Want to Win the Investing Game? Bet on the Losers

Alternative weighting of indexes strips emotion out of contrarian investing

If stocks are mispriced and it is possible to determine, generally, which ones are underpriced, why don’t more investors try to take advantage of this? And how can investors go about doing this?

Those are the questions addressed in a new paper from Dr. Vitali Kalesnik, head of equity research for Rob Arnott’s Research Affilliates, known for its fundamental indexing strategies.

The answer to the second question, in short, is to own a fundamental index, but the explanation makes this technical paper, titled “Smart Beta and the Pendulum of Mispricing,” worth reading.

Kalesnik states two important assumptions about stock prices: that they are “noisy,” that is, they are either overpriced or underpriced; and that they are mean-reverting, meaning that they head back to average values from high or low swings.

Just as in the swing of a pendulum, momentum determines the price’s short-term location, and long-term investors can tune out this noise and capture the value the pendulum’s mean reversion promises.

“If prices were moving in one direction in the past, they are likely to move in the opposite direction in the future," Kalesnik writes. "Moreover, the greater the swing in one direction, the stronger is the reverse movement.”

One classic empirical study he cites shows the power behind this mean reversion. In 1985, Werner De Bondt and Richard Thaler divided a group of stocks between winners and losers over a three-year period and then traced the performance of the two groups over the subsequent three years. They found that the losers beat the market, while the winners underperformed the market — and the losers bested the winners by nearly 25 percentage points.

One might have expected higher risk as an explanation for the loser portfolio’s outperformance, yet De Bondt and Thaler found significantly higher average market betas in the winner portfolio, leading them to reject a risk-based model to explain the return difference.

Instead, they proposed mispricing as key, with market participants (“noise traders”) driving these stocks’ prices lower because of their years of underperformance.

However, the momentum that created this loser portfolio eventually gives way to the corrective action of the pendulum’s mean reversion, and the farther the distance from the mean the greater the pendulum’s gravitational pull, writes Kalesnik:

“The degree to which stocks are mispriced can vary over time, and when there is more mispricing there are greater opportunities for generating profits.”

But why, one may ask (and fortunately, Kalesnik does), doesn’t arbitrage eliminate this profit potential, as textbook finance might suggest?

He cites another classic study that quotes John Maynard Keynes’ answer to this question: “Markets can remain irrational a lot longer than you and I can remain solvent.”

In other words, a clever asset manager may be buying undervalued assets and selling overvalued assets, but investors may at the same time be “withdrawing their capital from the losing manager and placing it with someone who appears to be more competent,” he writes.

Kalesnik cites the dot-com bubble as a classic instance of the irony that value-based managers become constrained at exactly the time mispricing opportunities increase.

And therein lies Kalesnik’s—and indeed Research Affiliates’—solution to this dilemma.

A rules-based Smart Beta strategy such as a fundamentals-weighted index can take advantage of the force of mean reversion by selling winners and buying losers — stripping the emotion out of this approach through a “transparent algorithmic rebalancing strategy.”

Kalesnik concludes:

“Tying weights to accounting measures of company size creates capacity; choosing to rebalance annually, rather than more often, controls turnover; and “buy low/sell high” is truly a sound investment principle.”

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Check out Arnott’s Value Firm Grabs Momentum ‘Hot Potato’ in Paper on ThinkAdvisor.

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