A new study finds that “momentum profits have disappeared since the late 1990.” Meanwhile, a pair of analysts report that “it is time to rethink the idea that small stocks outperform large stocks on a risk-adjusted basis.” And value stocks have been trailing growth and broad equity benchmarks by substantial margins over the last five years, according to Russell benchmarks. What’s going on? Should we be surprised? No, not really.
The idea that risk premiums are driven by multiple betas is still valid, but the case for thinking that you can do better than simply holding an expansive definition of the market always came with caveats. As Professor John Cochrane wrote in “Portfolio advice for a multifactor world“:
Investments do not come with average returns as clearly marked as grocery prices, however. Investors have to figure out whether an investment opportunity that did well in the past will continue to do well. This is one reason that it is important to understand whether average returns come from real or irrational aversion to risk.
That’s tricky, in part because even if there are truly bigger returns available by re-weighting the market portfolio, there’s limited capacity for earning superior performance. The average investor holds the market portfolio and will likely earn a risk premium over time. But there’s only so much room in small cap and value stocks, for instance, without bidding up prices to the point that expected returns fall to zero or perhaps even go negative. The same is true for the market overall, but the threat is less potent given the higher capacity.
Financial research over the last several decades has identified numerous “anomalies” (or risk factors or alternative betas, if you prefer). It’s easier than ever to tap into these risk factors courtesy of an expanding menu of ETFs and index mutual funds. But anticipating that holding a non-market portfolio will bring a higher return premium is also a reminder that holding a customized mix of other betas could bring subpar results at times.
In other words, there’s generally more risk in holding something other than the market portfolio. In the long run, alpha sums to zero. If too many investors are chasing alpha by holding non-market portfolios, simple mathematics will catch up with them eventually. Then again, a day of reckoning may be a sign of new opportunities.
Yes, the average investor must hold the market portfolio, but that doesn’t mean you have to follow that advice. But holding something different from the crowd is no free lunch.