What explains the investment anomaly in the Chinese stock market?

Abstract

Purpose

This paper aims to examine the Chinese investment anomaly and dissect it from a perspective of rational expectation framework.

Design/methodology/approach

Characteristic-based sorting and Fama–MacBeth two-stage cross-sectional regression are adopted to test the relationship between corporate investment and expected returns in both portfolio and individual stock levels. Under the framework of pricing kernels, an investment-based common risk factor is constructed to test the role of risk played in the negative investment-return relationship. Moreover, a Markov regime switching model is adopted to investigate the time-varying risk premium across market regimes.

Findings

Empirical results provide ample evidence showing that there is a negative relationship between investment and expected returns in the Chinese stock market. The new investment-based risk factor is found to capture the return differences across characteristic-based portfolios. In addition, risk premium of the new risk factor is not only statistically positive throughout the sample period, but also has an asymmetry that is higher during market downturn but lower under bull market.

Research limitations/implications

This paper merely tests the hypotheses derived from rational school.

Practical implications

Investment strategies based on characteristic-sorted portfolios should be adjusted to different market regimes.

Originality/value

First, this paper provides comprehensive empirical results by adopting different methodologies for investigating the investment anomaly in China. Second, an investment-based factor is constructed specifically for the Chinese stock market for the first time. Finally, this is the first paper to investigate the asymmetric risk premium across the Chinese bear and bull regimes by using a multivariate Markov regime switching model.

Citation

Chen, J. (2017), "What explains the investment anomaly in the Chinese stock market?", Nankai Business Review International, Vol. 8 No. 4, pp. 495-520. https://doi.org/10.1108/NBRI-05-2016-0021