Investor Library

Dimensions of Return in the Fixed Income Markets

Investors use fixed income securities to achieve a variety of investment goals. These goals can generally be divided into four broad categories: total return, customization of the overall portfolio risk profile, liability management, and capital preservation in real or nominal terms. More than four decades of research (by both academics and practitioners) suggest that the duration, credit quality, and diversification of a fixed income strategy are among the main considerations an investor must take into account when choosing a strategy designed to achieve those goals. Research also indicates that investors can use information in global yield curves and credit spreads to increase expected returns and/or manage risk within duration and credit quality ranges that are consistent with those goals. For example, an investor who desires capital preservation can use information in current prices in an attempt to dynamically capture the time-varying term and credit premiums among global, short-term, high quality bonds. In this way the investor may strike a better trade-off between expected return, expected volatility, and the capital preservation goal.

One very real and practical implication of the research into fixed income markets is that the duration ranges, yield curves, and credit quality ranges a strategy invests in can all be customized to meet individual objectives and constraints and help investors better achieve their goals.

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Dimensions of Equity Returns in Europe

Size, value, and profitability premiums are well documented in the returns of stock markets around the world. This paper extends the evidence of these cross-sectional return patterns to European equity markets and finds that they are pervasive and persistent in Europe. Investors can seek higher expected returns in well-diversified portfolios that target these dimensions of equity returns.

DIMENSIONS OF EXPECTED EQUITY RETURNS

A dimension of expected returns identifies systematic differences in expected stock returns. It must be sensible, persistent through time, pervasive across markets, robust to alternative specifications, and cost-effective to capture in well-diversified portfolios. Decades of rigorous theoretical and empirical research have identified four dimensions of expected returns in equity markets: market, company size, relative price, and profitability.

The market dimension reflects the premium of stocks over bills. Within equities, there are
also differences in expected returns. Securities with smaller market capitalization, lower relative prices, and higher profitability have had higher average returns than those with larger market capitalization, higher relative prices, and lower profitability. There is extensive empirical evidence that these premiums exist in equity markets around the world: See Fama and French (1992, 1993, 1998, 2006, 2012, 2015a, 2015b), Novy-Marx (2013), O’Reilly and Rizova (2013).

Have there been market, size, value (relative price), and profitability premiums in European markets similar to those documented for US and aggregated non-US developed and emerging markets? This paper examines 15 European markets generally classified as developed (Austria, Belgium, Denmark, Finland, France, Germany, Ireland, Italy, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, and the UK) over the period 1982–2014. We show that over the past 30 plus years, there have been market, size, value, and profitability premiums in European markets.

CONCLUSION

There have been market, size, value, and profitability premiums in Europe over the past three decades. Investors can target these dimensions to improve the expected returns of European equities by (1) using multiple dimensions of expected returns and (2) over-weighting firms with higher expected returns using a measured, controlled, low-turnover weighting schema that incorporates current price. Reliability of outcomes may be increased by using diverse sources of value added (profitability, relative price, and size) and broad diversification across securities and sectors. Low turnover, combined with that broad diversification, allows for a disciplined and patient approach that helps control implementation costs.

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