1. Persistent. It holds across long periods of time, and across different economic regimes.
2. Pervasive. It holds across countries, regions, sectors, as well as asset classes.
3. Robust. It holds for various definitions (i.e. the value premium can be measured with price-to-book, earnings, sales, etc…and the momentum premium can be measured on a relative or absolute basis with a variety of lookback periods or moving average parameters)
4. Investable. The strategy holds up not just on paper, but also after real life implementation issues, such as transaction costs.
5. Intuitive. There is a logical risk-based or behavioral-based explanation for the strategy’s return premium, and why it should persist in the future.
Investors would be well served to keep this checklist with them at all times, treating it like a cheat sheet when considering investment ideas, and requiring sources of investment products and recommendations to explain how their strategy meets these minimum criteria for consideration. As the cartoon character Pogo once said, “we have met the enemy, and he is us”, so this type of checklist may help you filter out interesting stories or investment narratives that may sound good, but have little real world evidence. Evidence based investors who treat their investments like a business have no room for anecdotal stories in their process of portfolio construction.
So what are some examples of what academic research suggests does meet our criteria for consideration?
Market beta: This is the return of the total stock market in excess of cash, and can be purchased for just a few basis points in annualized expenses today in the form of index funds and ETF’s. For this reason, there has never been a better time to be an investor. The market beta premium has historically been about 8% per year in the US, and is pervasive in stock markets across the globe. It’s easily explained with a risk-based explanation, which is important as risk cannot be easily or fully arbitraged away.
Size: Small stocks tend to outperform large stocks in both the US and across the world, especially when implemented along with other factors such as value, quality, and profitability. The size premium can largely be thought of as a risk premium as well.
Value: Stocks with low relative prices (value stocks) tend to outperform stocks with high relative prices (growth stocks), based on a variety of different measurements (robustness). The value premium over growth has been 4.8% per year since 1927 in the US, and value has outperformed growth in 86% of rolling 10 year periods and 94% of rolling 20 year periods. There are both risk-based and behavioral-based explanations for the value premium.
Momentum: Securities with recent good (poor) performance have the tendency to continue to produce near term good (poor) performance. It’s the premier market anomaly according to Nobel Laureate Gene Fama, as it’s difficult to apply any risk-based explanation. Instead, it’s explained by human behavior, which is unlikely to change. In our firm, we prefer to implement momentum with broad based equity indices, which minimizes turnover and transaction costs. We also recommend the type of momentum referred to as “trend-following” in building portfolios, which has been done for decades in a long/short manner across dozens of futures market contracts by CTA’s (satisfying our test of investability), offering a unique source of diversification that can be thought of as the “long volatility” part of a diversified portfolio.
Term: On the fixed income side, this is the premium (higher expected return) you earn for taking term risk by owning a 5 year bond instead of T-bills or money market funds. Or a 10 year bond instead of a 5 year bond, and so on. By focusing your bond portfolio on government and high quality investment grade securities, you minimize exposure to the other primary factor that influences bond returns, which is credit risk. High quality and government bonds also tend to act as a ballast during periods of stress in the equity market.
Volatility risk premium: This is what academics refer to with regard to explaining the expected returns associated with selling options. It’s a premium that can be explained by risk, but also behavior, and meets all of the tests when done in simple and repeatable ways like cash secured puts, strangles, or covered calls. Selling puts can be thought of as selling insurance, and selling calls can be thought of as selling lottery tickets. No rational investor would accept the risk of selling options where payouts are limited and losses can be substantial (creating undesirable negatively skewed risk/reward profiles) without the expectation of earning a positive average return, which is why we see a persistent and pervasive spread between implied volatility and realized volatility in the options markets.
Most portfolios only have two of these risk factors…market beta (even then, most people own too much of their market beta in their home country, i.e. US, and make the mistake of gaining exposure to market beta through high cost actively managed funds) and term risk via bond funds. By diversifying across these different sources of expected returns, your portfolio becomes more stable (higher Sharpe Ratios) in exchange for occasional tracking error regret…when a single source of return, i.e. US market beta, dominates for several years, those who have a more diversified portfolio may feel short term regret that is very real and hard to ignore. And that’s where this post ends, in that even as a well educated investor, long term real-life investing success is likely to be influenced as much by investor behavior as it is investment performance. As Warren Buffett has said, “It won’t be the economy that will do in investors, it will be investors themselves.”
For those interested in reading more about these concepts, we recommend the books and articles of Larry Swedroe, including his recently updated book, “Reducing the Risk of Black Swans”.
Jesse Blom is a licensed investment advisor and Vice President of Lorintine Capital, LP. He provides investment advice to clients all over the United States and around the world. Jesse has been in financial services since 2008 and is a CERTIFIED FINANCIAL PLANNER™ professional. Working with a CFP® professional represents the highest standard of financial planning advice. Jesse has a Bachelor of Science in Finance from Oral Roberts University. Jesse oversees the LC Diversified forum and contributes to the Steady Condors newsletter.