Sources of Over-performance in Equity Markets: Mean Reversion, Common Trends and Herding

In the field of optimisation models for passive investments, we propose a general portfolio construction model based on principal component analysis. The portfolio is designed to replicate the first principal component of a group of stocks, instead of a traditional benchmark, thus capturing only the common trend in the stock returns. The main advantage of this approach is that the reduction of the noise present in stock returns facilitates the replication task considerably and the optimal portfolio structure is very stable. We analyse the portfolio performance over different time horizons and in different international equity markets. The strategy over-performs both equally weighted and price weighted benchmarks, even after transaction costs. A market premium, a value premium associated with mean reversion in stock returns, and a volatility premium which give the strategy characteristics of a benchmark enhancer, all explain the over-performance, but have time-varying contributions to it. A behavioural explanation for the mean reversion mechanism leads to the conclusion that the portfolio performance is influenced by the extent of investors herding towards the common trend in stock returns.