Factorising equity returns in an emerging market through exogenous shocks and capital flows

TL;DR

This paper applies stochastic portfolio theory to decompose South African equity returns into factors like capital distribution, rank changes, and dividends, highlighting the influence of exogenous shocks and capital flows in an emerging market context.

Contribution

It introduces a novel application of stochastic portfolio theory to analyze equity returns in an emerging market, emphasizing the role of capital flows and exogenous shocks.

Findings

Capital flows significantly impact equity returns during crises.

Portfolio factorization reveals shifts in stock rankings and dividend effects.

Results suggest capital flows as key risk factors in emerging markets.

Abstract

A technique from stochastic portfolio theory [Fernholz, 1998] is applied to analyse equity returns of Small, Mid and Large cap portfolios in an emerging market through periods of growth and regional crises, up to the onset of the global financial crisis. In particular, we factorize portfolios in the South African market in terms of distribution of capital, change of stock ranks in portfolios, and the effect due to dividends for the period Nov 1994 to May 2007. We discuss the results in the context of broader economic thinking to consider capital flows as risk factors, turning around more established approaches which use macroeconomic and socio-economic conditions to explain Foreign Direct Investment (into the economy) and Net Portfolio Investment (into equity and bond markets).