When evaluating investments linked to non-standard indices, investors should first ask if the anomaly is expected to persist, as well as if a particular vehicle is well-designed to exploit the factor. At a general level, two reasons explain why a particular strategy might outperform. 1) The outperformance might simply be compensation for increased risk. Fama and French showed that cheap stocks outperform more expensive stocks over time. Perhaps this is because cheap stocks are more volatile than expensive ones and the outperformance might simply be a reward for the incremental risk of cheapness. 2) A strategy's incremental performance might not be a compensation for risk, but a true anomaly, implying the incremental outperformance of cheap stocks more than compensates for their putative higher risk. We stress that investors should be wary of analyzing returns in isolation without any consideration for the associated risk, and that seemingly persistent returns may actually be a reward for thus far unappreciated risks.
Authors: Hamish Preston, University of Birmingham; Tim Edwards, PhD Senior Director Index Investment Strategy, S&P Dow Jones Indices; Craig J. Lazzara, CFA Managing Director Index Investment Strategy, S&P Dow Jones Indicesview more white papers
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