Portfolio managers in financial companies such as mutual funds, hedge funds, and other funds which invest in financial securities face the difficult task of making the "right" investment decisions and establishing investment strategies to benefit their clients. One of their biggest challenges is appropriately weighing the risks and rewards of their investments.
Alexander Philipov, assistant professor of finance at George Mason School of Management, has new research, recently published in the Review of Asset Pricing Studies, that offers portfolio managers a better way to measure the potential returns for investing in international markets.
Philipov, together with colleagues Doron Avramov of Hebrew University of Jerusalem, Tarun Chordia from Emory University's Goizueta Business School, and Gergana Jostova from George Washington University's School of Business, used twenty years of data to examine risk factors associated with investing in emerging markets. Emerging markets are nations with social or business activity in the process of rapid growth and industrialization. The economies of China and India are considered to be the largest emerging markets.
"Based on previous research, from a portfolio management perspective, emerging equity markets were offering very attractive investment opportunities [in the form of buying stocks of public companies]. For a relatively small level of risk, they were offering rather large returns," explains Philipov. "What our research finds is that there is another non-diversifiable source of risk (a risk factor which we call world credit risk) that was previously unaccounted for, and the 'large' documented returns in emerging markets are actually compensation for it."
To construct the world credit risk factor, the researchers used a sample of 24 developed and 51 emerging countries from the time period January 1989 to December 2009. The world credit risk factor is computed as the difference between equity returns of high and low credit risk country portfolios sorted on credit ratings. A country's credit risk reflects the possibility that it may not be able to service its debt, as measured by S&P sovereign debt ratings.
"The world credit risk factor is a better choice than alternative factors previously proposed in the international asset pricing literature," says Philipov. His research shows that it may provide a more accurate indicator of the rate of return that investors should require when investing in the equity securities of a particular country.
"Exposure to the credit risk factor explains the higher returns of high credit risk countries. In the presence of the credit risk factor, country-level characteristics such as credit ratings, variance, and skewness of returns no longer have predictive power for the cross-section of country equity returns," Philipov explains.
The credit risk factor explains previously documented pricing errors in emerging markets. Emerging markets earn higher returns not because they are classified as emerging or have worse credit ratings. Rather, they exhibit higher exposure to the world credit risk factor.
Philipov says, "From a decision making perspective, investment managers will be able to use this research to better measure the required returns for investing in international markets and to improve their asset allocation, i.e., make better investment decisions."
This paper was received very well by both academics and practitioners. The paper won two research awards: the INQUIRE Europe Research Award and the Q-group Research Award. It was also invited on the programs of the 2012 Society of Financial Studies (SFS) Cavalcade and the 2012 11th Annual Darden International Finance Conference. It was published in the Review of Asset Pricing Studies. And most recently it received the Review of Asset Pricing Studies Best Paper Award for 2012.
Alexander Philipov is an assistant professor in the School of Management at George Mason
University. His areas of teaching include investments, derivatives, corporate finance, and financial institutions. He comes to Mason from American University. Philipov's research focuses on asset pricing, risk management, and credit risk. His work has appeared (or is forthcoming) in the Journal of Finance, the Journal of Financial Economics, the Review of Financial Studies, the Journal of Financial and Quantitative Analysis, and other journals. Click here for complete bio.