Making the most of equity market anomalies

Jason Kim and Tim Johnston explore how investors can tap into three consistent sources of outperformance in equity portfolios – value investing, low beta portfolios and concentrated portfolios.

Value has outperformed growth in the long term

There have been many studies on various equity markets that show value has consistently outperformed growth. Typically, these studies defined value stocks as those with low ‘Price to Book’ ratios, or in some cases, low ‘Price to Historical Earning’ ratios. 

Of course, this fact would come as no surprise to the many famous value investors, such as Warren Buffett and John Templeton, who have enjoyed enduring success following a value-based approach.

Australian market style indices produced by S&P/Citigroup, show that during the period October 1989 to January 2014, value investing in Australia has outperformed growth investing (see figure 1), as has been shown for the global share market. 

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During this period, value investing in Australia produced a return of 10.87 per cent per annum, while growth investing produced a return of 8.87 per cent per annum.  This means that value outperformed growth by 2 per cent per annum.  In dollar terms, if $100 was invested in the S&P/Citigroup Value Index during this time period, it would have accumulated to $1,221 by January 2014, whereas for growth, the amount would have been materially lower at $786. 

A cynic may argue that the only reason why value outperformed growth is because value shares are riskier than growth shares. Many value investors would totally disagree with this statement, and would argue that value investing is actually less risky than growth.  

One measure of risk is the volatility of returns as measured by the standard deviation of returns.  As figure 2 shows, value has been less volatile than growth with a standard deviation of 13.51 per cent per annum versus 14.27 per cent per annum for growth. 

Another measure of risk is beta, which is essentially a measure of market risk and strips out the impact of stock-specific risk, which can be diversified away. As figure 2 shows, value has had less market risk than growth, with a beta of 0.97 versus 1.03 for growth.  

This analysis thus shows that not only has value outperformed growth by a significant margin, but it has done so with less risk.

Lower beta portfolios outperform higher beta portfolios

There have been numerous empirical studies showing that lower volatility portfolios, and in particular, lower beta portfolios, outperform higher beta portfolios.  This phenomenon is widespread and applies to most equity markets, including the US and Australia.  

Clearly, this is contrary to the Efficient Market Hypothesis and the well-known investment axiom of “the higher the risk, the higher the return”.

Certainly, as shown above, as value portfolios tend to have a lower beta and have outperformed in the long run, value is one potential subset of lower beta portfolios.

The authors of the Efficient Market Hypothesis, Eugene F. Fama and Kenneth R. French , subsequently wrote “…funds that concentrate on low beta stocks, small stocks, or value stocks will tend to produce positive abnormal returns… even when the fund managers have no special talent for picking winners.” 

MSCI produces minimum volatility returns based on the MSCI index constituents, which is a proxy for low beta portfolios.  It is constructed using the Barra risk model and is subject to holding constraints by stock and sector. 

As figure 3 (next page) shows, the MSCI Minimum Volatility Index has outperformed the MSCI broader market index by 0.38 per cent per annum – despite targeting lower beta (or lower risk) portfolios by construction.

Why will value and low beta continue to outperform? 

If value as well as lower beta has consistently outperformed in the past and has done so for less risk, then isn’t it only a matter of time before investors arbitrage this away? If this was true, then these ‘anomalies’ should have disappeared a very long time ago, as they have been well known and documented for many years. In fact, these so-called anomalies are a permanent feature of the share markets. 

The real answer for why value investing and lower beta investing has outperformed and why it should continue to do so may be answered by delving into behavioural finance.

Time and time again, history has repeated itself with the various booms and busts of share markets, and speculative bubbles within the share market itself as investors chase the latest fads and ‘fashionable’ stocks. In each case, the markets have corrected themselves. There are numerous examples of varying degrees that have occurred in individual stocks, individual sectors, in whole countries and regions. They have occurred in so called ‘growth’ stocks which become ‘high beta’ stocks as they rise quickly relative to the market in a short period of time. 

In each and every case, a great opportunity was created for those investors who stayed with value and did not get caught up in the hype. These opportunities will periodically present themselves into the future due to the psychology of investors as inevitably, history will repeat itself again and again.

Diversification or “diworsification”: The case for concentrated portfolios

A third source of outperformance for equity portfolios is concentrated portfolios.  Studies have shown that concentrated portfolios are more likely to outperform their more diversified counterparts. 

One such study, conducted in 2006 by Jeffrey A Busse, T Clifton Green and Klass Baks at the Emory University concluded that “…focused (ie concentrated) managers outperform their more broadly diversified counterparts by approximately 30 basis points per month, or roughly 4 per cent annualised”. 

Another group of academics (Randolph B. Cohen, Christopher Polk and Bernhard Silli)  have found that institutional managers do have some identifiable skill in picking stocks. The researchers evaluated the performance of institutional investors’ ‘best ideas’, which they defined as being those stocks with the highest active positions. 

Figure 4 sourced from Cohen, Polk and Silli’s Best Ideas paper, shows the alpha generated by portfolio managers’ best idea, second best idea, down to their tenth best idea. What is evident is on average a manager’s largest active positions do in fact add significant value. 

This is an interesting finding given the widespread belief that institutional active managers as a group do not add value, especially after fees. Given the research from Cohen, Polk and Silli indicates managers actually can identify stocks which will outperform, why then, as a group are they not capable of adding value to investors’ portfolios?

The question is seemingly answered by another interesting finding from the research. Diversification within individual portfolios increased materially over the past 30-odd years. Figure 5 shows the growth in the average number of companies held in US mutual funds doubled between 1984 and 2007. It suggests that while institutions are capable of finding good investments, they dilute the benefit through excessive diversification. 

Jason Kim and Tim Johnson are portfolio managers and senior analysts at Tyndall Asset Management.