Popularity: Way to explain performance

Two well-known researchers are upending the fundamental standard of using a risk-and-return framework to explain relative performance of different asset classes and different securities.

Roger G. Ibbotson and Thomas M. Idzorek contend the central framework should be a concept they call popularity.

“Most everything is looked at in a risk framework,” said Mr. Ibbotson, professor in the practice emeritus of finance at Yale University School of Management, New Haven, Conn., and chairman and chief investment officer of Zebra Capital Management LLC, Milford, Conn.

Mr. Idzorek is president of Morningstar Investment Management, a unit of Morningstar Inc., Chicago.

While risk is an important factor in determining asset prices, it is only one dimension of popularity, Messrs. Ibbotson and Idzorek say.

“The beauty of what we are putting forth with the theory of popularity is that it is consistent with that risk-and-return traditional framework,” Mr. Idzorek said. “But all of the anomalies, or premiums” observed in the market “might not be consistent with that risk-and-return framework. Typically (investors) have looked to behavioral finance to help explain” anomalies or premiums not associated with additional risk. “Dimensions of popularity ... help to explain again not only the premiums associated with additional risk but those premiums that have not come with additional risk.”

Popularity explains most of the best-known market premiums and anomalies, they said.

The popularity concept embraces many factors institutional investors use to explain differences in asset prices, they said. Aside from risk, dimensions of popularity include size of market capitalization, value and liquidity.

Popularity “is an alternative” to the traditional risk-return framework, Mr. Ibbotson said. Popularity “is really broader because we're not denying you should look at things in a risk-return framework because risk is unpopular.”

He added, “There are unpopular things that are in the risk-return framework and there are things that are unpopular that are not associated with risk.”

With popularity, “we are expanding on” modern portfolio theory, Mr. Ibbotson said.

In the capital asset pricing model — widely used for valuing stocks based on risk — the equity premium and the small-cap premium “would be examples ... consistent with what is referred to as a risk premium,” Mr. Idzorek said.

“Roger and I are very careful to try to distinguish when we apply the modifier of risk to the word premium and when we just have a premium that may or may not go with additional risk,” Mr. Idzorek said. “So that equity premium (and) small-cap premium have historically been consistent ... with the CAPM-type framework” in that their returns are associated with taking more risk.

“The value premium, the low-beta anomaly, the low-volatility anomaly (among other factors), these are premiums that seem to exist in the marketplace but don't necessarily go hand in hand with additional risk. And our theory or concept of popularity seems to be able to explain again all of these premiums whether or not they are a risk premium or (another) form of a premium.”

Pricing assets based on the risk premium alone fails to capture the sources of these other premiums or anomalies, the two said.

“Liquidity is a good example,” Mr. Ibbotson said. “Less liquid isn't necessarily more risk. Some (investors) try to put liquidity in that framework when they talk about liquidity risk. But just being less liquid isn't necessarily a risk. ... It's related to higher transaction costs. It isn't a risk necessarily. ... So like risk, (investors) want liquidity. Liquidity is popular. ... But having something very liquid does not diminish your risk, because the risk dimension is different than the liquidity dimension. Liquidity is an example of something that is very popular but not necessarily associated with risk.”

Unlike the widely know CAPM for risk, there is no investment model for popularity.

“Basically, it is a framework” for investing a portfolio or allocating among asset classes, Mr. Ibbotson said.

“Now we are saying we should look at this (market premiums and anomalies) with another pair of glasses,” Mr. Ibbotson said.

“Strategies that systematically purchase baskets of securities that are unpopular will do better than strategies that systematically buy the most popular” investments, Mr. Idzorek said. “So buying small cap, value (and) less liquid (characteristics) are strategies that over time will outperform. It's consistent with the traditional contrarian-oriented investor.”

Some dimensions of popularity, such as the small-cap size effect or value characteristic, appear to be more permanent, while other factors can come in an out of favor with investors in the market, they said.

“But there are other things are go in and out of fashion that may lead to mispricing,” Mr. Ibbotson said.

“In the investment world, things that are permanently disliked would be high risk” and less liquid securities or asset classes, Mr. Idzorek said.

Even once discovered, a dimension of popularity won't necessarily disappear, they contend.

“Risk doesn't disappear once we discover it,” Mr. Ibbotson said. “Once we learn risk is unpopular ... it won't disappear. On the other hand, some things ....will become more popular or less popular.”

Investors will bid up prices of investments, making themincreasingly popular until they fall out of favor and prices fall, Mr. Idzorek said.

“Likewise at the other end of the spectrum, when out-of-favor, unpopular investments move along one of the dimensions, they will gain in value or price,” Mr. Idzorek said.

Strategies using popularity to guide investing can be active or passive, the two said.

In a passive implementation, “you buy things that are long term,” Mr. Ibbotson said. For example, “you buy less liquid, small and value stocks passively and hold them for a very long time. An active strategy takes into account the changing fashions,” trading in and out of popularity characteristics.

But investing based on popularity might not be easy. “We don't have a perfect measure of popularity,” Mr. Ibbotson said.

One measure of popularity they use is turnover of shares of a stock, which adjusts for large- and small-cap stocks, taking into account large-cap stocks have more shares outstanding and trade more frequently. The higher the turnover the more popular a security is, Mr. Ibbotson said.

“You might use turnover as a measure of liquidity” to identify popularity, Mr. Ibbotson said. n