BERND PAPE Asset Allocation, Multivariate Position Based Trading ...

ACTA WASAENSIA 33asymmetric GARCH and multivariate jump-diffusion processes.2.10 Anomalies2.10.1 Cross-Sectional PredictabilityAlthough stock returns are sereially close to uncorrelated, 40 it appears cross-sectionallythat stocks with certain characteristics offer higher returns than others even aftercontrolling for risk. Such effects are called anomalies because investors should beindifferent about any characteristic of their investment other than its return and therisk associated with it. In how much the term “anomaly” is justified, depends thenupon the quality of risk adjustment.The predominant form of risk-adjusting stock returns is the deduction of expectedreturns from the Capital Asset Pricing Model (CAPM) by Sharpe (1964) and Lintner(1965a,b), which accounts for covariance risk with the market portfolio of all stocks,but ignores all other sources of risk; in particular intertemporal effects such as riskdifferentials in different stages of the business cycle or microstructure effects such asliquidity. Characteristics giving rise to a cross-sectional anomaly may also often beargued to be a proxy for expected returns.The first cross-sectional anomaly was discovered by Nicholson (1968), who found thatstocks with a low price earnings (P/E) ratio tend to outperform high P/E stocks.Basu (1977) showed on 1400 stocks traded on the New York Stock Exchange (NYSE),that the P/E effect survives risk adjustment by the CAPM: Buying the lowest P/Equintile and short-selling the highest P/E quintile would have generated 6.75% averageabnormal return before trading costs in the period 1957—71.Banz (1981) found that the 50 smallest NYSE stocks, measured in terms of marketcapitalization, outperformed the largest 50 NYSE stocks in 1931—75 by 1% per month40 see section 2.2.