(PUB) Investing 2015

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9 Morningstar FundInvestor December 2015
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.
3 | Liquidity
This topic is easy. Liquidity kills pricing models because
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.
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
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.