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Monday, October 12, 2015

Tastes Bad, Performs Well: Is This the Future of Investing?

News summary by MFWire's editors

"Tastes bad, performs well." That description might be what drives many of your PMs' strategies going forward. Oh, and it might help to cut through the Gordian knot of smart or strategic beta.

John Rekenthaler
Morningstar, Inc.
Vice President, Research
That mantra is suggested by Morningstar's John Rekenthaler in his latest column, "How to Beat an Efficient Market." The article is a must-read for PMs and other fundsters with an eye for investing theory and a curiosity about where the industry is heading next.

Rekenthaler pushes back against efficient-market hypothesis (EMH) purists who try to explain away anomalies that don't fit EMH perfectly and urges fundsters and investors alike to turn the logic on its head.

"Why believe that the people are wrong and the model is right?" Rekenthaler writes. "The truth is almost surely the opposite."

Rekenthaler calls for "a new, richer model of stock-pricing ... one that can incorporate the many aspects that influence investor decisions." He points to an article last year by Tom Idzorek (also of M*) and Roger Ibbotson (of Zebra Capital, and founder of Ibbotson Associates which M* acquired years ago) and to an unpublished draft paper by James Xiong (also of M*), Ibbotson, and Idzorek. The key factor, as Rekenthaler describes it, is popularity:

A popular stock is a stock that has desirable characteristics. On the whole, investors find such stocks easy to own. As a result, they are willing to accept a lower rate of return on those securities than they are with unpopular stocks, which for various reasons may be unpleasant holdings. The search for higher return thus becomes the search for the unpopular — along with a willingness to accept their warts.

Rekenthaler lists four key popularity factors: value, low volatility, liquidity, and severe downside risk. He notes that it's still early in days and more factors need to catalogued; for now, he writes, "the recommendation is the limited one of favoring relatively illiquid value stocks that might get whacked." 

Edited by: Neil Anderson, Managing Editor

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