A battle is raging among finance theoreticians, and investors should stay out of it.
There’s a growing recognition that a handful of active investing styles — also known as factor investing or smart beta — can be expected to beat the market over time. Among them are value (buying cheap stocks), quality (buying profitable and stable companies), momentum (following the trend) and size (buying small companies).
The evidence is compelling. The cheapest 10 percent of U.S. stocks — sorted on price-to-book ratio and then weighted by market capitalization — returned 11.9 percent annually from July 1926 through March, including dividends, according to numbers compiled by Dartmouth professor Kenneth French. That’s 1.8 percentage points a year better than the S&P 500 Index during those nine decades and 3.1 percentage points a year better than the most expensive 10 percent of stocks.
Value also won over shorter periods. The cheapest 10 percent of stocks beat the S&P 500 roughly 72 percent of the time over rolling 10-year periods, and they beat the most expensive 10 percent of stocks 73 percent of the time.
The results are similar for stocks sorted on profitability, momentum and size.
It’s not entirely clear, however, why such simple strategies beat the market, and therein lies the debate. Proponents of risk-based explanations say that those strategies involve more risk than investing in the broad market and that the outperformance is compensation for that additional risk. It makes intuitive sense, for example, that beaten-down value companies are riskier than highflying growth ones. Or that the future of small companies is less certain than that of large ones.
Risk-based explanations for quality and momentum may be less obvious but still appealing. Profitable companies tend to attract competition and regulation, both of which are bad for business. And momentum is great at chasing the trend but can crash during sudden turns. It’s not unreasonable to expect a reward for taking on those risks.
On the other side are proponents of behavioral explanations who say that mistakes made by some investors create opportunities for others. Investors overreact to bad news. They invest in companies with the sexiest stories, not the highest profits. They chase performance, buying when stocks rise and selling when they decline. And they overlook smaller companies.