Morningstar Study: Which Investment Factors Work?

A recent article in Morningstar outlines results of a study the firm conducted on seven investment factors showing that volatility, size and momentum worked best.

The article provides the following chart, which depicts each factor’s excess return on a cumulative basis (over 16 years):

The article suggests focusing on the patterns illustrated: “The excess-return totals aren’t particularly meaningful,” it says, “because these factors cannot be purchased. They come attached to stocks, which in turn offer exposures to other factors.”

Here are highlights of the findings in order of performance:

Volatility: While this factor appears to be the best performer, the article notes that it may also be the most “confusing, because equity researchers don’t often treat absolute volatility as an investment factor.” But Morningstar’s analysis showed that, over time, volatile stocks (measured by standard deviation of returns) have “substantially outgained stocks that have posted stable prices.”

Size: The study found that stocks of smaller companies outperformed blue chips, although the article notes that the size premium “has disappeared over the past several years.” The article notes that smaller-company stocks have performed better overseas than in the U.S.

Momentum: Price momentum was found to be the most persistent of all factors, across all investment assets. The article says that researchers fail to understand why, if the strategy is not considered risky, it seems to generate extra profits? The question, the article says, “has yet to be satisfactorily answered.”

Yield: “Managers who run high-income stock funds praise dividends,” the article says, adding that the Morningstar findings “support their claims. Higher-yielding stocks have indeed outgained their lower-yielding rivals, and steadily, too.” The article qualifies the findings, however, saying that the gains from extra yield are “modest.”

Quality: The study found that the “overall excess returns for high-quality stocks, defined by Morningstar as having above-average returns on equity and below-average debt ratios, have been only modestly positive.” It adds that once returns are adjusted for factors such as country of origin, sector exposure and currency, the benefit from quality “all but disappears.”

Style: “Of all investment factors,” the article reports, “style has been the biggest dud.” Although it notes that value investing is “typically regarded as being the most academically accepted strategy” the data presents it as a “disappointment.”

Liquidity: The study found that those securities that are difficult to trade should, and do, enjoy excess returns to compensate investors for this undesirable feature, but adds that the data shows “it wasn’t much of a triumph. As explanatory factors go,” it concludes, “volatility, size, and momentum were considerably more meaningful than liquidity.”