Peter Berezin, chief strategist at BCA Research, reminded delegates at the 69th CFA Institute Annual Conference of the certainty that, net of fees, the average active investor will underperform the stock market.
Yet empirical data also suggest that there are a number of market anomalies that have persisted over time, and disciplined investors can exploit them to generate outsized returns. Overweighting low-beta stocks, small-cap stocks, value stocks, and stocks with significant insider buying are just some of the ways equity fund managers can produce alpha. Wall Street research, relative price strength, and trading volumes also contain signals for astute investors.
Anomalies persist even though people know about them. They may not be as potent as they once were, but still there, says Berezin. #CFAInvest
— Advisor.ca (@advisorca) May 9, 2016
To further boost returns, Berezin advised paying attention to the macroeconomic picture. Recognizing that the performance of certain stocks is tied to factors like interest rates and currency movements, his firm developed a trading algorithm that incorporates macroeconomic data and more than 30 anomalies.
Berezin opined on some of the most compelling anomalies.
- Low beta: Berezin noted that investment theory — namely, the capital asset pricing model (CAPM) — tells us that high-beta stocks offer higher expected returns because they carry more risk. History shows, however, that high-beta stocks have not outperformed the broader market. Berezin blamed the incentive structure in place for most active managers, particularly hedge fund managers. It’s become a “heads I win, tails you lose” proposition that encourages excessive risk taking. Fund managers buy high-beta stocks, pushing up their prices well beyond fair value and reducing their expected returns. As a result, low-beta stocks outperform.
- Small cap: In the US, small-cap stocks have outperformed their large-cap peers by an average of 2.7% per year since 1926. Among the most widely acknowledged anomalies, small-cap outperformance has been attributed to the dearth of analyst coverage, thin trading volumes, and acquisitions.
- Value: Berezin took issue with arguments that tie the value premium to the notion that value stocks are more risky, pointing out that these stocks tend to do best in weak markets. He thinks value stocks are too often mislabeled as “distressed” companies. He explains the value premium as a simple case of the market “getting things wrong.”
- Wall Street research: According to Berezin, forecasting earnings with any degree of precision is “a mug’s game.” In other words, it’s futile, and the data support this conclusion. Beyond one year, there is little to no correlation between earnings estimates and actual earnings. And while the evidence suggests that buy-and-sell recommendations from Wall Street analysts typically don’t add value, Berezin found some exceptions. When an analyst issues a “sell” recommendation on a small-cap stock, it pays to listen. Similarly, stocks that have been recently upgraded tend to outperform those that have recently been downgraded.
- Insider ownership: The data suggest that insider activity is worth paying attention to, and Berezin added that combining short interest produces an even stronger signal for investors. The best returns are from “companies whose insiders are buying and short interest is decreasing.”
- Momentum: There is a sweet spot when it comes to momentum. It seems to work best when viewed over a 12-month period. Reversals are typically seen in short-term (one-month) and long-term (five-year) periods.
- Volume: The old trading adage that a stock experiencing high turnover has “healthy volume” is misleading. In fact, low-volume stocks — occasionally undiscovered “jewels” — tend to outperform high-volume stocks.
Why do these anomalies persist? Berezin blamed deeply embedded institutional incentives and behavioral biases and concluded that rational thinkers could “exploit these anomalies in a meaningful and profitable manner.”
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Photo courtesy of W. Scott Mitchell