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Asian Review of Financial Research Vol.28 No.1 pp.135-162
Korean Equity Funds and Inflation Hedging: Skill or Luck
Sangbae Kim* Associate Professor, School of Business Adminstration, Kyungpook National University
Key Words : Korean Equity Fund,Inflation Hedge,Bootstrap,Cross-Sectional Luck Distribution,Persistence


Since the seminal work of Irving Fisher, the question of how stocks covary with inflation has been extensively examined because inflation risk erodes purchasing power and threatens invetor's long-term objectives (Ang et al., 2012). Most studies found that nominal stock market returns and inflation are negatively correlated. However, there are some evidence that some non-cyclical industries tend to covary positively with inflation, even though the inflation beta is not significant. In addition, the previous literature has focused on the hedging ability of aggregate stock market indices. Recently, Ang et al. (2012) found that some stocks have the ability to be good inflation hedges, suggesting that an investor seeking to hedge inflation risk would optimally hold this firm-level constructed portfolio rather than a market-weighted index. Therefore, if equity funds construct their portfolios based on individual stocks whose returns covary strongly with inflation, those funds have the potential to provide a better inflation hedge for investors, especially who want to avoid inflation risk. Based on this conjecture, this paper examines the inflation hedging ability of Korean equity funds during the January 2001 to May 2013 period. To measure the inflation hedging ability of individual equity funds, we compute fund-level inflation betas following Bekaert and Wang (2010), by regressing individual fund returns on inflation. This allows us to conduct an ex-post analysis of which funds provided the strongest realized covariation between fund returns and inflation. As Jiang, Yao, and Yu (2007) noted, evidence of timing ability can result simply from “luck.” For instance, even if no funds have timing ability, when there are a large number of them, some will have significant timing measures based on t-statistics, due to random chance (Jiang et al., 2007)and the sampling variation. To consider this problem and identify whether the inflation hedging ability is genuine, we use the cross-sectional luck distribution, estimated using the bootstrap approach, to distinguish between skill and luck (due to sampling variation), as proposed by Kosowski et al. (2006). The advantage of the cross- sectional bootstrap approach is that it allows researchers to obtain a distribution of the inflation betas for all funds; specifically, it does not consider the luck distribution of a particular fund but, rather, considers that of all funds, which allows us to draw a statistical inference of funds in the extreme tails of the cross-sectional distribution (i.e., extreme positive inflation betas). When using the realized and expected inflation, we find that while some Korean equity funds have inflation hedging ability, it is due more to fund managers' luck (or sampling variation) than skill. Some previous studies have shown that inflation betas are time-varying. To consider this finding, we divide our sample period into two sub-periods ranging from January 2001 to December 2005 and from January 2006 to May 2013, respectively. This sub-period analysis shows that slightly more funds have returns that covary significantly and positively, in the second sub-period than in the first period. However, the significantly positive inflation betas in both periods are due to luck, consistent with those of the whole- period analysis. The bootstrap procedure used by Kosowski et al. (2006) assumed that the residuals from the regression analysis were independently and identically distributed for funds. However, it is possible that the residuals have serial dependence over time or cross-sectional correlations across funds. To evaluate their effect on the bootstrap results for inflation hedging skill, we adopt the sieve and stationary bootstrap approaches. The empirical results for these two approaches do not differ from those of the previous results. Lee and Jeon (2012) found that most Korean equity funds tend to invest in large and growth stocks relative to the KOSPI 200 index, implying that their inflation hedging ability may influence our results. To examine this effect, we divide our sample funds into their investment styles: large/small and value/growth using the Fama-French three-factor model. The results for their investment styles are consistent with those of whole sample funds. Finally, examining the persistence of Korean equity funds' inflation hedging ability reveals no persistence, indicating that it is difficult for fund investors to construct portfolios of equity funds that are good inflation hedges. Overall, our results indicate that the good inflation hedging abilities of some Korean equity funds are merely the result of luck (or due to sampling variation) rather than fund managers' skills.
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