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Strategies Reprinted from Morningstar magazine

April/May 2015

How Popularity Drives Returns

When it comes to the many dimensions
of investing, its hip to be square.

Quant U ASSET ALLOCATION and people use different ways to measure

52 In Search of the Rational Investor Thomas Idzorek popularity. Disentangling the drivers and measures
of popularity isnt always clean cut. I find it
Investment Research easiest to say that popularity is multifaceted and
56 Impact of Energy Prices on High-Yield Bonds Last summer, Roger Ibbotson and I were invited that there are numerous dimensions to popularity.
60 Share the Wealth to contribute an article for the 40th anniversary
edition of The Journal of Portfolio Management. The relative popularity of something within its
Best Ideas Our article, Dimensions of Popularity, puts category is inevitably going to change over time.
64 Keeping the Faith forth a new framework for understanding risk For categories such as clothing styles, TV
66 Really Cheap Real Estate premiums and so-called market anomalies that are shows, and music, the popularity of the constitu-
68 Forging Profits inconsistent with the traditional risk-and-return ents seems to change quickly. For categories such
paradigm. When it comes to investing, it all comes as places to live and U.S. states, popularity
down to popularity. typically changes slowly, and the exact catalyst of
change can be hard to predict. This movement
Before looking at investments, lets consider in relative popularity is a naturally occurring social
the traditional concept of popularity. What makes phenomenon and visible in countless settings.
some people more popular than others? Why
do some TV shows attract millions of viewers and It is inevitable that the most popular items will
others only thousands? Why was Sophia the eventually decrease in popularity and the least
most popular baby name for girls in 2014 and popular items will increase in popularity. This isnt
Cadence only the 100th? Within categories to say that the least popular will become the
such as people, TV shows, and girls names, how most popular, or vice versa; rather, it is to say that
does popularity evolve over time and what are popularity changes.
the implications of changes in popularity?
Being too popular can be a bad thing. At
To download and read The Dimensions Im going to go out on a limb and suggest that some point, a high level of absolute popularity
of Popularity in the Journal of Portfolio among U.S. states, California is more popular than becomes unsustainable and will result in a
Management, please visit http://www.iijournals. South Dakota. I recognize that for some, South decrease in relative popularity. New wave nudges
com/doi/abs/10.3905/pa.2015.2.4.102 Dakota is superior, but for our purposes, we are away disco; wide lapels become thin; pleated
interested in the collective or aggregate popularity pants are replaced by flat fronts; the iPhone
of one state versus another state. What makes destroys BlackBerry; downtown areas boom, fall
one state more popular than another? Common into disrepair, and regentrification begins. Clich
answers might be the weather, geography, schools, phrases like what goes up, must come down
and the job market. How might we measure and too much of good thing is a bad thing seem
a states popularity? Measures might include to reflect somewhat universal phenomena
population size, the number of major cities, the that are consistent with ever-changing popularity
number of visitors per year, and survey responses. dynamics. As more people have moved to
California, housing prices, pollution, traffic,
For a category and its constituents, popularity is brown-outs, and water shortages have increased.
complex. Different factors contribute to popularity, On the other hand, a state such as South Dakota

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Strategies Reprinted from Morningstar magazine
April/May 2015

inevitably becomes more popular. Few could have For decades, academics have attempted When speaking of risk in this context were
predicted the impact shale oil would have on to develop models, frameworks, and theories that thinking of it in terms of the capital asset pricing
South Dakota. There has been a dramatic increase explain how the capital markets work. Broadly, model, or CAPM, in which the expected return
in jobs, economic activity, and housing prices. there are two major campsequilibrium efficient of an asset should be proportional to its variance
South Dakota may not be as popular as California market and behavioral finance. and correlation with the market. A stock with
in absolute terms, but among states, it has high variance and relatively high correlation with
certainly become more popular. The Equilibrium Camp the market should have a higher expected return
The equilibrium efficient market camp grew out than a correlated stock with lower variance.
These same dynamics are at work in investing. of the 1960s and 1970s. Considerable effort was Likewiseand this is an important subtlety
Strategies that systematically purchase a basket of spent defining different forms or levels of market a stock with high variance but low correlation with
unpopular investments, as defined by a character- efficiency (strong versus semistrong versus weak), the market should be expected to have lower
istic or measure (i.e., a dimension of popularity), arguing that investors are rational, debating returns than its highly correlated counterpart.
seem to outperform a basket of popular invest- which level of efficiency was most accurate, and This is because the stock with the lower correlation
ments. The root cause is the inevitable reranking unfortunately, discouraging alternative frame- will do relatively well when the market is doing
along one of the dimensions of popularity and works. Today, it would be impossible to argue for badlyit will pay off when needed most.
the corresponding increase in an assets price that perfect market efficiency, but the risk-and-return
is associated with an increase in popularity. paradigm that is synonymous with what we call Historical data suggest that for a number of the
Best of all, this framework seems to explain all of Modern Portfolio Theory continues to dominate our major asset classes, higher risk comes hand
the well-known market premiums and anomalies. perception of how and why capital markets in hand with higher returns, thus supporting the
function the way they do. Put simply, according equilibrium efficient market camp. EXHIBIT 1
At this point, one might ask what the difference is to the traditional risk-and-return framework, more shows the standard Ibbotson Stocks, Bonds, Bills,
between a market premium and an anomaly. risk should come with more return. and Inflation chart displaying the growth of $1

Higher Risk, Lower Popularity, Higher Returns In keeping with CAPM, Ibbotsons classic Stocks, Bonds, Bills, and Inflation
chart clearly shows the risk premium. If we go one step further and assume that more risk is unpopular and less risk is popular,
we see that that less-popular asset classes earned the best returns.
Small Stocks Large Stocks Corporate Bonds Government Bonds Treasuries Ination $
Geometric Arithmetic Standard
Mean (%) Mean (%) Deviation (%)
Large Stocks 10.1 12.1 20.1 10K
Small Stocks 12.2 16.7 32.1 5.3K
Corporate Bonds 6.1 6.4 8.4
Government Bonds 5.7 6.1 10.0
Treasury Bills 3.5 3.5 3.1
135.2 100
Inflation 2.9 3.0 4.1

13.1 10

12/1925 12/1935 12/1945 12/1955 12/1965 12/1975 12/1985 12/1995 12/2005 12/2014 0.1
Source: Ibbotson SBBI indexes.

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Strategies Reprinted from Morningstar magazine
April/May 2015


from 1926 to 2014 and the embedded table The Value Anomaly The Fama-French by turnover or the Amihud measure of liquidity).
with compounded returns and standard deviations Each of the premiums corresponds with lower
value indexes had higher returns
for these major asset classes. Here, we can realized risk.
see that higher risk has resulted in higher returns.
and lower standard deviations than
those of the growth indexes. EXHIB IT 3 borrows from the 2014 Ibbotson
Government bonds provided a duration premium SBBI Classic Yearbook. Monthly data for the largest
Growth over Treasury bonds, large stocks an equity FF Small Value FF Small Growth 3,500 U.S. stocks by capitalization from 1972
Growth premium $over bonds, and small stocks a size FF Large Value FF Large Growth $ to 2014 are used to form four annually rebalanced
100Kover large stocks. All of these
premium 94.2K100K quartiles of stocks. The quartiles are based
premiums came with more risk; thus, it would 10.8K on turnover rate (number of shares traded during
be appropriate to characterize them as the year divided by the number of shares
risk premiums. 2.6K 10K outstanding for the stock). Notice that similar
10K 1.9K to the value premium anomaly, the quartiles
Corporate bonds provided a credit premium over 1K of less-liquid stocks had higher returns with
government bonds, another example of trading risk lower risk.
for return. From a CAPM-type perspective in which 100
expected1Kreturn is a linear function of market Given that these premiums come with lower risk,
risk, each premium is directionally consistent with they are often thought of as anomalies because
the risk-and-return paradigm. If we assume that they are not consistent with the traditional
more risk is unpopular and less risk is popular, more-risk, more-return paradigm.
100 1
we see that less-popular asset classes earned
the best returns. As such, efficient market theory In the case of the value premium, in which value
is consistent with our popularity framework. 1927 1956 1985 2014 0.1 is typically thought of as stocks with lower-
10 Year-end than-normal price/book values, suggesting some
From a total debt-issuance perspective, Treasury sort of distress, one might argue that there
bills have been more popular than government Geometric Arithmetic Standard is an increased risk of bankruptcy, which while
bonds. Similarly, from a market-capitalization Mean (%) Mean (%) Deviation (%) highly unlikely would be a catastrophic event
1 large-cap stocks have been more FF Small Growth 9.44 14.01 32.84 greater than the volatility one might associate
popular than small-cap stocks. with growth stocks. While I dont particularly
FF Small Value 14.07 18.70 32.32
like this explanation, it's possible that eventually
While harder to measure, during the history Source: Fama-French data library. the value premium will be accompanied with
2014 depicted0.1in the SBBI chart, equity investing has greater risk.
(YE) been substantially democratizedwith the
creation of the first modern mutual fund in the The astute reader at this point might note the
1920s, steady decreases in trading costs, documented premiums that seemed to be apparent inconsistency in the popularity
the first index funds in the 1970s, and more realized at lower (not higher) risk levels and, thus, framework related to the idea of high risk being
recently the advent of exchange-traded funds. were characterized as market anomalies. bad or unpopular, yet the apparent desirable
This democratization has increased equity characteristic of low volatility or low beta being
investings relative popularity. An increase in its Perhaps the first and best known anomaly in the better returning characteristic on that
popularity seems to have corresponded with a which a premium was accompanied with low risk particular dimension of popularity. That is, on the
substantial return premium over bonds. was the value premium, in which value stocks surface, the low-vol and low-beta anomalies
seemed to produce higher returns than growth that have been documented would appear to be
The Behavioral Camp stocks at lower realized risk levels. Borrowing from unexplained by the theory of popularity.
The more-risk, more-return paradigm seems to hold the 2014 Ibbotson SBBI Classic Yearbook, the table
among asset classes, but it doesnt necessarily in E X H I BI T 2 highlights the Fama-French small- Looking deeper, however, an explanation that
hold at the security level and subasset-class growth and small-value indexes. It shows that the seems to square with it comes from Fischer Black:
levels. By the 1990s, strong-form market efficiency small-value index had a better return and a lower the theory of leverage aversion. Recently, Blacks
was no longer in vogue; the work of behavioral standard deviation than the small-growth index. theory of leverage aversion has been dusted off
economists such as Richard Thaler, Daniel by Asness, Frazzini, and Petersen as an explana-
Q4 Kahneman, $ and Robert Shiller was gaining Q1recently,
More Q2 documented
Q3 Q4
anomalies include low$ tion for why risk parity may work. According to the
1Kand there were a growing number of volatility, low beta, and low liquidity (as measured1K theory of leverage aversion, costs and restrictions

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Strategies Reprinted from Morningstar magazine
April/May 2015


The Liquidity Premium The quartiles securities that have done well in the recent past a rapid decrease (or crash) in popularity. Presum-
seem to continue to do well (before experiencing ably, this rapid change in popularity is related to a
of less-liquid stocks had higher returns
some sort of reversal). Momentum is a topic variety of different characteristics or dimensions of
with lower risk than the quartiles that Roger and I continue to discuss a lot. While popularity that are likely transitory in nature.
of more-liquid stocks. it doesnt seem to fit quite as nicely as I would like
with our popularity framework, I am not quite Explanation 2: It is possible that momentum is still
Q1 Q2 Q3 Q4 $ ready to throw in the towel. Here goes. related to one of the more permanent premiums
440.0 1K or anomalies, but rather than a slow, steady
We have not identified all of the different movement or change along one of the dimensions
333.0 characteristics (or dimensions of popularity) that of popularity (something Fama and French call
163.6 could affect an assets price. The world of migration as it relates to movement along the size
finance has identified the big characteristics that and value spectrum), there is a change in the rate
go hand in hand with the premiums and anomalies of movement or migration.
26.2 I have been discussing. We are often asked
10 why these premiums don't disappear upon Popularity as a Framework
discovery. These major premiums and anomalies The idea of investing in so-called unpopular
seem to be related to near-permanent or securities isnt new. Likewise, the idea that within
systematic investor preferences: Risk is unpopular; any given category of thingspeople, actors,
1 small (by dollar votes) is unpopular; value is beaten songs, fashion, pets, and investmentsthat some
down, distressed, and out of favor, and, dare items are more popular than others is clearly
I say, unpopular; credit risk representing an not new. A wider range of contrarian investment
1972 1986 2000 2014 0.1 increased possibility of a default is unpopular; the approaches has been around for a long time.
Year-end instability to sell a less-liquid investment without As Roger and I point out in our paper, more than
a significant price reduction is unpopular; etc. 80 years ago in Security Analysis, Ben Graham and
Wealth Indices of Investments in Low to High Quartiles of Liquidity in
It is hard to see these preferences changing, and David Dodd (1934) wrote:
NYSE/AMEX/NASDAQ Stocks. Cumulative Total Returns: Index (Year-End
1971 = $1.00). if they did reverse for some reason, the popularity
framework would still work. [T]he market is not a weighing machine, in which
Liquidity Geometric Arithmetic Standard the value of each issue is registered by an
Range Quartile Mean (%) Mean (%) Deviation (%) Momentum is different; it is clearly linked to rapid exact and impersonal mechanism, in accordance
Less Q1 15.21 17.04 20.15 changes in popularity, but it doesnt seem to be with its specific qualities. Rather we should
attached to a near-permanent investor preference say that the market is a voting machine, whereon
Q2 14.46 16.5 21.34
like the examples above. Like mushrooms that countless individuals register choices which are
Q3 12.58 14.98 22.82 have been shown to produce their own micro- partly the product of reason and partly the product
More Q4 7.89 11.52 27.84 winds, once a catalyst causes momentum of some of emotion.
sort to start, a series of actions from the herd
Source: Morningstar.
seems to be triggered. What I believe is new is coalescing this into a very
simple and intuitive framework that can simultane-
I have two different ways of trying to explain ously explain what may drive or cause these
on borrowing coupled with limits on shorting force momentum using popularity, neither of which is at numerous premiums and anomalies. Furthermore,
investors seeking high returns to buy higher- odds with one another, nor are they necessarily it requires almost no assumptions and seems to fit
beta stocks instead of simply levering up lower-risk mutually exclusive. nicely with both efficient market theory and
stocks or some proxy of the market portfolio. behavioral finance. Ill admit, finding such a simple
Thus, given the inability to borrow at low rates to Explanation 1: In contrast to the characteristics explanation is nice, but given the fickle nature of
increase portfolio returns, high-volatility and associated with the well-known premiums and popularity and our inability to fully understand
high-beta stocks are overly popular; this, in turn, anomalies that seem to be attached to near- what drives popularity, there is still much work to
suggests that the low-vol and low-beta anomalies permanent investor preferences (stationary be done. K
are consistent with the popularity framework. attitudes around what is good or bad), there are
unknown or less-well-known and short-lived Thomas Idzorek, CFA, is the head of investment
methodologies and economic research at
Momentum Conundrum characteristics that are more akin to a fad, in
Morningstar. He is a member of the editorial board
The final well-known anomaly that has been which there is a rapid change in popularitytypi- of Morningstar magazine.
challenging to explain is momentumin which cally a dramatic increase in popularity followed by

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