Monday, October 12, 2015

"How to Beat an Efficient Market"

From Morningstar:

Buy what others don't like.
Ugly Is Beautiful
Yes, that's a click-bait headline. The previous time I tackled this subject, my column title was the unappetizing "There's More to Expected Return Than Risk." That article's combined viewers could have gathered in the back of an independent bookstore, for a reading by Maine's leading poet. 
But while click-bait, the headline is not inaccurate. 
A bit of theory, before getting to the recommendations. The efficient-market hypothesis (EMH) is largely correct. The notion that the collective wisdom of all market participants is very difficult to outsmart cannot be questioned, as evidenced by 40 years' worth of index fund performance.
However, stock-pricing models that accompany the EMH are problematic. The trouble is that people tend to confuse the models with reality. They talk of "anomalies" that the model cannot explain as if these are investor mistakes. (One example of an anomaly: In William Sharpe's capital asset pricing model, where stock returns are attached to the single indicator of beta, lower-beta stocks tend to perform better than the model success, and higher-beta stocks perform worse.) 
Such a claim is inconsistent with the spirit of the EMH, which states that investors are collectively rational, not collectively error-prone. Why believe that the people are wrong and the model is right? The truth almost surely is the opposite. 
A new, richer model of stock-pricing is needed--one that can incorporate the many aspects that influence investor decisions, not just a single factor (as with CAPM) or four factors (as with the Fama-French-Carhart model). Last year, Zebra Capital's Roger Ibbotson and Morningstar's Tom Idzorek laid out such a path, in "Dimensions of Popularity," published in the Journal of Portfolio Management. The article suggested that the anomalies mindset be reversed. Rather than mine data to find anomalies, and then searching for reasons to explain those results, researchers should be thinking about aspects of popularity. 
(This concept, as with most, follows in the footsteps of other works; the ideas are not brand new, but rather reworked and clarified from previous versions. Indeed, Roger Ibbotson along with two co-authors--Jeffrey Diermeier and Laurence Siegel--articulated some of these ideas a full three decades ago.) 
A popular stock is a stock that has desirable characteristics. On the whole, investors find such stocks easy to own. As a result, they are willing to accept a lower rate of return on those securities than they are with unpopular stocks, which for various reasons may be unpleasant holdings. The search for higher return thus becomes the search for the unpopular--along with a willingness to accept their warts. 
The popularity concept, unlike that of the current framework of expected model returns plus anomalies, does not assume that the market functions in mysterious ways. Nor does it necessarily posit investor irrationality (although it can permit such a thing, by offering a behavioral-finance explanation for a source of unpopularity). By greatly expanding the potential reasons that investors use when valuing stocks, popularity provides a better framework for thinking about ways to achieve higher returns. 
Four FindingsHere are some examples, from an unpublished draft paper that Ibbotson, Idzorek, and Morningstar's James Xiong are now writing. Some are familiar, others less familiar. At this stage, the list is highly preliminary; many other sources of popularity remain to be catalogued. But it should give a flavor of the endeavor--and perhaps even an idea or two for how you might wish to tilt your portfolio: 
1) Value
The historic outperformance of value stocks breaks traditional pricing models. As the authors point out in their new paper, "deep value is less risky than deep growth," as measured by volatility, yet deep-value stocks have handily beaten deep-growth companies over time. But a behavioral preference for the apparent safety of growth companies, which tend to be healthier businesses with stronger corporate brands, can explain what the CAPM cannot....MORE
HT: The Big Picture

Possibly also of interest:

Improving on the Four-factor (beta, size, value, momentum) Asset Pricing Model
What a Long Strange Trip: From CAPM To Fama-French to Four (or more) Factor
"A new benchmark model for estimating expected stock returns"
Fama-French Have A Come-to-Buffett Moment
Rob Arnott's Research Affiliates: "Finding Smart Beta in the Factor Zoo"
"Two centuries of trend following"
"The Equation that Will Change Finance"

and many more. Use the 'search blog' box if interested.