Pakistan: a study of market's returns and anomalies.
| Autor | Tauseef, Sana |
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Introduction
Asian emerging markets have enjoyed some of the fastest economic growth rates and spectacular equity returns in the past few years, making Asia the world's leading emerging market region (McKinsey and Company, 2018; OECD, 2019). Among Asian markets, Pakistan has come under the limelight in recent years. Specifically, Pakistan Stock Exchange (PSX) was ranked amongst the ten best-performing markets in the world by Bloomberg for the years 2012, 2013 and 2014. For the year 2016, Pakistan was ranked as Asia's best and world's fifth best-performing stock market by Bloomberg. Despite its relatively small size, high uncertainty, evolving regulatory environment and substantial differences in market microstructures compared to the world's other equity markets, the outstanding performance of Pakistan's stocks market in recent years has helped it to regain domestic investors' confidence and is serving as an attraction for foreign investors (Mangi, 2020).
The literature documents substantially benefit investors associated with fund allocation to emerging market equities in the form of expanded risk-return possibilities (Conover et al., 2002, 2014). Some markets such as Korea, Hong Kong, Taiwan and Singapore are well-known to investors. But several others like Pakistan remain unknown territories. In this paper, we aim to expand foreign investors' understanding of the potential return enhancement and risk diversification advantages offered by Pakistan's equity market.
We also investigate what matters for investing in Pakistan's market. Unlike the literature on cross-sectional variations in stock returns available on US and other developed markets, the literature available on this topic, especially for emerging Asian markets is recent, limited and inconclusive. Our cross-sectional analysis of Pakistan's stocks adds to the growing literature on factor analysis in emerging markets.
Pakistan's market is challenging for foreign investors because it is characterized by a low level of market depth, unavailability of derivatives and substantial variation of market liquidity. We take account of this feature by studying a liquidity factor. The literature documents that liquidity risk becomes stronger for the economies facing political risk, lacking diversity in securities and investor types, having poor disclosure and governance, and with poor law and order conditions (Amihud et al., 2012). Since Pakistan displays the characteristics of a typical emerging market, we analyze the role of liquidity in the crosssection of stock returns in Pakistan.
This paper demonstrates efficiency gains through adding Pakistan to global portfolios and identifies investment styles to yield high returns on PSX. The rest of this work is organized as follows: the literature review in Section 2 and the status of Pakistan's equity market in Section 3. Next, the methodology is described. Section 5 details our findings and we discuss them and conclude in Section 6.
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Literature review
Benefits to international diversification have recently been driven by emerging market investments due to the increasing correlations between developed equity markets, opening of emerging markets for foreign investors and the expanded risk-return possibilities provided by emerging equity markets (Goetzmann et al., 2005; Cha and Jithendranathan, 2009; Conover et al., 2014). Early research considered emerging markets as a whole and documented the benefits of adding an emerging market indexto global portfolios (Wilcox, 1992; Conover et al., 2002). However, emerging markets remain heterogeneous in terms of capital market development, political risk, institutional quality and global integration level; therefore, investment benefits vary across these markets. Hence, emerging market selection in portfolio investment is of utmost importance (Conover et al., 2014). Typical emerging market features of Pakistan along with the remarkable performance ofits equity make it aninteresting case to study Pakistan's role in international portfolio diversification. Hence, we formulate the following hypothesis:
H1. Inclusion of Pakistan's equity increases return and reduces the risk of the foreign portfolio.
Among the many asset pricing models presented over past decades, Fama and French (1992) (FF three-factor), Carhart (1997) (four-factor) and Fama and French (2015) (FF five-factor models) have become widespread in explaining stock returns across markets (Walkshausl and Lobe, 2014). Specifically, empirical evidence from developed markets shows that small stocks outperform large stocks and value stocks with high book-to-market (BM) outperform growth stocks with low BM; however, there are discrepancies in these relationships for emerging markets. Drew et al. (2003), for example, reported the existence of a significant size premium in China; however, in this case, the BM effect was not found to be pervasive.
Many subsequent studieson Chinese and Korean markets confirmed the presence ofonly size premiums (Wang and Xu, 2004; Kang and Jang, 2016). Connor and Seghal (2003) reached the same conclusion for Indian stocks. Similarly, Firozjaee and Jelodar (2010), Al-Mwalla (2012) and Eraslan (2013) found weak results on multifactor models for other emerging markets. However, in contradiction to these results, recent studies have reported significant value premiums along with significant size premiums for several emerging markets. Cheung et al. (2015), for example, reported size and value premiums in the Chinese market, Rugwiro and Choi (2019), for the Korean market and Aziz and Ansari (2014) confirmed the same for the Indian market.
Mirza and Shahid (2008) conducted the earliest study testing the FF three-factor model in Pakistan and confirmed significant size and value premiums thatis confirmed byRashidetal. (2018). However, Haque and Sarwar (2013) found an insignificant size effect and a significant but negative BM effect. Further, Mirza and Reddy (2017) documented a significant momentum effect in Pakistan; however, the same factor was proposed as redundant by Ali et al. (2021). Reconciling the existing discrepancies necessitates re-examining the significance of traditional factors in explaining Pakistan's equity returns and we derive the following hypothesis:
H2. There is a positive relationship between traditional risk factors and stock returns in Pakistan.
Liquidity is an important factor for investors who require a higher return for illiquid investments. Empirical research uses different liquidity measures like bid-ask spread, transaction costs, turnover rate and price impact. Regardless of the specific measure, studies have established a negative relationship between liquidity and stock returns (Amihud and Mendelson, 1986; Brennan and Subrahmanyam, 1996; Datar et al., 1998; Amihud, 2002).
Compared to developed markets, emerging markets have lower stock liquidity (Lesmond, 2005). However, the negative relationship between liquidity and returns is not established in these markets. Rouwenhorst (1999), for example, suggested that returns in emerging markets cannot be explained by liquidity. Further, Batten and Vo (2014) documented a positive relationship between liquidity and stock returns for an emerging market. Existing studies on stock liquidity from Pakistan's market confirm the relationship between liquidity and stock returns; however, they do not analyze the role of liquidity in terms of the cross-section of returns (Sadaqat and Butt, 2017; Saeed and Hassan, 2018). Taking traditional factors as control variables, we concisely investigate the incremental effect of liquidity risk.
H3. There is a positive relationship between liquidity risk and stock returns in Pakistan.
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An overview of Pakistan stock exchange
Pakistan's financial system, including the equity market has undergone profound developments over the last 30 years. Notably, Pakistan's financial system went through liberalization and deregulation during the 90s with major policy actions by the government. Specifically, a monetary policy with less government interference was undertaken and foreign investors were permitted to buy securities of listed firms leading to the establishment of efficient capital markets. In 2016, in a bid to attract more investors, especially foreign investors, the three stock exchanges of the country, Karachi Stock Exchange, Lahore Stock Exchange and Islamabad Stock Exchange merged to form PSX. In 2019, foreign investment in Pakistan's equity amounted to $4.13 billion (increasing by 221% over the past decade) and represented 8.2% of market capitalization.
Figure 1 presents year-by-year returns that the investors earned in the leading PSX index over the last 27 years. Remarkably, the equity market experienced fast growth following liberalization and deregulation. For instance, in 2002, in the midst of a global market meltdown, the index increased by 112%, and Pakistan's market was reported as the best performing market in the world by US news magazine Business Week. Beyond, over a fiveyear period from 2002 to 2007, Pakistan's equity market earned an impressive average annualized return of 52.62%. Only in 2008 did Pakistan record a steep drop in equity prices in wake of the global financial crises. Even, a floor rule was imposed on PSX in August 2008 resulting in a near-total paralysis of Pakistan's equities market for more than three months and the removal of the market from the Morgan Stanley Capital International (MSCI) and Standard & Poor's (S&P) emerging markets indices.
As reported in Table 1, good performances of the market since 2002 came together with an increase of market capitalization by around 1,250% from $6.79 billion to $91.5 billion representing about 30%ofthe country's Gross domestic product (GDP). This makes Pakistan one of the leaders in terms of capitalization increase in the world.
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Method
4.1 Data
Our analyses use different sets of data from Thomson-Reuters DataStream...
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