Swedroe: Anomalies Can Mean Alpha

May 13, 2015

 

Among the low-turnover (and thus low-cost) anomalies are size; gross profitability; value; combining value and profitability; and investment. Among the mid-turnover strategies are momentum; combining value and momentum; combining value, momentum and profitability; and idiosyncratic volatility. Among the high-turnover strategies are industry momentum and industry-relative reversals.

 

Results

The following is a summary of the authors’ findings:

  • The cost of trading the low-turnover strategies is generally quite low, often less than 10 bps per month.
  • Most of the anomalies considered that had one-sided monthly turnover lower than 50 percent continued to remain significantly profitable, at least when the strategies were designed to mitigate transaction costs.
  • The cost of trading the high-turnover strategies, at least when they were designed with complete disregard for trading costs, always exceeded 1 percent per month. Transaction costs significantly exceeded the gross spread for all but two of the anomalies examined, with only the high-frequency combo strategy and the low-volatility industry-relative reversal strategy achieving positive net excess returns. Transaction costs in all cases reduced the strategies’ profitability and associated statistical significance, raising the barriers to arbitrage and increasing concerns related to data snooping.
  • The buy/hold range was the most effective cost-mitigation technique for most of the anomalies considered, though for very-high-turnover strategies (for which transaction-cost mitigation is most important), a combination of all three techniques yielded greater performance enhancements.

In summary, Novy-Marx and Velikov provide strong evidence that at least some “anomalies” (including value, momentum, profitability and investment) survive transactions costs.

 

What’s more, their paper provides further evidence supporting the findings of a 2012 study—“Trading Costs of Asset Pricing Anomalies” by Andrea Frazzini, Ronen Israel and Tobias Moskowitz—that also concluded value and momentum survive trading costs. Novy-Marx and Velikov also provide evidence that “intelligent design” (some would use the term “smart beta”) can improve the performance of simple indexing strategies by reducing transactions costs.


Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country. 

 

 

 

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