Strategies
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
52 In Search of the Rational Investor Thomas Idzorek
Investment Research
56 Impact of Energy Prices on High-Yield Bonds Last summer, Roger Ibbotson and I were invited
60 Share the Wealth to contribute an article for the 40th anniversary
edition of The Journal of Portfolio Management.
Best Ideas Our article, Dimensions of Popularity, puts
64 Keeping the Faith forth a new framework for understanding risk
66 Really Cheap Real Estate premiums and so-called market anomalies that are
68 Forging Profits inconsistent with the traditional risk-and-return
paradigm. When it comes to investing, it all comes
down to popularity.
Before looking at investments, lets consider
the traditional concept of popularity. What makes
some people more popular than others? Why
do some TV shows attract millions of viewers and
others only thousands? Why was Sophia the
most popular baby name for girls in 2014 and
Cadence only the 100th? Within categories
such as people, TV shows, and girls names, how
does popularity evolve over time and what are
the implications of changes in popularity?
To download and read The Dimensions Im going to go out on a limb and suggest that
of Popularity in the Journal of Portfolio among U.S. states, California is more popular than
Management, please visit http://www.iijournals. South Dakota. I recognize that for some, South
com/doi/abs/10.3905/pa.2015.2.4.102 Dakota is superior, but for our purposes, we are
interested in the collective or aggregate popularity
of one state versus another state. What makes
one state more popular than another? Common
answers might be the weather, geography, schools,
and the job market. How might we measure
a states popularity? Measures might include
population size, the number of major cities, the
number of visitors per year, and survey responses.
For a category and its constituents, popularity is
complex. Different factors contribute to popularity,
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Reprinted from Morningstar magazine
and people use different ways to measure
popularity. Disentangling the drivers and measures
of popularity isnt always clean cut. I find it
easiest to say that popularity is multifaceted and
that there are numerous dimensions to popularity.
The relative popularity of something within its
category is inevitably going to change over time.
For categories such as clothing styles, TV
shows, and music, the popularity of the constitu-
ents seems to change quickly. For categories such
as places to live and U.S. states, popularity
typically changes slowly, and the exact catalyst of
change can be hard to predict. This movement
in relative popularity is a naturally occurring social
phenomenon and visible in countless settings.
It is inevitable that the most popular items will
eventually decrease in popularity and the least
popular items will increase in popularity. This isnt
to say that the least popular will become the
most popular, or vice versa; rather, it is to say that
popularity changes.
Being too popular can be a bad thing. At
some point, a high level of absolute popularity
becomes unsustainable and will result in a
decrease in relative popularity. New wave nudges
away disco; wide lapels become thin; pleated
pants are replaced by flat fronts; the iPhone
destroys BlackBerry; downtown areas boom, fall
into disrepair, and regentrification begins. Clich
phrases like what goes up, must come down
and too much of good thing is a bad thing seem
to reflect somewhat universal phenomena
that are consistent with ever-changing popularity
dynamics. As more people have moved to
California, housing prices, pollution, traffic,
brown-outs, and water shortages have increased.
On the other hand, a state such as South Dakota
 Strategies
inevitably becomes more popular. Few could have
predicted the impact shale oil would have on
South Dakota. There has been a dramatic increase
in jobs, economic activity, and housing prices.
South Dakota may not be as popular as California
in absolute terms, but among states, it has
certainly become more popular.
These same dynamics are at work in investing.
Strategies that systematically purchase a basket of
unpopular investments, as defined by a character-
istic or measure (i.e., a dimension of popularity),
seem to outperform a basket of popular invest-
ments. The root cause is the inevitable reranking
along one of the dimensions of popularity and
the corresponding increase in an assets price that
is associated with an increase in popularity.
Best of all, this framework seems to explain all of
the well-known market premiums and anomalies.
At this point, one might ask what the difference is
between a market premium and an anomaly.
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
Geometric Arithmetic Standard
Mean (%) Mean (%) Deviation (%)
Large Stocks 10.1 12.1 20.1
Small Stocks 12.2 16.7 32.1
Corporate Bonds 6.1 6.4 8.4
Government Bonds 5.7 6.1 10.0
Treasury Bills 3.5 3.5 3.1
Inflation 2.9 3.0 4.1
12/1925 12/1935 12/1945 12/1955
Source: Ibbotson SBBI indexes.
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For decades, academics have attempted
to develop models, frameworks, and theories that
explain how the capital markets work. Broadly,
there are two major campsequilibrium efficient
market and behavioral finance.
The Equilibrium Camp
The equilibrium efficient market camp grew out
of the 1960s and 1970s. Considerable effort was
spent defining different forms or levels of market
efficiency (strong versus semistrong versus weak),
arguing that investors are rational, debating
which level of efficiency was most accurate, and
unfortunately, discouraging alternative frame-
works. Today, it would be impossible to argue for
perfect market efficiency, but the risk-and-return
paradigm that is synonymous with what we call
Modern Portfolio Theory continues to dominate our
perception of how and why capital markets
function the way they do. Put simply, according
to the traditional risk-and-return framework, more
risk should come with more return.
Government Bonds Treasuries
12/1965 12/1975
Reprinted from Morningstar magazine
April/May 2015
When speaking of risk in this context were
thinking of it in terms of the capital asset pricing
model, or CAPM, in which the expected return
of an asset should be proportional to its variance
and correlation with the market. A stock with
high variance and relatively high correlation with
the market should have a higher expected return
than a correlated stock with lower variance.
Likewiseand this is an important subtlety
a stock with high variance but low correlation with
the market should be expected to have lower
returns than its highly correlated counterpart.
This is because the stock with the lower correlation
will do relatively well when the market is doing
badlyit will pay off when needed most.
Historical data suggest that for a number of the
major asset classes, higher risk comes hand
in hand with higher returns, thus supporting the
equilibrium efficient market camp. EXHIBIT 1
shows the standard Ibbotson Stocks, Bonds, Bills,
and Inflation chart displaying the growth of $1
Ination $
100K
27.4K
10K
5.3K
1K
189.8
135.2 100
20.6
13.1 10
12/1985 12/1995 12/2005 12/2014 0.1
 Strategies
from 1926 to 2014 and the embedded table
with compounded returns and standard deviations
for these major asset classes. Here, we can
see that higher risk has resulted in higher returns.
Government bonds provided a duration premium
Growth over Treasury bonds, large stocks an equity
Growth premium $over bonds, and small stocks a size
100Kover large stocks. All of these
premium
premiums came with more risk; thus, it would
be appropriate to characterize them as
risk premiums.
10K
Corporate bonds provided a credit premium over
government bonds, another example of trading risk
for return. From a CAPM-type perspective in which
expected1Kreturn is a linear function of market
risk, each premium is directionally consistent with
the risk-and-return paradigm. If we assume that
more risk is unpopular and less risk is popular,
100
we see that less-popular asset classes earned
the best returns. As such, efficient market theory
is consistent with our popularity framework.
10
From a total debt-issuance perspective, Treasury
bills have been more popular than government
bonds. Similarly, from a market-capitalization
perspective,
1 large-cap stocks have been more
popular than small-cap stocks.
While harder to measure, during the history
2014 depicted0.1in the SBBI chart, equity investing has
(YE) been substantially democratizedwith the
creation of the first modern mutual fund in the
1920s, steady decreases in trading costs,
the first index funds in the 1970s, and more
recently the advent of exchange-traded funds.
This democratization has increased equity
investings relative popularity. An increase in its
popularity seems to have corresponded with a
substantial return premium over bonds.
The Behavioral Camp
The more-risk, more-return paradigm seems to hold
among asset classes, but it doesnt necessarily
hold at the security level and subasset-class
levels. By the 1990s, strong-form market efficiency
was no longer in vogue; the work of behavioral
economists such as Richard Thaler, Daniel
Q4 Kahneman, $ and Robert Shiller was gaining
followers,
1Kand there were a growing number of
2015 Morningstar, Inc. All Rights Reserved. Morningstar, the Morningstar logo, and Morningstar Advisor are
Reprinted from Morningstar magazine
April/May 2015
EXHIBIT 2
The Value Anomaly The Fama-French by turnover or the Amihud measure of liquidity).
Each of the premiums corresponds with lower
value indexes had higher returns
realized risk.
and lower standard deviations than
those of the growth indexes. EXHIB IT 3 borrows from the 2014 Ibbotson
SBBI Classic Yearbook. Monthly data for the largest
FF Small Value FF Small Growth 3,500 U.S. stocks by capitalization from 1972
FF Large Value FF Large Growth $ to 2014 are used to form four annually rebalanced
94.2K100K quartiles of stocks. The quartiles are based
10.8K on turnover rate (number of shares traded during
the year divided by the number of shares
2.6K 10K outstanding for the stock). Notice that similar
1.9K to the value premium anomaly, the quartiles
1K of less-liquid stocks had higher returns with
lower risk.
100
Given that these premiums come with lower risk,
they are often thought of as anomalies because
10
they are not consistent with the traditional
more-risk, more-return paradigm.
1
In the case of the value premium, in which value
1927 1956 1985 2014 0.1 is typically thought of as stocks with lower-
Year-end than-normal price/book values, suggesting some
sort of distress, one might argue that there
Geometric Arithmetic Standard is an increased risk of bankruptcy, which while
Mean (%) Mean (%) Deviation (%) highly unlikely would be a catastrophic event
FF Small Growth 9.44 14.01 32.84 greater than the volatility one might associate
with growth stocks. While I dont particularly
FF Small Value 14.07 18.70 32.32
like this explanation, it's possible that eventually
Source: Fama-French data library. the value premium will be accompanied with
greater risk.
The astute reader at this point might note the
documented premiums that seemed to be apparent inconsistency in the popularity
realized at lower (not higher) risk levels and, thus, framework related to the idea of high risk being
were characterized as market anomalies. bad or unpopular, yet the apparent desirable
characteristic of low volatility or low beta being
Perhaps the first and best known anomaly in the better returning characteristic on that
which a premium was accompanied with low risk particular dimension of popularity. That is, on the
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
stocks at lower realized risk levels. Borrowing from unexplained by the theory of popularity.
the 2014 Ibbotson SBBI Classic Yearbook, the table
in E X H I BI T 2 highlights the Fama-French small- Looking deeper, however, an explanation that
growth and small-value indexes. It shows that the seems to square with it comes from Fischer Black:
small-value index had a better return and a lower the theory of leverage aversion. Recently, Blacks
standard deviation than the small-growth index. theory of leverage aversion has been dusted off
by Asness, Frazzini, and Petersen as an explana-
Q1recently,
More Q2 documented
Q3 Q4
anomalies include low$ tion for why risk parity may work. According to the
volatility, low beta, and low liquidity (as measured1K theory of leverage aversion, costs and restrictions
100either trademarks or service marks of Morningstar, Inc.
 Strategies
EXHIBIT 3
The Liquidity Premium The quartiles
of less-liquid stocks had higher returns
with lower risk than the quartiles
of more-liquid stocks.
Q1 Q2 Q3 Q4
440.0 1K
333.0
163.6
100
26.2
10
1972 1986 2000 2014 0.1
Year-end
Wealth Indices of Investments in Low to High Quartiles of Liquidity in
NYSE/AMEX/NASDAQ Stocks. Cumulative Total Returns: Index (Year-End
1971 = $1.00).
Liquidity Geometric Arithmetic Standard
Range Quartile Mean (%) Mean (%) Deviation (%)
Less Q1 15.21 17.04 20.15
Q2 14.46 16.5 21.34
Q3 12.58 14.98 22.82
More Q4 7.89 11.52 27.84
Source: Morningstar.
on borrowing coupled with limits on shorting force
investors seeking high returns to buy higher-
beta stocks instead of simply levering up lower-risk
stocks or some proxy of the market portfolio.
Thus, given the inability to borrow at low rates to
increase portfolio returns, high-volatility and
high-beta stocks are overly popular; this, in turn,
suggests that the low-vol and low-beta anomalies
are consistent with the popularity framework.
Momentum Conundrum
The final well-known anomaly that has been
challenging to explain is momentumin which
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securities that have done well in the recent past
seem to continue to do well (before experiencing
some sort of reversal). Momentum is a topic
that Roger and I continue to discuss a lot. While
it doesnt seem to fit quite as nicely as I would like
with our popularity framework, I am not quite
$ ready to throw in the towel. Here goes.
We have not identified all of the different
characteristics (or dimensions of popularity) that
could affect an assets price. The world of
finance has identified the big characteristics that
go hand in hand with the premiums and anomalies
I have been discussing. We are often asked
why these premiums don't disappear upon
discovery. These major premiums and anomalies
seem to be related to near-permanent or
systematic investor preferences: Risk is unpopular;
1 small (by dollar votes) is unpopular; value is beaten
down, distressed, and out of favor, and, dare
I say, unpopular; credit risk representing an
increased possibility of a default is unpopular; the
instability to sell a less-liquid investment without
a significant price reduction is unpopular; etc.
It is hard to see these preferences changing, and
if they did reverse for some reason, the popularity
framework would still work.
Momentum is different; it is clearly linked to rapid
changes in popularity, but it doesnt seem to be
attached to a near-permanent investor preference
like the examples above. Like mushrooms that
have been shown to produce their own micro-
winds, once a catalyst causes momentum of some
sort to start, a series of actions from the herd
seems to be triggered.
I have two different ways of trying to explain
momentum using popularity, neither of which is at
odds with one another, nor are they necessarily
mutually exclusive.
Explanation 1: In contrast to the characteristics
associated with the well-known premiums and
anomalies that seem to be attached to near-
permanent investor preferences (stationary
attitudes around what is good or bad), there are
unknown or less-well-known and short-lived
characteristics that are more akin to a fad, in
which there is a rapid change in popularitytypi-
cally a dramatic increase in popularity followed by
Reprinted from Morningstar magazine
April/May 2015
a rapid decrease (or crash) in popularity. Presum-
ably, this rapid change in popularity is related to a
variety of different characteristics or dimensions of
popularity that are likely transitory in nature.
Explanation 2: It is possible that momentum is still
related to one of the more permanent premiums
or anomalies, but rather than a slow, steady
movement or change along one of the dimensions
of popularity (something Fama and French call
migration as it relates to movement along the size
and value spectrum), there is a change in the rate
of movement or migration.
Popularity as a Framework
The idea of investing in so-called unpopular
securities isnt new. Likewise, the idea that within
any given category of thingspeople, actors,
songs, fashion, pets, and investmentsthat some
items are more popular than others is clearly
not new. A wider range of contrarian investment
approaches has been around for a long time.
As Roger and I point out in our paper, more than
80 years ago in Security Analysis, Ben Graham and
David Dodd (1934) wrote:
[T]he market is not a weighing machine, in which
the value of each issue is registered by an
exact and impersonal mechanism, in accordance
with its specific qualities. Rather we should
say that the market is a voting machine, whereon
countless individuals register choices which are
partly the product of reason and partly the product
of emotion.
What I believe is new is coalescing this into a very
simple and intuitive framework that can simultane-
ously explain what may drive or cause these
numerous premiums and anomalies. Furthermore,
it requires almost no assumptions and seems to fit
nicely with both efficient market theory and
behavioral finance. Ill admit, finding such a simple
explanation is nice, but given the fickle nature of
popularity and our inability to fully understand
what drives popularity, there is still much work to
be done. K
Thomas Idzorek, CFA, is the head of investment
methodologies and economic research at
Morningstar. He is a member of the editorial board
of Morningstar magazine.