POPULARITY
A Bridge between Classical
and Behavioral Finance
Roger G. Ibbotson, Thomas M. Idzorek, CFA, Paul D. Kaplan, CFA, and James X. Xiong, CFA
Statement of Purpose
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Cover photo credit: Ho Ngoc Binh / Moment / Getty Images
ISBN 978-1-944960-61-2
Biographies
Roger G. Ibbotson is Professor in the Practice Emeritus of Finance at Yale School of Management. He is also chairman of Zebra Capital Management, LLC, a global equity investment and hedge fund manager. Professor Ibbotson is founder and former chairman of Ibbotson Associates, now a Morningstar company. He has written numerous books and articles, including “Stocks, Bonds, Bills, and Inflation” with Rex Sinquefield (updated annually), which serves as a standard reference for information and capital market returns. Professor Ibbotson conducts research on a broad range of financial topics, including popularity, liquidity, investment returns, mutual funds, international markets, portfolio management, and valuation. He recently published The Equity Risk Premium and Lifetime Financial Advice . Professor Ibbotson has also co-authored two books with Gary Brinson, Global Investing and Investment Markets . He is a regular contributor to and editorial board member of both trade and academic journals and serves on numerous boards, including Dimensional Fund Advisors’ funds. Professor Ibbotson frequently speaks at universities, conferences, and other forums. He received his bachelor’s degree in mathematics from Purdue University, his MBA from Indiana University, and his PhD from the University of Chicago, where he taught for more than 10 years and served as executive director of CRSP.
Thomas M. Idzorek , CFA, is chief investment officer, retirement, for Morningstar Investment Management LLC. He also serves as a member of Morningstar’s 401(k) committee and Public Policy Council, chair of Morningstar’s overall Research Council, and as a member on the editorial boards of Morningstar magazine and the CFA Institute Financial Analysts Journal . Idzorek was formerly president of Morningstar’s global investment management division, where he oversaw the firm’s global investment advice, consulting, retirement solutions, broker/dealer, index, and financial wellness businesses. Additionally, he has served as president of Ibbotson Associates, president of Morningstar Associates, board member/responsible officer for a number of Morningstar Investment Management subsidiaries, global chief investment officer for Morningstar Investment Management, chief investment officer for Ibbotson Associates, and director of research and product development for Ibbotson. Most recently, Idzorek served as head of investment methodology and economic research for Morningstar. Before joining Ibbotson, he was a senior quantitative researcher for Zephyr Associates. Idzorek has written numerous articles for academic and industry journals and collaborated on papers that have won a Financial Analysts Journal Graham & Dodd Scroll Award. He is an expert on multiasset class strategic asset allocation, the Black–Litterman model, target date funds, retirement income solutions, fund-of-funds optimization, risk budgeting, and performance analysis. Idzorek is the key methodological creator of Morningstar’s target date and retirement managed account (robo-advice) solution. He holds a bachelor’s degree in marketing from Arizona State University and a master’s degree in business administration from Thunderbird School of Global Management.
Paul D. Kaplan , CFA, is director of research for Morningstar Canada and is a senior member of Morningstar’s global research team. He led the development of many of the quantitative methodologies behind Morningstar’s fund analysis, indexes, adviser tools, and other services. Kaplan conducts research on asset allocation, retirement income planning, portfolio construction, index methodologies, and other investment topics. Many of his research papers have been published in professional books and publications, such as the Financial Analysts Journal and the Journal of Portfolio Management , and he has served on the editorial board of the Financial Analysts Journal . Kaplan has received a Graham & Dodd Top Award and a Graham & Dodd Award of Excellence. Many of his works appear in his book Frontiers of Modern Asset Allocation . Previously, he has served as quantitative research director for Morningstar Europe in London, director of quantitative research in the United States, and chief investment officer of Morningstar Associates, LLC, where he developed and managed the investment methodology for Morningstar’s retirement planning and advice services. Previously, Kaplan was a vice president of Ibbotson Associates and served as the firm’s chief economist and director of research. Prior to that, he served on the economics faculty of Northwestern University, where he taught international finance and statistics. Kaplan holds a bachelor’s degree in mathematics, economics, and computer science from New York University and a master’s degree and doctorate in economics from Northwestern University.
James X. Xiong , CFA, is head of scientific investment management research at Morningstar Investment Management. He leads research and develops new methodologies and algorithms on the time-varying capital markets model, tail risk management, portfolio optimization, asset allocation, dynamic portfolio choice, insurance product allocation, mutual fund selection, alternative asset class investments, Monte Carlo simulations, and other investment and financial planning areas. Xiong’s work has been published in the Financial Analysts Journal , Journal of Investment Management , Journal of Portfolio Management , Journal of Risk Management in Financial Institutions , and Journal of Financial Planning , among other publications. His co-authored “Liquidity Style of Mutual Funds” was awarded with a Graham & Dodd Scroll, and his co-authored “Momentum, Acceleration and Reversal” won a Harry M. Markowitz Award. Xiong has published more than 15 papers in scientific journals, including Physical Review Letters , a prestigious world journal in physics. He holds a bachelor’s degree in physics from Wuhan University in China and a doctorate in physics from the University of Houston.
Contents
Copyright
Foreword
Laurence B. Siegel
The Classical Answer
The Behavioral Answer
Reducing the Complexity of the Market
How Popularity and Other Factors Set Prices
From New Equilibrium Theory to the Popularity Asset Pricing Model
Understanding Historical Returns
A New Kind of Forecasting
The Supply of Capital Market Returns
The Liquidity Factor
Conclusion: It’s Hard but Not Impossible
to Beat the Market
Preface
1. Introduction
What Is Popularity?
Principles and Models of Classical Finance
Principles of Behavioral Finance
Demand and Supply
Popularity Premiums
Premiums vs. Mispricing
Popularity and Adaptive Markets
2. Premiums, Anomalies, and Popularity
Asset Class Risks
The Equity Premium
Premiums and Anomalies within Equity Markets
Conclusion
Appendix A. Psychic Returns in Art Markets
Conclusion
3. Popularity and Asset Pricing
Refining the Popularity Framework
Precursors to the Popularity Approach
Efficient Markets, Behavioral Finance, or Something Else?
A Popularity-Based Asset Pricing Formula
Conclusion
4. New Equilibrium Theory
The Central Ideas of NET
A Formal Model for NET
Issues That the NET Framework Can Address
Asset Class Characteristics
Conclusion
5. The Popularity Asset Pricing Model
Review of the CAPM
The Popularity Asset Pricing Model
A Numerical Example
Conclusion
Appendix B. Formal Presentation of the CAPM
Appendix C. Formal Presentation of the PAPM
6. New Empirical Evidence for Popularity
Popular Company Characteristics
Tail Risk (Coskewness)
Lottery Stocks
Conclusion
7. Empirical Evidence of Popularity from Factors
Returns and Factors
Beta and Volatility
Size
Value
Liquidity
Momentum
Conclusion
8. Summary and Conclusions
Popularity as a Concept
Popularity as a Bridge between Classical and Behavioral Finance
Popularity as a Theory
Empirical Evidence for Popularity
References
This publication qualifies for 4.5 CE credits under the guidelines of the CFA Institute Continuing Education Program.
Foreword
Why does value investing work? Why do other factor strategies work? For that matter, why does any active strategy—meaning, any strategy other than capitalization-weighted indexing—“work” in the sense of having a reasonable chance of beating the cap-weighted index other than by random variation? The answer could lie in classical finance, or behavioral finance, or both.
The Classical Answer
Classical finance posits that all investors are rational and fully informed. This starting point seems to lead to a recommendation to index all assets, but that advice is not necessarily where it leads.
Although most of classical finance focuses only on risk and expected return, investors differ in their tastes and preferences and assets differ in their characteristics other than risk and expected return. These observations, which form the basis for the current book, are the essence of an article that predates this book, written way back in 1984, by Roger Ibbotson, Jeffrey Diermeier (then, at Brinson Partners, and now, the Diermeier Family Foundation), and myself. The article, entitled “The Demand for Capital Market Returns: A New Equilibrium Theory,” incorporates investor preferences—sometimes called “clientele effects”—into an equilibrium framework conforming to neoclassical economics and classical finance. The connection between the more recent popularity framework and the new equilibrium framework from 1984 was made in an unpublished manuscript started by Tom Idzorek that has evolved into this book. The new equilibrium framework is based on the assertion that economic agents are rational utility maximizers. Classical finance does not say what information agents should not look at, as long as they behave rationally.
For example, one investor could be strongly averse to illiquidity whereas another is not, or one investor might pay taxes at a different rate than another. Everybody’s different. Moreover, we differ in more than simply risk aversion, so we are motivated to hold substantively different portfolios, not just index funds levered up or down to the desired risk level. I will revisit these ideas in greater detail when I discuss how our 1984 effort links with the current book. But for now, I want to note that just observing differences among investors doesn’t mean you can beat the market. Let’s add in the fact that some of the investor groups that like or dislike an attribute common to a group of assets are numerous and control a lot of money. If a large, well-funded group of people avoids (or pays less for) an asset because it has an attribute they don’t like, that asset might be attractively priced from the viewpoint of an investor who doesn’t care about that attribute. An active manager might buy that asset.
A portfolio of assets accumulated according to this rule should beat the market (on average over time). This clientele effect is consistent with classical finance, broadly understood, and the possibility of adding alpha within a classical finance paradigm.
The Behavioral Answer
Active investment strategies could also work for behavioral reasons, in the sense of allowing for the possibility (I’d call it a fact) that not all investor preferences are rational or well-informed. Researchers have accumulated a great deal of evidence that investors are not fully rational and are far from fully informed. They do all kinds of crazy stuff. It seems like it ought to be profitable to take advantage of that fact.
Reducing the Complexity of the Market
Whichever story you subscribe to, classical or behavioral—and both could apply—the market is very complex. It contains far more securities than can be practical to analyze individually. To reduce the units of analysis to a manageable number, researchers and investment managers have compressed securities and their attributes into factors , such as value, momentum, liquidity, and profitability. This technique is well-known, so I will not describe it here.
The number of factors observable in the markets is still considerable, but the number is far higher than logic suggests should exist. So, a valuable contribution would be to identify a common theme that links the factors in a way that makes economic sense and is consistent with the clientele-driven equilibrium described in the 1984 paper. That link is one of the aspirations of this new CFA Institute Research Foundation book by my former business associates and friends, Roger Ibbotson and Paul Kaplan, and their current colleagues, Thomas Idzorek and James Xiong (hereafter, IIKX).
The phenomenon that IIKX have identified as explaining a great deal about the cross-section of equity returns is popularity or, to stand the issue on its head and consider what explains excess returns, unpopularity . Specifically, any characteristic that drives away investors in sufficient number—for whatever reason—and causes the demand curve for an investment to shift to the left (meaning less demand) is a characteristic you should seek out. Popularity is not, itself, a factor. It is a framework for understanding and predicting factors.
How Popularity and Other Factors Set Prices
This book incorporates the popularity framework into an equilibrium setting, meaning that the quantity of each asset supplied equals the quantity demanded and all assets are voluntarily held by somebody. Such an equilibrium can apply under the assumptions of either classical or behavioral finance.
As long as aggregate preferences are relatively stable over time, they will play a role in setting asset prices. The preferences can be rational (classical), irrational (behavioral), or a combination of the two. The investors with weaker aversion to generally disliked characteristics will load up on the less popular stocks, which will have higher expected returns. Those with stronger aversion to those characteristics will willingly accept lower expected returns. Because the equilibrium includes all preferences, the popularity framework provides a “bridge” between classical and behavioral finance.
/> Want to learn more? Read the book, especially Chapter 4 , which summarizes the 1984 article. Like Johnny Appleseed, our article scattered the seeds that would grow into various bushes and plants in subsequent decades and, finally, into the tree that is this book.
From New Equilibrium Theory to the Popularity Asset Pricing Model
We called our proposition NET, New Equilibrium Theory, partly because it examined returns net of all the additions and subtractions for desired and undesired characteristics (Ibbotson, Diermeier, and Siegel 1984 ). At the time, a wag (sounds better than a critic) remarked that as Voltaire said about the Holy Roman Empire—it was neither holy, nor Roman, nor an empire—our NET was neither new, nor equilibrium, nor a theory.
Of course, the wag was mostly correct. NET was just an application of the principles of Economics 101 to finance, so it was not new in any of its elemental parts, although the assembly was new. The equilibrium it described is not fully general. And although NET meets the philosophical definition of a theory—an integrated body of knowledge that explains a wide variety of phenomena—it did not have the full mathematical development that it deserved until the current book.
Having been crafted into proper form in Chapter 5 of this book as the popularity asset pricing model (PAPM), NET now is a fully mathematized theory. Combining elements of both classical and behavioral finance, the PAPM follows the rich traditions of neoclassical microeconomics. Specifically, it is based on the following pillars of economic theory as applied to finance:
Subjectivism —The values of assets are not determined solely by their inherent properties. Investor preferences play a major role in determining value.
Marginalism —Each investor constructs his or her portfolio so that the marginal contribution to utility of each asset is equal to the marginal cost of holding the asset—namely, its price.
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