Have you ever read a book or article, only to come back to it later and realized you missed some important information? That recently happened to me regarding the Schwert Rule. G. William Schwert is currently the Distinguished University Professor and Professor of Finance and Statistics at the University of Rochester Simon School of Business in Rochester, New York. Dr. Schwert performed interesting research on what are known as “anomalies.” Before getting into what anomalies are, it is better to define efficient market. In general, an efficient market states that the price of a security reflects all know information. Burton Malkiel’s very popular book, “A Random Walk Down Wall Street” is built on the efficient market hypothesis. The passive vs. active management debate is rooted in the efficient or inefficient market viewpoint. Which is correct?
Here at ITA we tend to straddle this argument, but tilt toward the side of the inefficient market. In other words, there are profit opportunities available due to anomalies. We may be incorrect in taking this position. If you have read articles by Fame and French you are aware of their findings as to the benefits of tilting the portfolio toward value vs. growth, small cap size vs. large cap size, and more recently, the opportunity to take advantage of momentum, profitability, and investment beta. I’ll not go into the latter two as they are more appropriate when running screens for individual stocks. Nevertheless, all these “factors” fall into what are known as “anomalies” to the efficient market hypothesis. A few others you have heard about are the “January Effect” where one buys on the first trading day of January and sells a few days later. On average, the purchases will gain ground. The “Halloween Effect” is another “anomaly” where one buys after Halloween and sells in May. Remember the saying, “Sell in May and go play.” All these “anomalies” call into question the efficient market hypothesis.
Now enters research from Dr. Schwert. Quoting Schwert from a paper on Anomalies and Market Efficiency we read the following.
“After they are documented and analyzed in the academic literature, anomalies often seem to disappear, reverse, or attenuate. This raises the question of whether profit opportunities existed in the past, but have since been arbitraged away, or whether the anomalies were simply statistical aberrations that attracted the attention of academics and practitioners.”
Schwert raises two possibilities in the above quote. 1) There was once a profit opportunity, but once discovered, the opportunity decreased in value as more and more investors sought to benefit from the opportunity. The efficient market took over and smoothed out the profit opportunity. 2) If one tortures data sufficiently, it will eventually yield profit opportunities. This reminds me of a time nearly 50 years ago when I was working part-time as a lab technician operating a Varian Nuclear Magnetic Resonator. Several runs of a sample showing nothing except noise, but if hundreds of scans were captured during a nighttime run, the next morning, spikes in the sample would appear as the noise canceled out into a semi-flat line. Financial data can be made to respond in similar fashion if one continues to run regression after regression. Eventually an opportunity will spike from the noise. But will it spike from the noise over the next five to ten years?
The Schwert Rule concludes that pricing opportunities from “anomalies” are statistical accidents and they are unique only to the time period over which they are run. If the “anomaly” is other than a statistical accident, it will be arbitraged away much as the price of an ETF returns to its underlying value when the price deviates too far from that value.
Academicians need to publish or perish. With this motivating factor, study after study is conducted on data looking for the “Holy Grail” and this search uncovers statistical patterns that appear to be profit opportunities. Some of the major factors used here at ITA are: value, size, beta, and momentum. Momentum in particular is one anomaly that seems to have no rhyme or reason other than something related to the behavior of investors. Do these factors merit sufficient consideration when constructing a portfolio or would one be better off buying nothing except a global ETF (VT for example) plus one or two more ETFs for diversification in REITs and bonds? Testing with portfolios going forward is the only way I know to answer this puzzling question.