This past spring I asked why everyone isn’t beating the market when countless strategies have been shown to deliver outsized returns—at least in theory. I put it down to self-destructive behaviour, but now two US researchers have a different explanation: they’ve demonstrated that market-beating strategies tend to lose their mojo after they’ve been published.
In their paper, Does Academic Research Destroy Stock Return Predictability?, David McLean and Jeffrey Pontiff examine 82 characteristics that have been offered up in peer-reviewed journals to explain variations in stock returns. These include things like market cap, value measures, liquidity, dividend policy, momentum, credit downgrades, and many others. If an investor could use of any of these characteristics to pick market-beating stocks they would be called market anomalies.
Anomalies can come and go for various reasons, the researchers tell us. They may be the result of statistical biases: in other words, if you were to look at a different data sample the anomaly would probably disappear. For example, if stocks with a given characteristic delivered higher returns in the US but not in other countries, or only during a specific period, chances are there’s no real anomaly.
Anomalies may also be the result of mispricing. In this case, they are real, but as McLean and Pontiff write, “if publication draws the attention of sophisticated investors, then we might expect anomalies to disappear post-publication because of arbitrage.”
It works until doesn’t
Whatever the reason for the fleeting anomaly, investors who try to capitalize on it will end up disappointed. And that’s exactly what the researchers discovered. For each of the characteristics they examined, McLean and Pontiff conducted two statistical tests to see how well they predicted future stock returns. They found the average anomaly became significantly less meaningful after it was reported in the academic literature: “We estimate the average anomaly’s post-publication return decays by about 35%. Thus, an in-sample alpha of 5% is expected to decay to 3.25% post-publication.”
It should be noted that a 5% alpha is huge: most strategies designed to beat the market promise much more modest results. The value and small-cap premiums identified by Fama and French, for example, are much smaller: since 1927, large-cap value stocks outperformed the S&P 500 by 1.5% annually, while small caps managed an extra 2%. Reduce these by 35% and you’re not left with much outperformance at all.
Moreover, McLean and Pontiff’s paper was unable to account for the higher fees usually charged by funds that try to capture these anomalies, nor could they measure transaction costs and taxes. But McLean did comment on this important point later: “Investors should also keep in mind that these papers are written by researchers whose first priority is to better understand how financial markets work, and not to identify money making mechanisms. As a result, most studies do not estimate the costs of implementing the strategy, which can be substantial.”
I’ve made this argument before in regards to fundamental indexing, though it applies equally to any strategy that requires frequent portfolio turnover. It explains why ETFs that use strategies other than cap-weighting typically have higher tracking errors.
These findings are worth keeping in mind as the ETF world explodes with new “enhanced indexing” products designed to deliver higher returns than the broad market. Many of these are based on peer-reviewed research that may have identified legitimate market anomalies. But it seems likely many will not persist, or their alpha will evaporate after fees and costs are subtracted.
I’m optimistic that at least the risk premium will persist. The tendency for people to think short term isn’t likely to go away completely. If this is correct, then buy-and-hold on a portfolio that takes on some risk will continue to beat short-term government debt over the long run. However, the stock market results of the past decade show little evidence of a risk premium.
Excellent article, but I take issue with your examples. The enhanced return from small cap and value stocks is not attributed to being a market anomaly. It’s the investor being compensated for taking on more risk.
You also mention fundamental indexing, which is designed to avoid bubbles and also gives the index a value tilt. I don’t think they are necessarily looking to create alpha (not that you said that they are).
@Mike and Kiyo: Yes, I guess we need to be clear on the difference between a risk premium and a market anomaly. Stocks can be expected to outperform government bonds because of a risk premium: that is entirely rational, and should be expected to persist. But the value premium is a bit more controversial:
There is evidence that value stocks (and it depends on how you define that term) have lower volatility and higher expected returns than growth stocks. Fundamental indexing has also made this claim. This may be behavioural: people are simply willing to pay more for glamour stocks and less for companies deemed to be stodgy or out of favour. That would make value an anomaly, not a risk premium. But one might reasonably expect this anomaly to persist unless one believes that humans will change their nature.
I should note that the McLean and Pontiff paper did not discuss the various anomalies individually, so I don’t know what they would say about the persistence of size and value premiums. The data they present is all aggregate.
I found this book chapter on market anomalies to be interesting. It includes both the size and value factors in the discussion:
That a risk premium exists at all is rational, but it’s size over the last century has been irrationally high IMO. There seems to be near unanimous agreement among those willing to make future predictions (including Buffet) that the risk premium will be smaller in the coming century than it was in the past. If this turns out to be true, I think this would be a move toward greater rationality.
Many of these anomalies were identified 30, 40, 50 years ago, and yet they persist. In a perfectly efficient market, once such an anomaly is identified, it should be eliminated. The market is not perfectly efficient, so this is likely why these effects persist.
Very interesting post on a much debated subject!
Implementation is indeed a key point of any market-beating strategy. One such strategy that caught my attention was the Sabrient’s Insider Sentiment Index (ticker NFO). Why not buy if insider’s are buying was my thinking, maybe they could get it right more often than wrong?
Reading upon the strategy you can notice that the strategy had to incorporate analyst’s views in making the index as well as considering insider buying. The arguments did seem reasonable though. Furthermore, using the word index IMHO seems a bit of a stretch since portfolio turnover can be quite high. And of course the management fees are higher than with a plain market cap weighted index.
Will NFO have higher returns than say VTI (Vanguard total US market) in the future? Hard to say, but I decided to give it a try, but with only 10% allocation within my US equities allocation. I consider it my own (and only) little experiment to see if some market-beating strategies will produce higher returns.
You can give the Holy Grail formula to 100 people, only 5 of them will have the discipline to stick to it. We are the anomaly and it looks like there is no learning curve…. which is great if you are one of the 5 people.
It seems the research is essentially validating elements of the Efficient Market Hypothesis, namely when information (in this case information about anomalies or market outperforming strategies) is disseminated in the market, prices will adjust and revert to some “norm”. No securities whether be ETF’s or straight up individual stocks appears would be exempt from this premise. The question then is, is the market efficient? Academically it might be but reality offers a different, more sobering view. It seems to reinforce the notion that actively managed portfolios be it in a mutual fund or an “enhanced” ETF will lead to more disappointing returns long term than a simple portfolio of index based, passive ETF’s
The whole issue of outperforming the market is just irrelevant because it’s just impossible to consistently outperform over a long period, but sadly the industry is judging and compensating people for this unrealistic performance, which leads to not necessarily sound decision-making. It then becomes a fools game. The best standard for an individual investor to hold against is the long-term historical returns for stocks (i.e. going back 100+ years) which has been between 7-9% depending on what indexes or combination of indexes you use. Given the current climate, you have to temper your expectations even more, so if you’re getting 6% or above, then you’re doing very very well (Disclosure we’re up 3.5% YTD, 3% after expenses, equities only).
@Spy Surfer: I would add that you could give the formula to 100 investors and only five would succeed, but all 100 will think they’re one of the five.
@CCP: Hahaha, so true! I guess market anomalies are fuelled by denial. Fascinating!
@Cdn Couch Potato: That made me laugh! I experienced something slightly different when I tried to explain why I think I can’t beat the market picking stocks, other people tried to persuade me that I really did have stock-picking skill.
Great debate! I believe the only market beating strategy that does not go away is paying attention to valuation. The only reason that works is because people to let their emotions cause them to make bad investment decisions.
If everyone followed your advice there would be no inefficiencies, but there will always be a “herd mentality” that cause prices to move significantly above and below intrinsic value. Those that have the patience and ability to identify those time periods can reap above average rates of return by adjusting their asset allocation accordingly (tactical asset allocation).
The other fundamental process that adds value is tracking dividends.
Siegel and Dimson have demonstrated that 90% of equity Market returns come from dividends, growth of dividends and reinvested dividends.
The problem is that the first 17 years are the most difficult
@Rob: Cool. I’ve also heard that 90% of returns come from asset allocation. So, if I track dividends and focus on asset allocation I can get 180% of the market return!
Andrew F has it right. The book Security Analysis has been around for an amount of time nearing a decade but there is no shift towards value regardless of how well the Superinvestors of Graham and Doddsville have performed.
Investors are likely to always favor growth over slow-growing value names. As long as greed is good on Wall Street this will be true.
@Rob: High yield and dividend growth may indeed be important, but this idea of 90% of returns coming from dividends is just more bad math. For a lengthy discussion of this idea see this article:
@Michael: You can only get 160% of the market return after fees. :)
Are you adding the Barclays Equity Gilt study to the list of professors who can’t do maths?
@Rob: Whoever wrote the Beta Investor piece you pointed to is either being deliberately misleading or is confused. If capital gains and dividends both provide 4% each year for 60 years, then excluding either return component would reduce your final portfolio value by just over 90%. By the reasoning in the Beta Investor article, both capital gains and dividends provide over 90% of returns. By sensible reasoning, both capital gains and dividends make equal contributions in the hypothetical scenario I described.
@Rob: I didn’t mean to be disrespectful to you or the authors of the Barclay’s report. As Michael points out, however, these data are highly misleading, and they are regularly misunderstood by investors who advocate dividend-focused strategies. The implication seems to be that by selecting stocks with high dividends you will earn dramatically higher returns, but this is not at all what the data say. I urge you to read the article I linked from RetailInvestor.org, which explains the flaws in the argument.
The data in the Barclay’s report has nothing to do with yield. It is all about dividends which is a seperate item altogether. What the reports says, every year, is that the bulk of the return from the stock Market has a whole come from dividends.
It says nothing about biasing a portfolio to high yield stocks.
Even low yielding stocks can deliver more return through dividends than through capital growth.
@Rob: The beta investor link says that 100 pounds invested in 1945 would have grown to 7401 pounds without dividends and 131,469 pounds with reinvested dividends. A misguided dividend investor then concludes that (131,469 – 7401)/(131,469 – 100) = 94.4% of the returns come from dividends.
A similarly misguided capital gains investor might calculate that if there had been no capital gains at all, then reinvesting dividends would have grown the 100 pounds to only 1776 pounds. Then he concludes that (131,469 – 1776)/(131,469 – 100) = 98.7% of the returns come from capital gains.
Both conclusions are nonsense.
The data on the betainvestor site is from Barclays.
The important factor here is the power of compounding those returns over a long period of time.
Those reinvested dividends will deliver both capital and dividend returns.
Reinvesting dividends is easy because of the cash thrown off. It is is just not so easy to harvest capital in the same mechanistic way.
@Rob: The data on the Beta Investor site is from Barclay’s, but the statement “the bulk of the returns delivered by the equity market come from dividends, growth in dividends, and gains from reinvesting the dividends” did not come from Barclay’s (I read Barclay’s 2012 report). Barclay’s would not say this because it is highly misleading.
It’s true that investors should not just throw away dividends. But the claim that “Reinvesting dividends is easy” but that “It is is just not so easy to harvest capital in the same mechanistic way” is utter nonsense. To harvest capital gains on stocks that pay no dividends, all one has to do is buy them and go to sleep. There is no need to reinvest anything.
Well I guess we will just have to disagree.
It suits me. The fewer people agree the more stocks are mispriced.
This is why many successful investors won’t publish the strategies that are working for them.
Market Anomalies? Sure – this might have some influence
Destructive Behaviours? Definitely – Much like poker (Hold’em) this is why the majority of inexperienced traders fail.
In my opinion once a strategy goes mainstream and has considerable traction from the general public, it also leaves room for market manipulation from the big boys …
Just my .02c!