“
Ross’s “arbitrage pricing theory” and Rosenberg’s “bionic betas” posited that the returns of any financial security are the result of several systematic factors. Although seemingly stating the obvious, this was a seminal moment in the move toward a more vibrant understanding of markets. The eclectic Rosenberg was even put on the cover of Institutional Investor in May 1978, the bald, mustachioed man depicted as a giant meditating guru with flowers in his hair, worshipped by a gathering of besuited portfolio managers. The headline was “Who Is Barr Rosenberg? And What the Hell Is He Talking About?”8 What he was talking about was how academics were beginning to classify stocks according to not just their industry or their geography, but their financial characteristics. And some of these characteristics might actually prove to deliver better long-term returns than the broader stock market. In 1973, Sanjoy Basu, a finance professor at McMaster University in Ontario, published a paper that indicated that companies with low stock prices relative to their earnings did better than the efficient-markets hypothesis would suggest. Essentially, he showed that the value investing principles espoused by Benjamin Graham in the 1930s—which revolved around buying cheap, out-of-favor stocks trading below their intrinsic worth—was a durable investment factor. By systematically buying all cheap stocks, investors could in theory beat the broader market over time. Then Banz showed the same for small caps, another big moment in the evolution of factor investing. Follow-up studies on smaller stocks in Japan and the UK showed similar results, so in 1986 DFA launched dedicated small-cap funds for those two markets as well. In the early 1990s, finance professors Narasimhan Jegadeesh and Sheridan Titman published a paper indicating that simply surfing market momentum—in practice buying stocks that were already bouncing and selling those that were sliding—could also produce market-beating returns.9 The reasons for these apparent anomalies divide academics. Efficient-markets disciples stipulate that they are the compensation investors receive for taking extra risks. Value stocks, for example, are often found in beaten-up, unpopular, and shunned companies, such as boring industrial conglomerates in the middle of the dotcom bubble. While they can underperform for long stretches, eventually their underlying worth shines through and rewards investors who kept the faith. Small stocks do well largely because small companies are more likely to fail than bigger ones. Behavioral economists, on the other hand, argue that factors tend to be the product of our irrational human biases. For example, just like how we buy pricey lottery tickets for the infinitesimal chance of big wins, investors tend to overpay for fast-growing, glamorous stocks, and unfairly shun duller, steadier ones. Smaller stocks do well because we are illogically drawn to names we know well. The momentum factor, on the other hand, works because investors initially underreact to news but overreact in the long run, or often sell winners too quickly and hang on to bad bets for far longer than is advisable.
”
”
Robin Wigglesworth (Trillions: How a Band of Wall Street Renegades Invented the Index Fund and Changed Finance Forever)