(PUB) Investing 2015

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December 2015

Morningstar FundInvestor

2 | Low volatility As mentioned earlier in this column, stocks with relatively low betas (or volatilities, to use the more general term) are often said to be anomalous because their performance, broadly speaking, keeps pace with that of less-predictable stocks, which should not be the case if return falls in line with risk. There is a popularity explanation, though. Because few investors use leverage, and most investors wish to beat the overall market index (particularly active professional managers, who are employed directly to achieve such a feat), there is a crowding effect. Too much money pursues the market’s high-beta stocks, thereby pushing down their expected returns. They are too popular. Conversely, low-volatility stocks are relatively underappreciated. often the less-liquid securities show up as being less risky. Since they do not trade very often, their prices can be sticky, so that they show less volati- lity than a security that can be readily traded. That is backward. A lack of liquidity is an unmitigated bad thing; customary pricing models are bamboozled by the issue, and the popularity approach sensibly states that less-liquid securities should be expected to have higher future returns to compensate for their trading drawbacks. 4 | Severe downside risk This was a new one for me. Although investors aren’t particularly afraid of high-volatility stocks in general, as stated in the second point above, they make an exception for securities that have particularly steep downside risk. It’s sensible, of course, to dislike securities that might crater! But per behavioral theory, where people feel losses more strongly than gains (as articulated by Larry Bird: “I hate losing more than I like to win”), the dislike extends further than can be explained by pricing models. The models do not incor- porate behavioral findings—but people do, as does the popularity concept. 3 | Liquidity This topic is easy. Liquidity kills pricing models because

Looking Forward Much work remains. At this stage, the recommen- dation is the limited one of favoring relatively illiquid value stocks that might get whacked. That doesn’t sound particularly palatable, does it? Tastes bad, performs well—such is the idea behind the popularity concept. (As you may have noticed, I left low volatility out of the recommendation. While low-volatility stocks fare well on a risk/return basis, they do not neces- sarily outperform on return alone, and the stated purpose of this column is to identify return opportuni- ties, setting risk aside. That said, tilting toward low-volatility securities does make sense, for taking some of the sting out of the portfolio, but that by itself will not goose returns.) You may be asking whether the popularity concept can help clarify the chaos known as smart-beta funds (which we call strategic-beta funds). Yes, I think it can. The claims of strategic-beta promoters can now be put to the test. Is there a credible, ongoing reason to explain why a strategic-beta fund’s holdings are unpopular? Or is the logic wanting, suggesting that in creating the fund, the sponsoring fund company tortured the data until the numbers confessed? That is a project that I alone cannot tackle, nor can the three authors. It will require a concerted Morningstar effort. Happily, I think the will is there. It would be splendid to see each strategic-beta fund classified according to the source—or sources—of unpopularity that it seeks to exploit. Those cats very much need to be herded. K Contact John Rekenthaler at john.rekenthaler@morningstar.com

Ibbotson, R.G., & Idzorek, T.M. 2014. “Dimensions of Popularity.” Journal of Portfolio Management , Vol. 40, No. 5, P. 68.

Diermeier, J.J., Ibbotson, R.G., & Siegel, L.B. 1984. “The Supply of Capital Market Returns.“ Financial Analysts Journal , Vol. 40, No. 2, P. 74.