Journal of Banking & Finance 36 (2012) 11441151

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Journal of Banking & Finance

journal homepage: www.elsevier.com/locate/jbf

An empirical analysis of marginal conditional stochastic dominance

Ephraim Clark a,b, Konstantinos Kassimatis c,
a

Middlesex University, The Burroughs, Hendon, London NW4 4BT, United Kingdom
Univ. Lille Nord de France-SKEMA, Euralille, France
c
Athens University of Economics and Business, Department of Business Administration, 76 Patission Str., Athens 10434, Greece
b

a r t i c l e

i n f o

Article history:
Received 22 November 2010
Accepted 6 November 2011
Available online 11 November 2011
JEL classication:
G11
G12
Keywords:
Marginal conditional stochastic dominance
Stock returns
Arbitrage portfolios

a b s t r a c t
Stochastic dominance is a more general approach to expected utility maximization than the widely
accepted meanvariance analysis. However, when applied to portfolios of assets, stochastic dominance
rules become too complicated for meaningful empirical analysis, and, thus, its practical relevance has
been difcult to establish. This paper develops a framework based on the concept of Marginal Conditional
Stochastic Dominance (MCSD), introduced by Shalit and Yitzhaki (1994), to test for the rst time the relationship between second order stochastic dominance (SSD) and stock returns. We nd evidence that
MCSD is a signicant determinant of stock returns. Our results are robust with respect to the most popular pricing models.
2011 Elsevier B.V. All rights reserved.

1. Introduction
Expected utility maximization lies at the heart of modern
investment theory and practice. Within this comprehensive
framework the intuitive attractiveness of meanvariance (MV)
optimization, based on a single measure of risk, is the special case
that is most widely accepted throughout the nancial profession.
MV, however, has a major handicap in that the conditions for it to
be analytically consistent with expected utility maximization,
such as quadratic utility functions or normally distributed returns, seldom hold in practice.1 Stochastic dominance is an alternative, more general approach to expected utility maximization
that does not share this handicap. It requires neither a specic utility function nor a specic return distribution and is expressed in
terms of probability distributions rather than the usual MV parameters of standard deviation and return. The rules for second order
stochastic dominance (SSD), which is appropriate for the class of
all risk-averse expected utility maximizers, state the necessary

Corresponding author. Tel.: +30 210 8203923.

E-mail addresses: eclark@orange.fr (E. Clark), kkassima@aueb.gr (K. Kassimatis).
1
Quadratic utility functions have many shortcomings (for example, third derivatives and higher are equal to zero) and it is a well documented fact since Mandelbrot
(1963) that asset distributions are generally not normally distributed. Furthermore, it
has been shown that risk measures other than variance, such as the third and the
fourth moments of return distributions skewness and kurtosis respectively do
matter to investors, who show a preference for positive skewness and an aversion to
kurtosis (see, Kraus and Litzenberger, 1976; Athayde and Flores, 1997; Fang and Lai,
1997; Dittmar, 2002; Post et al., 2008).
0378-4266/$ - see front matter 2011 Elsevier B.V. All rights reserved.
doi:10.1016/j.jbankn.2011.11.006

and sufcient conditions under which one portfolio is preferred

to another by all risk-averse expected utility maximizers.2 The
problem, as Thistle (1993) has pointed out, is that generalizing
the theory of SSD complicates the rules to the point that they become all but intractable, especially when applied to portfolios of
assets, which is the most relevant case for an investor. Consequently, empirical research based on SSD has been constrained by
the fact that results cannot be reasonably explained and one must
rely on faith in the rules themselves and in the algorithm producing the optimal portfolios.3 In fact, up to now, there has been no
investigation (to our knowledge) of an empirical relationship between SSD and actual investor behavior and portfolio performance.
This paper is a rst step to ll this gap.
Building on the concept of Marginal Conditional Stochastic
Dominance (MCSD), introduced by Shalit and Yitzhaki (1994),
and a small but growing literature that seeks to operationalize it,

2
See, for example, Hanoch and Levy (1969), Hadar and Russell (1969), and
Rothschild and Stiglitz (1970). The rules are typically obtained by comparing the
areas under the cumulative distributions of portfolio returns (e.g. see Levy, 2006).
3
This extensive and growing literature focuses on testing portfolio efciency (e.g.
Shanken, 1987; Gibbons et al., 1989; Shalit andYitzhaki, 1994; Anderson, 1996; Fama
and French, 1998; Post, 2003; Post and Versijp, 2007; Kuosmanen, 2004; Linton et al.,
2005). The evidence suggests that the indices available to academics and practitioners
for asset pricing and benchmarking are generally inefcient. However, other recent
papers by Levy and Roll (2010) and Ni et al. (2011), show that the efciency of market
indices cannot typically be rejected.

E. Clark, K. Kassimatis / Journal of Banking & Finance 36 (2012) 11441151

this paper investigates the relationship between SSD and stock returns.4 MCSD expresses the conditions under which all risk averse
investors holding a specic portfolio prefer one asset to another,
but is a less demanding concept and more adapted to empirical analysis than SSD because it considers only marginal changes of holding
risky assets in a given portfolio. However, although MCSD is conditional and marginal, it also denes simple SSD. Yitzhaki and Mayshar
(2002) have proven that the assumption of continuity in the portfolio space implies that, if there is no portfolio that dominates a given
portfolio under MCSD, then there will be no other portfolio (among
all portfolios, not just marginal ones) that dominates the given portfolio. Thus, under the general assumption of no restrictions on portfolio weights, our results are equivalent to those that obtain under
SSD.
The innovation of this paper is that we use the concept of
MCSD to develop a framework for testing the relationship between SSD and stock returns. We make no assumptions regarding
the efciency of the market portfolio or the return distributions.
The only assumption is that investors are risk averse and that part
of their investment decision process is to improve the return distribution of their portfolios, i.e. they diversify but do not necessarily aim to create efcient portfolios in the sense of Markowitz
portfolio optimization. The major contribution of this study is
the evidence that portfolios based on second order stochastic
dominance constructed with MCSD decision rules consistently
generate statistically signicant abnormal returns. These results
are robust with respect to a range of conventional risk factors
and statistical tests.
The remainder of the paper is organized as follows. The next
section briey presents the concept of MCSD, its implications for
asset allocation and formalizes our testing hypotheses. Section 3
presents the data we use and our methodology. In Section 4 we report our results and Section 5 concludes.

2. Marginal conditional stochastic dominance

Under the general assumption that investors are risk averse,
MCSD provides the probabilistic conditions under which all riskaverse investors prefer one risky asset over another. In the terminology of stochastic dominance, MCSD provides the tools to assess
the dominance or superiority of one asset over another. Dominance means that the utility of all risk averse investors can be improved by increasing the share of the dominant asset at the
expense of the dominated asset.
P
Consider a portfolio P ni1 ai Ai where R is the rate of return
Pn
such that R i1 ai X i with weights given by a1,a2, . . . , an where
Pn
i1 ai 1 and Xi represents the return on assetAi. The joint distribution (X1,X2, . . . , Xn) is given by their joint probability distribution
f(x1,x2, . . . , xn). Their cumulative density functions are F X 1 ; F X 2 ; . . . F X n
respectively. The program to be solved is: Max EuR where u is
a1 ;a2 ;...an

the utility function and E stands for the expectation operator.

The rst order condition is given by:

EX i u0 R 0 8i 1; . . . ; n

Let dak and daj be the marginal changes in holding asset Ak and asset Aj such that dak + daj = 0. The marginal change in expected utility will be:

dEuR EX k dak X j daj u0 R

4
Shalit and Yitzhaki (2010) relate SSD rules to MV theory, Clark and Jokung (1999)
derive conditions for determining MCSD efcient portfolio weights and Clark et al.
(2011) generalize the Clark and Jokung (1999) conditions to generate MCSD efcient
portfolios.

1145

It will be optimal to increase the weight of asset Ak at the expense of

asset Aj if and only if this expression is non-negative, or, equivalently if and only if:

dEuR
EX k  X j u0 R P 0
dak

According to MCSD, asset Ak dominates asset Aj if and only if the

expression in Eq. (3) is non-negative for all risk-averse
individuals.
To determine MCSD Shalit and Yitzhaki (1994) introduce the
notion of Absolute Concentration Curves (ACC), a concept widely
used in the eld of income. Dene the unconditional and the conditional expectation of each asset as li = E(Xi) and li(r) = E(Xi/R = r)
P
where r represents the return on portfolio P ni1 ai Ai and Xi
stands for the return on asset Ai. The Absolute Concentration Curve
(ACC) associated with asset Ai with respect to portfolio P is dened
as follows:

ACC Xi =R n

1

li tfR tdt8r

where R represents the return of the given portfolio P and r is

implicitly dened by the cumulative distribution of the given
portfolio:

fR tdt F R r

1

For a given probability n, ACC is the cumulative return on asset Ai,

given that the portfolios return is less than r. ACC curves give the
expected return on each asset conditional on the given portfolio
P
P ni1 ai Ai with respect to the cumulative probability of the given
portfolio. The three basic properties of the ACC are:
a: ACC X i =R 0 0

b: ACC X i =R 1 li
c:

@ACC X

i =R

@n

li r

The theorem for marginal conditional stochastic dominance can

P
be stated as follows: Given portfolio P ni1 ai Ai , asset Ak dominates asset Aj for all concave utility functions u if and only if
ACC X k =R n P ACC X j =R n for 0 6 n 6 1 with at least one strict
inequality. The theorem states that for a given portfolio, all riskaverse individuals will prefer to increase the weight of asset Ak
with the ACC above the ACC of asset Aj.5
In the empirical testing that follows, we rst identify the dominant and dominated assets by calculating the ACC for every stock,
every month. We then apply the MCSD theorem whereby we sell
the dominated assets short and use the proceeds to purchase the
dominant assets to create a zero cost MCSD portfolio. We then look
at the out of sample performance of this portfolio and assess statistical inference. Our hypothesis is that risk averse investors maximize
their expected utility according to MCSD rules: when dominance has
been identied, dominant stocks will be purchased with a resulting
capital gain for owners of these stocks and dominated stocks will be
sold with a resulting capital loss for owners of these stocks, which
represents a capital gain for short sellers. The empirics that follow
test the validity of this proposition.
5
It should be noted that if asset A dominates asset B, which in turn dominates asset
C, then A also dominates C; in other words for MCSD binary relations, the transitivity
property applies.

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E. Clark, K. Kassimatis / Journal of Banking & Finance 36 (2012) 11441151

3. Data and methodology

The sample includes UK stock market data from January 1999 to
June 2009 obtained from Datastream.6 For each month of the sample period we identify the dominant and dominated stocks and follow the MCSD rules to form a portfolio by purchasing dominant
stocks and selling dominated stocks. In order to establish dominance, we consider daily returns including dividends from the previous 6 months.7 We exclude stocks that do not trade at least 40% of
the test period and stocks with an average price below 50 pence during the test period. The rst restriction is to exclude stocks which do
not have a full distribution because inference based on such stocks
is unreliable8 (investors are also likely to avoid illiquid stocks). The
second restriction is because penny stocks report large positive or
negative returns from small changes in their value.9
The MCSD portfolios were generated as follows. For each month
in the sample period we test for dominance in all pairs of stocks
based on observations from the previous 6 months, using as base
the value-weighted portfolio of our sample stocks, which, as specied in footnote 9, can change every month.10 For example, in order
to establish dominance for January 2000, we use daily total returns
from July 1999 to December 1999. By denition, a dominant stock
is one that dominates at least one other stock but is not dominated
by any other stock (DOMINANT) and a dominated stock is one that is
dominated by at least one other stock but does not dominate any
other stock (DOMINATED). We sell short equal amounts of dominated stocks and use the proceeds to purchase equal amounts of
dominant stocks.11 For example, suppose that there are m dominated stocks, n dominant stocks and the total amount of the short
sale is equal to S. The amount of each dominated stock sold short will
be equal to m1 S. The amount of each dominant stock purchased will
be 1n S.12 In other words, the MCSD arbitrage portfolios are zero cost
portfolios. Finally, we examine the out-of-sample returns of these

6
Ince and Porter (2006) identify a series of problems with Datastream data. Based
on their ndings and recommendations, to correct for errors in the database we apply
4 lters to our data: (i) all equities not listed on UK exchanges are deleted, (ii) noncommon equities are deleted (e.g., ADRs, warrants), (iii) zero returns resulting from
the delisting of a stock are deleted, (iv) high returns that are reversed in the next
period are checked and corrected if they are indeed incorrect.
7
The 1st MCSD improved portfolio is for July 1999, generated from data beginning
in January 1999 to the end of June 1999.
8
For example, if a stock rarely trades, its daily return is zero for most of the sample
period. In bear markets, when most stocks generate negative returns, the illiquid
stock may seem like a good investment (dominant stock) because it does not generate
negative returns. However, no rational investor would prefer this stock simply
because its price does not change due to illiquidity.
9
The stocks in our sample may change every ranking period because some stocks
are delisted while others may be listed. Also, some stocks may become illiquid (based
on our denition) or their average price may fall below 0.50, while others which
were illiquid or had a low price may become liquid or their average price may
increase. Thus, to construct the monthly portfolios, the sample is re-adjusted every
month.
10
The choice of the length of the ranking period is arbitrary. We also tested for a 3
and a 9 month ranking period but the premiums generated were lower. A 6 month
ranking period feels right in the sense that it includes enough observations for a
safe comparison of return distributions, while it does not include old information
which may be irrelevant.
11
Equal weights are appropriate for the testing we propose. MCSD means that the
utility of all risk averse investors can be improved by increasing the share of the
dominant asset at the expense of the dominated asset on a 1 for 1 basis but has
nothing to say on the size of the adjustment to attain efciency. In this paper we are
not concerned with efciency. We test only the hypothesis that when dominance has
been identied, dominant stocks will be purchased with a resulting capital gain for
owners of these stocks and dominated stocks will be sold with a resulting capital gain
for short sellers. See Clark and Jokung (1999) and Clark et al. (2011) for balancing
rules to generate MCSD efcient portfolios.
12
Since a dominant (dominated) asset can dominate (be dominated by) more than
one asset, the number of dominant and dominated assets can differ. However, the
total amount of assets purchased must equal the total amount of assets sold.

Table 1
Statistics on the sample portfolio. Panel A reports average returns, standard deviation,
skewness and kurtosis for the daily returns of our capitalization weighted market
portfolio (row 2). We also report the same statistics for the FTSE All Share index (row
3) for comparability. The last column reports the correlation coefcient of the daily
returns (including dividends) of the Market and FTSE All Shares indexes. Panel B
reports statistics on the number of stocks in the sample per month.

Panel A
Market
FTSE All

Panel B.
Market

Average (%)

St. Dev. (%)

Skewness

Kurtosis

Correl. %

0.051
0.003

1.209
1.205

0.083
0.210

7.50
7.23

99.8

Average

Maximum

Minimum

Median

745.4

899

498

752

MCSD portfolios in the 6 months following the ranking period used

to identify dominance.
Panel A of Table 1 reports statistics on our sample as well as the
corresponding statistics on the FTSE-All Share index for comparison.
It shows a high correlation between the returns of the valueweighted sample portfolio and the FTSE-All Share index, although
average returns are quite different due to the exclusion of illiquid
and penny stocks from the sample. Panel B shows that, given the
sampling restrictions described above, the sample varies between
498 stocks and 899 stocks. The average number of stocks in any
month during the sample period is just above 745, which, considering the size of the UK market, is a good representative sample.
4. Results
4.1. MCSD portfolio returns
Table 2 reports the results for the MCSD portfolio as well as for
portfolios composed of dominant and dominated stocks for 1
6 months after the test period. The returns in Panel A assume a
buy-and-hold strategy, while the returns in Panel B assume that
at the end of each month the portfolio is rebalanced at equal
weighting.13 Since it is unlikely that most investors would rebalance
their portfolio at the end of each month at equal weights, the relevant results are those reported in Panel A. One month into the holding period, the MCSD portfolio generates an average statistically
signicant return of 2.64%. Also, the dominant portfolios report positive returns and the dominated negative returns, as expected. This
is evidence that dominant stocks are purchased and dominated
stocks sold in an ongoing process that continues over a relatively
long period. Two months after the test period, dominated stocks continue to generate negative returns and the return of the MCSD portfolio is higher than the rst months (3.50%). The MCSD portfolio
continues to generate statistically signicant positive returns (at
the 1% level) up to the 3rd month into the formation period and positive returns (but not statistically signicant at the 1% level) up to
the 6th month into the formation period. A strategy of buying and
holding the MCSD portfolio generates on average a compound return
of 9.37% per quarter. This return does not include trading costs but,
considering that this is a 3 month buy-and-hold strategy and that we
have excluded illiquid and penny stocks, the average return is too
high to be signicantly affected by trading costs. The results suggest
that MCSD is a signicant determinant of stock returns. They also
suggest that investors identify dominant (dominated) stocks and adjust their trading accordingly. This serves to eliminate dominance
13
It is unlikely that any investor would rebalance their portfolio at equal weights at
the end of each month. However, many studies in the literature use simple average
returns when they decompose returns from a holding period into monthly returns,
which is why we report the results of Table 2b for comparability to other studies
examining arbitrage portfolio returns.

1147

E. Clark, K. Kassimatis / Journal of Banking & Finance 36 (2012) 11441151

Table 2
Monthly out-of-sample portfolio returns of MCSD portfolios. Returns for the MCSD, dominant, and dominated portfolios 16 months after the test period. The MCSD portfolio is
long on dominant stocks and short on dominated stocks. The sample period is 07/1999 to 06/2009. Figures in parentheses are t-ratios. Standard errors are adjusted for
heteroscedasticity and serial correlation using the Newey-West estimator.
1st month

2nd month

3rd month

Panel A. Monthly returns assuming a 6-month buy-and-hold strategy with initial equal weighting
MCSD
0.0264
0.0350
0.0295
(2.81)
(3.97)
(3.39)

6th month

0.0189
(1.95)

0.0139
(1.38)

0.0168
(2.14)

0.0100
(1.30)

0.0067
(0.88)

0.0062
(0.96)

0.0051
(0.74)

0.0041
(0.62)

0.0058
(0.92)

Dominated

0.0164
(1.40)

0.0284
(2.30)

0.0233
(1.94)

0.0138
(1.04)

0.0098
(0.72)

00109
(0.93)

0.0119
(1.17)

0.0110
(1.08)

0.0161
(1.87)

Dominant

0.0100
(1.30)

0.0059
(0.80)

0.0046
(0.71)

0.0027
(0.40)

0.0014
(0.22)

0.0044
(0.65)

Dominated

0.0164
(1.40)

0.0200
(1.80)

0.0180
(1.51)

0.0092
(0.69)

0.0096
(0.70)

0.0117
(0.89)

Signicance at the 5% level.

Signicance at the 1% level.

but the results also suggest a process of gradual discovery that continues for several months.14
4.2. Dominance portfolio characteristics
In this section, we analyze the characteristics of dominant or
dominated stocks. Figs. 13 depict the average number of companies, the average book-to-market value and the average size of the
dominant and the dominated portfolios of stocks respectively.
Fig. 1 shows that the average number of dominant and dominated
stocks varies considerably. Fig. 2 shows that the book-to-market
value of the dominant stock portfolio is relatively stable over the
whole sample period, including the two major crises in the sample
period: the 9/11 attack in the US and the global nancial crisis in
2008. However, the book-to market value of dominated stocks
exhibits two sharp spikes that coincide with the two crisis periods.
14
As a robustness check to verify that the MCSD effect is not specic to the UK
market we ran the program on an important sub-set of the US market, the S&P 500.
The results, reported below, are weaker but qualitatively similar to those in Table 2A.

1st
month

2nd
month

3rd
month

4th
month

5th
month

6th
month

0.0221

0.0235

0.0165

0.0129

0.0160

0.017

(0.18)

(1.98)

(1.55)

(1.32)

(1.72)

(1.89)

08

07

Ju

n-

nJu

05

06
nJu

04

nJu

nJu

02

03
nJu

01

nJu

nJu

n00
Ju

Dominant

Dominated

Fig. 1. Average number of dominant and dominated stocks.

MCSD
S&P

n-

08
n-

07

Ju

nJu

n06

05

Ju

nJu

n04
Ju

03
n-

02

Ju

nJu

Ju

n01

00

99

nJu

nJu

Dominant

99

10
9
8
7
6
5
4
3
2
1
0

200
180
160
140
120
100
80
60
40
20
0

Ju

5th month

Dominant

Panel B. Monthly returns assuming rebalancing at the end of each month to equal weighting
0.0258
0.0226
MCSD
0.0264
(2.81)
(2.83)
(2.36)

4th month

Dominated

Fig. 2. Average book-to-market value of the dominant and dominated stocks.

In both cases the book-to-market value of dominated stocks increases sharply (especially compared to the dominant stocks), suggesting that dominated stocks tend to lose more value during
crises than dominant stocks. Fig. 3 shows that dominant stocks
tend to be relatively small, while the size of dominated stocks
varies.15
Given the results in Table 2 that suggest a relatively long discovery-rebalancing period, we examine how persistent dominance
is, i.e. once a stock is identied as dominant (dominated) how long
it remains dominant (dominated). Table 3 reports the percentage
of stocks which remain in the same category n months after they
have been characterized as dominant or dominated. More than half
of both dominant and dominated stocks remain in the same category for at least 1 month after they have been characterized as
dominant (dominated) and about a third remain in the same category 3 months later. These results verify why the MCSD premium
remains sizable and statistically signicant for at least 3 months.
It seems that the elimination of dominance is a gradual process
that proceeds monotonically over time.

15
Apart from the book-to-market and size, we also checked for an industry effect in
the dominant and dominated stock portfolios. The distribution of dominant and
dominated stocks across industries seems random and we could not identify an
industry effect.

1148

E. Clark, K. Kassimatis / Journal of Banking & Finance 36 (2012) 11441151

12000
10000
8000
6000
4000
2000

08
nJu

06
n-

n07
Ju

Ju

Ju

Dominant

Ju

n05

04
n-

03
nJu

n02
Ju

01
nJu

n00
Ju

Ju

n-

99

Dominated

Fig. 3. Average size of the dominant and dominated stocks (in millions ).

Table 3
How persistent are MCSD dominances? The table reports the percentage of MCSD dominant and dominated stocks which remain in the same category after n months. The sample
covers the period 06/1999 to 06/2008.
6 months (%)

9 months (%)

12 months (%)

Panel A. Percentage of MCSD dominant stocks that remain dominant after n months
Average
57.1
32.0
Maximum
82.4
60.6
Minimum
28.1
13.8
Median
56.6
31.3

1 month (%)

3 months (%)

14.0
32.1
2.7
13.0

12.0
29.9
1.5
11.1

10.8
27.2
0.0
9.9

Panel B. Percentage of MCSD dominated stocks that remain dominated after n months
Average
61.7
38.3
Maximum
90.0
81.8
Minimum
17.4
12.1
Median
61.7
35.3

21.3
72.7
1.8
20.0

16.3
60.0
0.0
15.7

13.9
41.7
0.0
12.7

4.3. MCSD excess return estimation

4.4. Robustness tests

In this section we investigate to what extent the returns reported

in Table 2 can be attributed to factors outside the MCSD paradigm. To
this end we test the MCSD returns against the CAPM, the Fama and
French (1993) 3-factor model, and the Fama and French 3-factor
model augmented by momentum (Carhart, 1997).16 Table 4 reports
the results for the 1, 2 and 3 month buy-and-hold returns. The market
and momentum factors are always statistically signicant. The four
factor model looks like the best specication with an adjusted R2 ranging between 0.35 and 0.49. The constant in the regressions represents
the returns specic to the MCSD strategy. Interestingly and importantly, they are all large and signicant, which is further evidence that
MCSD decision rules are major determinants of the portfolio returns.
Since the four factor model gives the best t and the lowest constant, we check the robustness of the results reported in Table 4 by
calculating the value and size factors from the stocks in our sample
as in Fama and French (1993), and the momentum factor as in
Carhart (1997), and re-estimating the regressions in Table 4. In results not reported here, we nd that the constant remains above
1.5% and statistically signicant. We also regress using momentum
as a stand-alone factor; the R2 falls to about 20% and the constant
remains above 2% in all cases.

In this section we take a closer look at the MCSD portfolio returns

and undertake a series of robustness tests. Table 5 compares the
sample statistics of MCSD portfolio returns for the rst 3 months
after the test period with those of the monthly excess returns to
the FTSE All Share index and those of the excess return to the value
weighted (VW) portfolio of our sample stocks.17 MCSD returns are
much higher than both portfolios, but standard deviation is higher
as well. However, taken together in the coefcient average return
to standard deviation, MCSD outperforms the FTSE All Share and
the VW portfolio by a large margin. MCSD skewness is also generally
much better than the two indexes while they outperform MCSD in
kurtosis. Overall, Table 5 suggests that the MCSD portfolio is superior
to the FTSE All Share index and the VW portfolio of our sample stocks.
To verify this result with respect to all moments, we test for
MCSD between the MCSD 1, 2 and 3 month returns with the VW
portfolio and the FTSE All Share. Importantly, although the MCSD
1 month returns portfolio does not MCSD dominate any of the
two indexes, we nd that MCSD 2 and 3 month returns do effectively MCSD dominate the FTSE All Share, which is further evidence

16

We use the value, size and momentum factors constructed by Gregory et al.
(2009) that take into consideration the special characteristics of the UK stock market,
such as the large tail of small and illiquid stocks and the UK tax year end. On risk
factors for the UK stock market, see also: Gregory and Michou (2009) and Michou
et al. (2010).

17
Each of the MCSD 1, 2 and 3 month returns come from a strategy where we hold a
portfolio for 1 month and are therefore comparable to the monthly excess returns of
other portfolios. The excess returns of the FTSE All Share index and the valueweighted portfolio of the sample stocks are also the product of a zero cost portfolio
(as the MCSD portfolios) where we assume that we borrow at the risk free rate and
invest the proceeds of the loan in the reference portfolio.

E. Clark, K. Kassimatis / Journal of Banking & Finance 36 (2012) 11441151

Table 4
Conditional MCSD returns. The table reports conditional returns for the MCSD
portfolios 1, 2 and 3 months after the test period. RM  Rf is the excess return on the
FTSE All Share index, the risk free rate is the rate of the UK 1 month Treasury bill,
WML, HML and SMB are the momentum, value and size factors respectively,
constructed by Gregory et al. (2009). These factors are available at: http://
x.exeter.ac.uk/researchandpublications/portfoliosandfactors/les.php. Figures in
parentheses are t-ratios. Standard errors are adjusted for heteroscedasticity and
serial correlation using the Newey-West estimator.
C

(RM  Rf)t

HMLt

SMBt

WMLt

Panel A: 1 month returns

1.210
MCSD
0.0222
(2.31)
(5.37)

R2 adj.
0.23

MCSD

0.024
(2.74)

1.276
(6.08)

0.055
(0.13)

0.075
(0.35)

MCSD

0.015
(1.98)

1.043
(6.31)

0.452
(1.20)

0.063
(0.30)

0.25
0.708
(3.60)

Panel B: 2 month returns

MCSD
0.031
1.183
(4.41)
(5.66)

0.35

0.31

MCSD

0.030
(4.80)

1.169
(5.70)

0.200
(0.57)

0.007
(0.03)

MCSD

0.019
(3.18)

0.906
(6.08)

0.650
(2.36)

0.008
(0.04)

0.30
0.801
(5.89)

Panel C: 3 month returns

MCSD
0.028
1.031
(3.77)
(4.99)

0.49

0.28

MCSD

0.026
(4.47)

1.043
(5.57)

0.335
(1.03)

0.035
(0.16)

MCSD

0.017
(2.87)

0.821
(4.88)

0.713
(2.81)

0.043
(0.24)

0.30
0.674
(4.63)

0.45

Signicance at the 10% level.

Signicance at the 5% level.

Signicance at the 1% level.

1149

In another robustness test we use the generalized sign test to

examine whether the MCSD strategy generates more positive returns than expected18:

pos  Np

z p
Np 1  p
where pos is the number of months with positive returns, N is the
number of months in the sample and p+ is the expected percentage
of months with positive returns. The advantage of the generalized
sign test is that it is more powerful than the simple sign test and
it does not necessarily assume a 50% probability of positive returns
so, it can accommodate skewed distributions. The z statistic has an
approximate unit normal distribution. The number of months with
positive and negative returns for the MCSD arbitrage portfolios 1, 2
and 3 months after formation, as well as the respective gures for
the excess return on the VW and the FTSE All Share indexes are reported in Table 6.
The MCSD portfolios generate positive returns for about 2/3s of
the sample period. Specically, out of 115 months, they generate
positive returns 75 months one month after formation, 79 months
2 months after formation and 76 months 3 months after formation.
The excess return of the FTSE All Share index is positive 66 months
out of 115 while the excess return on the VW portfolio is positive
70 out of 115 months. The generalized sign test suggests that the
number of months with positive returns (at least for the MCSD 2
portfolio) is statistically signicant whether we assume that the
expected number of months with positive returns is 50% of the
sample months, the number of months that the VW portfolio return is positive or the number of months that the excess return
of the FTSE All Share is positive. This is further evidence that the
consistent positive returns documented above are related to the
MCSD investment strategy.
4.5. MCSD and momentum

of the superiority of the MCSD portfolio. MCSD 2 also MCSD dominates the VW portfolio.
To control for potential sample bias, we look at how the MCSD
strategy performs if it is initiated at different times over the sample
period. Fig. 4 plots the average return of the buy-and-hold MCSD
portfolio 1, 2 and 3 months into the holding period from month t
to the end of the sample period, where month t is each month of
the sample. For example, the values for MCSD 1, 2 and 3 for
December 2003 are 2.06%, 2.93% and 1.04% respectively. This
means that when the strategy is initiated in December 2003 and
continued to the end of the sample period (03/2009), the average
monthly return of the MCSD portfolio 1, 2 and 3 months into the
holding period is 2.06%, 2.93% and 1.04% respectively. Except for
the end of the sample period (when the nancial crisis had already
begun) the average return of all 3 months is positive and stable.
The return of the arbitrage portfolio during the 2nd month into
the holding period is always positive, always generates the highest
return and it performs best in the crisis period towards the end of
the sample. Interestingly, these returns also dominate both the VW
and the FTSE All Share indexes. In contrast, RM-Rf, the excess return on the FTSE All Share index if it is held from t to the end of
the period, is consistently negative and sharply negative at the
end of the sample period. VW, on the other hand, generates positive but low returns, except for the end of the period where the returns of the portfolio become negative. The conclusion from Fig. 4
is that the performance of the MCSD portfolio is not dependent on
when the strategy is implemented. There are no outlier periods
of exceptionally good performance that make the strategy work
on average over the whole period and the strategy is effective in
bear markets as well as bull markets. No matter when the strategy
is implemented, by the end of the period it yields a positive return.

In this section we take a closer look at the relationship between

momentum and MCSD. It is reasonable that dominant stocks are
those with good past performance and dominated stocks are those
with bad past performance so, our results could be driven by the
well-known momentum effect. Therefore, a more in-depth examination between MCSD and momentum is warranted.
As a rst test we construct arbitrage momentum portfolios from
the stocks in our sample using several permutations of the percentages of stocks which enter the portfolios (e.g. long 5%, 7.5%, 10%
and 12.5% of stocks with the highest returns and short 5%, 7.5%,
10% and 12.5% of stocks with the lowest returns).19 We then rerun the regressions reported in Table 4 (the results are available
upon request). Using variations of the momentum portfolio does
not increase the explanatory power of the 4-factor model or help explain the MCSD premium, which remains statistically signicant.
In order to understand why momentum returns cannot explain
MCSD returns, we examine the composition of the two arbitrage
portfolios. For the momentum portfolio we use the standard
long/short percentages of 10%, which, since the average number
of stocks in our sample is 745.4 stocks each month, means that
the momentum arbitrage portfolio includes on average 74.5 winner and 74.5 loser stocks each month. The average number of dominant and dominated stocks in the MCSD arbitrage portfolios is
99.2 and 49.2 each month respectively. If MCSD returns are simply
driven by momentum, then we would expect that most of the
dominant stocks are also winners and most of the dominated
18
Since the MCSD arbitrage portfolios are zero cost portfolios, the expected
percentage of months with positive returns is 50%.
19
We thank an anonymous referee for suggesting this to us.

1150

E. Clark, K. Kassimatis / Journal of Banking & Finance 36 (2012) 11441151

Table 5
Statistics on the MCSD portfolio returns. The table reports statistics for the monthly buy-and-hold returns for the MCSD portfolio 13 months into the holding period. The last
column reports the Average return to standard deviation of returns ratio. The last two rows report statistics on the value-weighted portfolio of our sample stocks and the FTSE All
Share index excess returns respectively.

MCSD 1st month

MCSD 2nd month
MCSD 3rd month
V-W portfolio
FTSE All Share index

Average return

St. Dev.

Skewness

Kurtosis

Aver. Ret./St. Dev.

0.0264
0.0350
0.0295
0.0062
0.0034

0.1065
0.0891
0.0838
0.0399
0.0424

0.4800
0.5426
0.3392
0.7067
0.9128

3.4019
1.2569
1.9742
0.8744
0.9160

0.2476
0.3931
0.3523
0.1545
0.0811

Table 7
MCSD arbitrage returns excluding winner and loser stocks. Returns for the MCSD,
dominant, and dominated portfolios 16 months after the test period. The MCSD
portfolio is long on dominant stocks which are not winners at the same time and
short on dominated stocks which are not losers at the same time. The sample period is
07/1999 to 06/2009. Figures in parentheses are t-ratios. Standard errors are adjusted
for heteroscedasticity and serial correlation using the Newey-West estimator.

Average Period Returns

0.1

0.05

1st
month

2nd
month

3rd
month

4th
month

5th
month

6th
month

0.0187

0.0260

0.0195

0.0137

0.0135

0.0144

(2.14)

(2.66)

(1.97)

(1.22)

(1.20)

(1.90)

8
l-0

7
l-0

MCSD
excluding
winners and
losers

Ju

6
Ju

l-0
Ju

l-0

Ju

l -0
Ju

l-

03

Ju

l-0

1
Ju

l-0

0
l-0

Ju

Ju

Ju

l-9

-0.05

-0.1

Signicance at the 5% level.

Signicance at the 1% level.

-0.15
ARB 1m

ARB 2m

ARB 3m

VW-Rf

RM-Rf

Fig. 4. MCSD portfolio returns from month t to the end of the sample period.
MCSD1, 2 and 3 are the MCSD portfolio buy-and-hold returns 1, 2 and 3 months
into the holding period respectively. Rm-Rf is the excess return on the FTSE All
Share index where the risk free rate is the rate of the UK 1 month Treasury bill. The
gure shows the average return for each of the MCSD1, 2 and 3 portfolios from
month t to the end of the sample period. For example, the values for MCSD 1, 2 and
3 for December 2003 are 2.06%, 2.93% and 1.04% respectively which means that this
is the average return of the MCSD portfolios 1, 2 and 3 months after the test period
from December 2003 to the end of the sample period (03/2009).

Table 6
Number of months with positive and negative returns for the MCSD arbitrage
portfolios. MCSD 1 m, 2 m and 3 m are the MCSD arbitrage portfolio returns 1, 2 and
3 months into the holding period. N is the number of months in the sample for the
period 06/1999 to 03/2009. + and  are the number of months with positive and
negative returns respectively. z (50%) is the generalized sign test assuming that the
expected number of months with positive returns is 50% of the sample period
months. z (V-W) is the generalized sign test assuming that the expected number of
months with positive returns is 70; i.e. the number of months that the excess return
of the value-weighted portfolio is positive during the sample period and z (FTSE) is
the generalized sign test assuming that the expected number of months with positive
returns is 66; i.e. the number of months that the excess return of the FTSE All Share
index is positive during the sample period.

N
+

Z (50%)
Z (V-W)
z (FTSE)

MCSD
1m

MCSD
2m

MCSD
3m

V-W
portfolio

FTSE All
Share

115
75
40
3.264
0.955
1.697

115
79
36
4.010
1.72
2.451

115
76
39
3.450
1.146
1.89

115
70
45
2.331

115
66
49
1.585

Statistical signicance at the 10% level.

Statistical signicance at the 5% level.
Statistical signicance at the 1% level .

not winners and about half of the dominated stocks are not losers.
This is more evidence that MCSD returns are not due to
momentum.
To further examine this relationship, each month we exclude
from the dominant stock portfolios stocks which are also winners
and from the dominated stock portfolios stocks which are also losers. The returns for these arbitrage portfolios up to 6 months after
formation are reported in Table 7. Although these returns are lower
than those reported in Table 2, they are quite high and statistically
signicant.
These results provide evidence that although the MCSD portfolio is related to momentum, the MCSD effect yields excess returns
above and beyond the momentum returns. If we compare Tables 2
and 7, we can see that about 1/3 of the MCSD effect can be explained by momentum while the other 2/3 cannot.20

5. Conclusion
This paper provides evidence that MCSD is a signicant determinant of investment strategy and stock returns. Portfolios constructed on the principle of short selling dominated stocks and
purchasing an equivalent amount of dominant stocks generate
consistently high, out-of-sample returns over the entire sample
period that includes two major crises. These returns are persistent
20
As a robustness check to verify that the relationship between momentum and
MCSD effect is not specic to the UK market we excluded the winners and losers from
the S&P 500 MCSD portfolio in footnote 14 and recalculated returns. The results,
reported below, are weaker but qualitatively similar to those in Table 7.

1st
month

2nd
month

3rd
month

4th
month

5th
month

6th
month

0.0107

0.0152

0.0133

0.0117

0.0076

0.0072

(1.14)

(1.78)

(1.67)

(1.21)

(1.01)

(0.90)

stocks are also losers. However, this is not the case. Only 38.1% of
dominant stocks are also winners and 51.9% of dominated stocks
are also losers. In other words, most of the dominant stocks are

MCSD S&P
excluding
winners and
losers

E. Clark, K. Kassimatis / Journal of Banking & Finance 36 (2012) 11441151

and remain statistically signicant three months after the portfolio

has been constructed. They also seem strikingly high when compared with the FTSE All Share index. Total returns are much higher,
return/risk is much higher and skewness is much better. The 2 and
3 month returns also dominate the FTSE All Share and the 3 month
returns dominate the VW portfolio. When tested with respect to
three major asset pricing models, the CAPM, the Fama and French
3-factor model, and the Fama and French 3-factor model augmented by momentum, these returns are abnormal and statistically signicant. We show that the strategy is effective in bear
markets as well as bull markets and that there is no sample bias
of outlier periods that favor the MCSD strategy. We also show
that the consistent positive returns related to the MCSD investment strategy are statistically signicant and are not driven by
momentum.
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