Swedroe: The Best Returning Styles

October 28, 2014

For evidenced-based investors, it’s easy enough to measure the best-returning investment styles.

In their January 2014 study “Risk and Return Within the Stock Market: What Works Best?” authors Roger G. Ibbotson and Daniel Y.-J. Kim examined the return-predictive characteristics of some well-known investment styles: beta, volatility, size, value, liquidity and momentum.

Their study covered the 42-year period from 1971 through 2012, and included the largest 3,000 stocks in the U.S. CRSP database. Following is a summary of their findings, which basically serve to confirm prior research:

1. Beta/Volatility

Defying economic theory that risk and return should be positively related when ranking stocks either by beta or volatility, the authors found that the highest quartile of stocks had the lowest returns.

However, the relationship isn’t linear. The annual average return from the lowest quartile to the highest quartile beta stocks were 16.0 percent, 16.5 percent, 15.4 percent and 13.0 percent, respectively. Similarly, when ranking stocks by daily volatility, the returns from the lowest quartile to the highest were 15.3 percent, 16.4 percent, 16.5 percent and 12.8 percent, respectively.

The common explanation is that leverage-aversion on the part of some market participants resulted in the popularity of high-volatility, high-beta securities. Their popularity pushes up prices and reduces returns. The bottom line is that it’s not that low volatility is good, it’s that high volatility is bad.

2. Size

Small-cap stocks outperform large-cap stocks. When ranking stocks by market capitalization from the smallest to the largest quartile, the annual average returns were 17.4 percent, 15.2 percent, 15.0 percent and 13.3 percent, respectively. Here, risk and return were positively related as the smallest stocks had the highest standard deviation and the relationship was monotonic.

3. Value

Value stocks outperform. It doesn’t matter whether the valuation metric was price-to-book (P/B) or price-to earnings (P/E), returns decreased monotonically as the sample moved from value to growth quartiles. For example, ranking by P/E, the annual average returns by quartile were 19.1 percent, 15.9 percent, 13.2 percent and 12.7 percent, respectively.

However, again, defying economic theory, the stocks with the lowest P/E ratios not only had higher returns, but lower volatility (a standard deviation of 23.2) than the stocks with the highest P/E ratios (a standard deviation of 28.5).



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