From the April 2013 issue of Research Magazine • Subscribe!

April 1, 2013

Experts Tackle Theories, Trends at Event

(Hollywood, Fla.) The Morningstar Ibbotson Conference 2013 had an informative and ground-breaking start to its Feb. 21-22 agenda with Roger Ibbotson’s talk about market theories that fall apart under close scrutiny. Ibbotson, who is the founder of Ibbotson Associates (now part of Morningstar), a Yale professor and the chairman of Zebra Capital Management, revealed findings from an unpublished study that he and Daniel Kim, research director of Zebra Capital, recently completed.

Ibbotson said, “While in theory, high-beta and high-volatility stocks outperform their low-beta and low-volatility counterparts, in practice it’s the low-volatility and low-beta stocks that outperform.”

The difference? From 1972-2012, the mean performance of low-beta stocks was 14.03%. The result for high-beta stocks was 8.25%. “Low beta beats high beta,” said the investment expert, “and the same is true when you look at low daily and monthly volatility.”

In other words, “The relationship is the opposite of what we are used to thinking about less risk,” Ibbotson pointed out. “This turns 60 years of theory on its head.” This finding, he adds, is both “a gold mine” for experts and a “troubling” development. “Do we smile or get upset? ... I’m in both camps.”

Another surprise revealed by Ibbotson and Kim was that large companies outperform smaller ones when using Fama-French analysis. “Surprisingly, large beats small,” he said. “This is a big surprise.”

In the Fama-French analysis, which looks at beta factors/coefficients, large companies had returns of 12.44% over the 1972-2012 time period on average vs. 9.89% for small. Plus, the larger firms had lower volatility (as measured by standard deviation).

Small companies did outperform when capitalization was examined as the key variable: 13.49% vs. 11.22% for large firms. But large companies do better when their total assets, revenue and net income are taken into consideration.

In other analysis, the latest Ibbotson research found that value beats growth. “In this area, theory and practice are consistent—you get premiums for going into value vs. growth,” the speaker said, noting that value portfolios tend to have lower risk.

The researchers also found that less-liquid stocks outperform their more-liquid counterparts as measured by two different analytical methods. One method, for instance, found that less-liquid stocks had returns for 14.74% over the last 40 years vs. 10.77% for more-liquid issues. “But, the risks differ,” Ibbotson said. “Less-liquid stocks are higher risk.”

The standard deviation (or beta) was 24.6% for the less-liquid stocks vs. 19.35% for the more-liquid issues. Overall, Ibbotson said, “The lower-turnover stocks give you the greater returns at lower risk than value stocks do, and coming in a close second are the low-beta, low-volatility shares.”

Investor Intelligence

While mutual fund investors may have problems over the timing of when to buy and sell funds, they aren’t really “dumb” in the traditional or theoretical sense, says John Rekenthaler, vice president of research for Morningstar. He and his colleagues looked at why investors were “not making money that one might expect from funds,” a conundrum they defined as the “return gap.”

Most analysis looks at total returns, which are time-weighted, and compares them to investor returns, which are dollar-weighted. But the Morningstar experts decided to calculate a money-weighted measure of returns to help them assess a fund’s internal rate of return and then compare these numbers with time-weighted returns. 

The result? A return gap, which could help the analysts better assess investor behavior.

From 2002-2012, the initial research revealed that this gap was 1.01% for domestic-stock funds, 3.11% for international-stock funds, 1.35% for municipal bonds, 0.87% for taxable-bond funds, and 0.84% for allocation funds.

The Morningstar team then dug deeper to look at whether or not investors were buying the “wrong funds,” funds with high charges, poor fund managers or the wrong assets. “These are the four ways to get this wrong,” he explained.

The researchers then discovered that investors got fund selection right across the five fund categories (mentioned above). They also concluded that investors were overpaying. 

“The expenses are larger than the benefits of their fund selection,” said Rekenthaler, implying that there should be continued fee pressure on fund companies.

Other conclusions of the research? Fund managers overall are not buying the wrong securities, but investors are allocating their assets in a less-than-stellar fashion. The rigorous analysis also found that the return gap combined with investor selection produces an overall gap in investors’ performance versus that of index funds of 1.38% for domestic-stock funds.

This is related to expenses (0.72%), the manager (0.33%) and asset allocation (0.33%). “The biggest negative is expenses,” Rekenthaler said. “And investors are hurting themselves by [poor] asset-allocation decisions, like moves they made to get out of emerging-market funds in the ’08-’09 timeframe, for example.”

That is bad news for investors, but it is a positive situation for advisors, who can help turn this situation around, he and other Morningstar experts point out. 

Economic Trends

An economist with the Federal Reserve Bank of St. Louis, who spoke at the conference, said there were several factors that prompted him to “make the case for stronger growth in 2013.” 

Kevin Kliesen, who shared his own views (not necessarily those of the Federal Reserve System), also cautioned “that economic momentum weakened over the last three months of 2012, though there were pockets of strength in key areas.”

Kliesen pointed out that the St. Louis Financial Stress Index, which tracks 17 indicators (including risk spreads), is now lower than its long-run average level. Plus, “Some calm has returned to European sovereign debt markets,” he said.

An additional positive factor is that business capital spending is rebounding, after remaining in a lull for most of 2012. “Financial market conditions are supportive of faster growth,” he said, “and there is not much worry about inflation in the near future.”

The economist shared three other sets of reasons behind his expectation that the economy will have a strong year in 2013: Consumer spending is improving, forecasters expect long-term interest rates to stay low, and household wealth should keep improving; housing fundamentals “look good,” inventories are low, prices are moving higher, labor markets are seeing improvement, and affordability is high; plus, housing growth is usually followed by growth in business capital spending.

“It appears that most, if not all, of the excess housing inventory has been worked off,” Kliesen said. The economist also outlined several trends that do not bode well for the U.S. economy in the longer term.

One of his main concerns is the impact of the jump in the payroll tax, “which should have a significant impact on the low and middle strata of consumers.” Compounding that problem and its impact on growth will be fiscal policy, he noted. These shifts could lead to a 1.2% drop in consumption during the first half of 2013 and a 2.5% decline in the second half, said Kliesen, pointing to Goldman Sachs’ estimates.

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