BM410: Investments
Portfolio Construction 2:
Market Anomalies
and Portfolio Tilts
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Objectives
 A. Understand different market anomalies
 B. Review active versus passive investing
 C. Understand portfolio tilts
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A. Understand Market Anomalies
• What is a market anomaly?
• A market anomaly refers to price behavior that
differs from the behavior predicted by the
efficient market hypothesis.
• An anomaly discussed means it is known
• It is less like to do the same next time
because others will be watching for it as
well.
• Are there known anomalies?
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Anomalies (continued)
 Price Earnings Effect
• Portfolio’s of low P/E stocks have exhibited higher
average risk-adjusted returns than higher P/E
Stocks
• Investors prefer cheaper stocks to more
expensive stocks even if risk levels are the
same.
 Small Firm Effect
• Smaller firms generally earn higher returns
• May be tied to fact that ownership of smaller
firms is left to smaller investors who require a
higher return to invest.
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Small Firm Effect
Source: Ibbotson Associates 2000
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Anomalies (continued)
 January Effect
• Stocks tend to exhibit a higher return in January
than any other month (higher for smaller stocks)
• May be tied to tax-loss selling or window
dressing at year-end
 Neglected Firm Effect
• Firms not followed by analysts tend to perform
better than those followed
• Because costs are higher to analyze smaller
firms, investors require a higher rate of return to
invest in less liquid stocks
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Anomalies (continued)
 Liquidity Effect
• Less liquid stocks sometimes perform better than
more liquid stocks
• Investors may require a higher return premium
to compensate for lower liquidity
 Market to Book Ratios
• Stocks with lower price to book ratios (or higher
book to market ratios) perform better
• Investors prefer to invest in cheaper stocks (in
reference to their assets) than more expensive
stocks
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Book to Market Ratios
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Anomalies (continued)
 Reversals
• Extreme stock market performance tends to reverse
itself, i.e. reversion to the mean.
• Losers rebound and winners fall
 Value Line Enigma
• Stocks rated highly by Value Line perform better
• Investors may actually read Value Line
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Anomalies (continued)
 Post-Earnings Announcement Drift
• The effect of earnings announcements continue for
many days after the announcement
• May be due to trading costs, particularly for
smaller companies
• In addition, this drift shows consistency
• If a company consistently has above market
expectations, the market learns it
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Anomalies (continued)
 Market Anomalies are due to:
• Risk Premia
• Are we accounting for all the appropriate risk
factors, such as in an multifactor framework?
(there may be more factors than just market
portfolio)
• Behavior - Irrational or rational
• Investors prefer to purchase large and growth
stocks and neglect small and value stocks.
• Data Mining
• By chance, some criteria will appear to predict
returns. Is it logical? If not, don’t bet on it!
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Anomalies (continued)
Over-fitting the S&P 500: Butter Production in Bangladesh and the United
States, United States Cheese Production, and Sheep Population in Bangladesh
and the United States.
R2=.99
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Questions
 Do you understand the market anomalies?
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B. Review Active versus Passive
Investing
• What is Active Portfolio Management?
• Trading to earn more than a “market” return for
time and risk
• It is using publicly available data to actively
manage a portfolio in an effort to consistently
beat the benchmark after all costs, taxes,
management, and other fees (not just from luck)
 What is passive management?
• Not trading to earn a market return for time and
risk.
• The process of buying a diversified portfolio
which represents a broad market index (or
benchmark) without any attempt to outperform
the market
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Active versus Passive (continued)
 What does active management require?
• Active management requires a competitive
advantage in at least one of three categories:
• 1. Information. You should have information
not widely available and not already reflected in
stock prices
• 2. Trading costs. You should have a lower cost
to trade, possibly helped by being a dealer or
floor trader
• 3. Analysis. You should have the ability to
convert public data into private knowledge about
value that is not fully reflected in current prices.
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Active versus Passive (continued)
 Does it have to be one or the other?
• Why not use a combined approach
• Index when that is perceived to add value
• Actively manage when you can add value there
• What about in-between?
• What about enhanced-indexing?
• It is often called risk-controlled active funds
or hybrid active-passive strategies
• For example, you could have a bond and
equity index funds, and you could
dynamically market time by varying your
allocations in each fund (i.e. asset
allocation)
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C. Understand Index-tilt Strategies
 What is an index-tilt strategy?
• It is the process of using an index as a performance
benchmark and departing from the exact index
weighting in order to overweight assets or sectors
you expect to outperform
 Are their different types of “tilts?”
• There are a number of them
• Interestingly, most are bets on the persistence of socalled long run market anomalies discussed earlier
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Index-tilt Strategies (continued)
 What is the key question for anomaly-tilt
strategy?
• Will the market anomaly continue?
• Can the excess returns from the tilt cover the
additional costs in research, trading costs
and fees, and taxes?
• Is the additional return sufficient to justify
the increase in fees for the active strategy?
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Index-tilt Strategies (continued)
 What are some variations on index-tilting?
• Suppose you want excess returns from your U.S.
portfolio. You decide on an 80% passively managed
portfolio with a 20% actively managed portfolio.
• This strategy would give you the stability of the
index fund (i.e. risk reduction and close to
benchmark returns)
• In addition, it would give the opportunity to earn
higher than benchmark returns if you do well on
your actively managed portion of your portfolio
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Index-tilt Strategies (continued)
• The 20% might include:
• Stocks not in the index
• Purchase assets from other asset classes that
have higher than the expected returns from
your benchmark
• Industry tilts
• Overweighting more attractive industries that
you expect to add value above the
benchmark
• Size tilts
• Overweight (underweight) smaller
companies if you expect their returns to be
higher (lower)
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Index-tilt Strategies (continued)
• Anomaly tilts
• Invest in market anomalies that you expect to
continue, i.e., low PE or high book to market
stocks
• Risk tilts
• Increase (decrease) the beta if you expect is
market forecast is for higher (lower) returns
• Tax tilts
• Increase (decrease) investments in high dividend
(taxed at 15%) stock companies versus bonds
(taxed at marginal tax rates) if your forecast for
market returns is higher (lower)
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Index-tilt Strategies (continued)
• What is the key to portfolio construction?
• The key is to build that optimal portfolio to help
you achieve your goals the quickest
• There are distinct advantages for active, passive,
and hybrid strategies
• Understand your goals
• Understand what you want to accomplish, and
• Understand the tools that can help you achieve
them
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Review of Objectives
 A. Do you understand different market
anomalies?
 B. Do you understand active versus passive
investing?
 C. Do you understand portfolio tilts?
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