(PUB) Investing 2015

8

How to Beat an Efficient Market Morningstar Research | John Rekenthaler

(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, Jeffrey Diermeier, and Laurence Siegel articulated some of these ideas three decades ago.) A popular stock is a stock that has desirable character- istics. 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 Four Findings Here are some examples from an unpublished draft paper that Ibbotson, Idzorek, and Morningstar’s James Xiong are now writing. Some are familiar, others less so. At this stage, the list is highly prelimi- nary; many other sources of popularity remain to be cataloged. 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 com- panies 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.

The efficient-market hypothesis, or 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, or CAPM , where stock returns are attached to the single indicator of beta, lower-beta stocks tend to perform better than the model, 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 mind-set 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.