normal, the products of returns and the

elements of Zt-1 are not normal.

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Obtained Results: Inefficiency of the

SP500 Relative to Industry Portfolios

Using the resampling scheme the researchers found no

evidence to reject the efficiency of the market index with

the multiplicative approach. Panel C uses the conditioning

information Z optimally. The empirical p-values are 0.5%

or less in the full sample and each ten-year subperiod, and

4.4% or less during 1995-2002. Thus, they could reject the

hypothesis that the SP500 is efficient when using the

conditioning information optimally. They even found

marginal rejections during the 1995-2002 sample period.

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Obtained Results: Size and Book/Market

Portfolios

Consistent with previous studies, efficiency is rejected for

the 1963-1994 period. However, in the 1995-2002 period,

the efficiency of the market index is not rejected when

the finite sample bias in the statistics is corrected. This is

consistent with a weakening of the size and book-to-

market effects during 1995-2002.

The empirical p-value based on resampling is marginal, at

4%, over the 1963-1994 sample.

including the 1995-2002 subsample. Thus, efficiency can

be strongly rejected with the approach.

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Obtained Results: Expanding the Mean

Variance Boundary

information expands the mean variance boundary. This is a

portfolio on the simulations’ “population” mean variance

boundary with no conditioning information. The efficiency of

this portfolio with respect to the expanded boundary was

tested.

boundary was used. The empirical p-values are 0.464

and 0.686, thus providing no evidence that the multiplicative

approach expands the boundary.

0.1% and 2.5%, showing that when the conditioning

information is used optimally the mean variance boundary is

expanded. However, during 1995-2002 we do not reject the

null hypothesis.

Tuesday, January

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Obtained Results: Testing Static

Combinations of the Fama-French Factors

the excess return of high book-to-market over low book-to-

market stocks, and RSMB is similarly constructed using small

and large market-capitalization stocks. Without conditioning

information the only rejections occur for the industry

portfolios. The GRS and empirical p-values produce similar

conclusions. Fama and French (1997) also find that their

factors don’t explain average industry returns very well.

empirical p-values strongly reject the model for 1963-94. This

is consistent with studies such as Ferson and Harvey (1999)

who find that the Fama-French factors do not explain time-

varying expected returns over a similar sample period. The

multiplicative approach cannot be examined over the shorter

sample because the covariance matrices are too large to

invert.

Tuesday, January

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Obtained Results: Testing Static

Combinations of the Fama-French Factors

efficient-with-respect-to-Z frontier. The tests confirm the

value of using the conditioning information optimally. We

observe strong rejections, both over 1963-1994 and in the

1995-2002 sample, and for both portfolio designs.

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Obtained Results: Testing Time-Varying

Combinations of Factors

efficiency of the market index (Panel A) and of time

varying combinations of the three Fama-French factors

(Panel B). Both models over 1963-1994 in both portfolio

designs were rejected. The bootstrapped p-values are

1.2% or less. Both models in the 1995-2002 sample period

with p-values of 1.8% or less were also rejected. Thus,

when the conditioning information is used optimally our

tests strongly reject conditional versions of both the

CAPM and the Fama-French three-factor model.

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Obtained Results: A Hedge Fund Example

0.05 to 0.76 across the fund styles. Fixed-weight combinations of

the Fama-French portfolios and the CRSP value weighted market

index produce a Sharpe ratio of 0.72 (Panel B). Using industry

portfolios and the market, the maximum Sharpe ratio is 0.76

(Panel C). Using the correction in Ferson and Siegel (2003) the

Sharpe ratios are 0.31 and 0.38. The hedge funds appear to offer

impressive Sharpe ratios in comparison. However, using the

efficient-with-respect-to Z portfolio weights the Sharpe ratios

are 1.39 and 1.36 before adjustment, and 1.05 and 1.02 after

adjustment.

expansion of the mean variance opportunity set is tested.

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Obtained Results: A Hedge Fund Example

expansion of the mean variance opportunity set is tested. The test

strongly rejects the null hypothesis using the fixed weight

benchmark, with empirical p-values of 1.2% or less. Using the

lagged variables optimally the p-values range from 4.9% to

17.5%. Thus, while the hedge funds do expand the fixed-weight

boundary, the tests do not reject the hypothesis that the hedge

fund returns could have been generated with nonlinear

strategies based on the lagged instruments.

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Conclusion

efficiency of a portfolio with respect to the conditioning information,

a version of efficiency introduced by Hansen and Richard (1987).

▪ Asset pricing models identify portfolios that should be efficient with

respect to the conditioning information, and by testing the efficiency

of the portfolio, the researchers tested the asset pricing model.

▪ Using a standard set of lagged instruments and test portfolios, the

efficiency of all time varying combinations of the Fama-French

factors is rejected. In the same setting, the commonly-used

“multiplicative” approach to conditioning information does not

significantly expand the mean variance boundary, nor can it reject all

the models.

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Conclusion

▪ The predictive power of the lagged variables declines after 1995, but

even during this period the optimal use of these variables is

economically and statistically significant.

▪ The paper suggests opportunities for future research. It should be

interesting to apply the framework in a setting where the zero beta

rate is a parameter to be estimated.

▪ Future applications of the framework should consider alternative test

statistics, test assets, asset pricing models and data generating

processes. International asset pricing and portfolio performance

evaluation where nonlinearities may be important, such as for hedge

funds, could be especially interesting applications.

Tuesday, January

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23, 2018

Thank You…

Tuesday, January

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23, 2018

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