March 31, 2003

Shanken looks at portfolios & 'market anomalies'

By Victor Rogers

It’s enough to make even the most risk-loving investor quake in fear. Portfolio managers recently were reportedly giving technology stocks a longer look, betting that a war in Iraq will fuel a short-term rally in the sector.

Technology stocks? They were largely responsible for the burst of the market bubble in early 2000 that set off the current decline.

The balance of financial investments in portfolios has become even more delicate in the current unstable economic climate. Market conditions aside, how investors should combine financial investments in an overall portfolio to maximize objectives is a popular theme in investment analysis. A so-called efficient portfolio has as high a level of expected return as possible for the given level of risk and uses the minimum risk needed to achieve that expected return. But how to get there?

The appropriate composition of an efficient portfolio is far from obvious, noted Jay Shanken, Dean’s Distinguished Professor of Finance in the Goizueta Business School. Shanken, along with coauthor S.P. Kothari of MIT’s Sloan School of Management, recently had a monograph published by the Association for Investment Management and Research (AIMR), the organization that administers the chartered financial analyst exam and publishes the Financial Analyst Journal.

The study, titled “Anomalies and Efficient Portfolio Formation,” analyzes the properties of efficient stock portfolios that exploit the most prominent market anomalies related to company size or market capitalization, company book-to-market ratios and past-year momentum. While empirical literature has touched on these anomalies—phenomena observed in the stock market that deviate from classic risk-and-return theories—it has not examined how they relate to creating the optimal portfolio.

“We’ve got this very simple theory that says everybody should just hold index funds—this market portfolio idea,” Shanken said. “But there’s plenty of evidence that that would not be the best portfolio to hold. It’s not efficient. The anomalies show that other things affect expected returns besides what the theory says should work. We analyze the properties of efficient portfolios that take into account these anomalies.”

Shanken’s analysis focuses on the three most prominent stock market anomalies: the tendency for the stocks of smaller firms, for those of firms with high book-to-market ratios (value stocks) or for those with high past-year returns (momentum stocks) to have high average future returns.

“These anomalies represent deviations from a theory called the ‘capital asset pricing model,’ which predicts that expected stock returns are determined only by a particular risk measure called ‘beta’ and not by these other stock characteristics,” Shanken said.

For each anomaly, the authors estimate the amount that investors should tilt their portfolios away from the market index—toward the anomaly-based portfolio—to exploit the gains of efficiency. The analysis looks at stock return data from 1963 to 2000, as well as data on firms’ book-to-market ratios.

In doing the actual statistical analysis, Shanken and Kothari considered portfolios that were combinations of a broad stock market index, Treasury bills—a riskless investment—and the three anomaly portfolios of small firms, value stocks and high momentum stocks. They allowed for the possibility that the positive “alphas” (a standard measure of performance) of the three anomaly portfolios might not be as large in the future as they appeared to be in the past.

“We found that even if they are expected to be just a quarter of the size they were in the past, an optimal portfolio would invest more than half in value stocks and about one-third in momentum stocks,” Shanken said. “This would increase the annual expected return by about 0.6 percent, relative to the market index, holding risk constant. With alphas half the historical level, the increase in expected return is more substantial, almost 2 percent per year.”

The authors say they expected value and momentum to play an important role in optimal portfolio decisions based upon past literature about anomalies. They were surprised, however, by the extent to which aggressive investment in these anomalies seems to be called for.

Investors should take heed of the risk-and-return characteristics of anomaly-based investment strategies, Shanken advised. “In broad terms,” he said, “we would continue to want to exploit these anomalies and invest more in higher book-to-market stocks and more in stocks that have high momentum in the previous year, even if we’re somewhat skeptical that the effect would be as strong in the future.”

—This article first appeared in Knowledge@Emory and is reprinted with permission.