STREET DOGS

Academics Lu Zhang, Kewei Hou and Chen Xue published a paper in 2017 that challenges much of the research on market “anomalies”. Titled Replicating Anomalies, it is the result of nearly three years spent compiling and replicating 447 market anomalies identified in academic literature.

The takeaway: most of the supposed market anomalies academics have identified don’t exist or are too small to matter. In short, the market is probably more efficient than you think. On the face of it, 447 anomalies would seem to suggest the market is easy to beat. But 54% of the anomalies cannot be replicated. What’s more, if one minimises the effect that small-cap stocks have on the results, 85% of the anomalies cannot be replicated.

The classic investing factors – value and momentum – survive scrutiny. Value, generally represented by portfolios of cheap stocks, holds up well in the analysis, earning higher expected returns than the general market and growth stocks. Momentum, or strategies that hold on to winners, also holds up. The simplest momentum strategies, based on past returns, hold up best relative to fancier momentum strategies.

Cheap companies with high return on equity generate the highest returns — baskets of stock in small companies that are cheap (value) and have high returns on equity (quality).

Portfolio construction matters. A lot. The big takeaways from the massive research project: small stocks are preferable to larger stocks; equal-weight is better than market-cap weighting; rebalancing more is better than rebalancing less.

Finally, don’t believe everything you read. The factors verified represent strategies investors have known about for decades: buy cheap stocks, buy winners, buy quality and so forth. — adapted from a Wall Street Journal article by Wesley Gray