It’s well understood that investment risk and returns go together.  Simply put, investors expect a premium, generally in the form of a higher return, for investing in higher-risk securities, where risk is quantified as return variability or volatility. This explains why over time stocks outperform bonds and why the returns on small company stocks are higher than on large company stocks.  But it doesn’t explain why value stocks beat growth stocks, nor why stocks with less liquidity may perform better than those with greater liquidity.  There is also no explanation for the numerous inconsistencies and anomalies that abound within the efficient market hypothesis, especially when looking at individual securities and shorter periods of time.  There is even mounting evidence that low-volatility stocks may have better returns than high-volatility stocks, which is counter to the standard risk-return paradigm.

Roger Ibbotson (professor of finance at the Yale School of Management and founder of Ibbotson Associates) and Thomas Idzorek (head of Morningstar’s Investment Management Group) have come up with a theory that they believe explains not only the risk-return paradigm in general but also many of the anomalies that go along with it.  They call it “Dimensions of Popularity.”  As the authors put it, “We believe that most of the best-known market premiums and anomalies can be explained by an intuitive and naturally occurring (social or behavioral) phenomenon observed in countless settings: popularity… Society places a greater relative value (monetary or otherwise) on the more popular items.”

Here’s how the theory works in the investment world.  If an asset has characteristics that investors really like, they will bid up its price, making it more expensive to purchase than other assets with less popular characteristics.  As a result the more popular assets should have lower expected returns (since they cost more) as compared to less popular assets, all other things (such as market growth) being equal.  And the greatest returns should be found in assets that are transitioning from unpopular to popular.  What’s interesting about this theory is that it attempts to explain returns beyond the traditional definition of risk.  While risk is clearly one dimension within the unpopular category, there are other dimensions that (so the theory goes) can affect returns.

Take value stocks, for example.  These are stocks with a low price to book value ratio and are not inherently riskier than those with high ratios (growth stocks).  Yet research has established that value stocks do outperform growth stocks over time.  Liquidity is another factor for which investors demand a premium, whether in bonds or in real estate or private equity.  Yet it’s not a risk factor per se.  (The research on whether or not liquidity impacts stock returns has been mixed).  Momentum is another anomaly that cannot be explained by the efficient market hypothesis.  Stocks that perform well over certain periods of time frequently outperform those that haven’t over the next time period.  Despite the fact that this phenomenon is not well understood and does not appear to behave consistently, Ibbotson & Idzorek argue that momentum is simply another component of popularity.

To test the Dimensions of Popularity theory, the two researchers looked at all U.S. stocks from 1972 through 2013 and sorted them by popularity, as defined by share turnover.   They found that those stocks in the lowest quartile of turnover—the least popular stocks—outperformed the highest quartile by more than 7% on average each year over the period.  That’s huge!

From a practical standpoint, how can you apply this theory?   At this point in time there are no indices, ETFs, or mutual funds that are structured to hold the lowest turnover stocks and reconstitute their holdings periodically.  You’d have to buy and sell the individual stocks yourself.  The trading costs associated with such activity, not to mention the cost of identifying the stocks to buy and sell, are probably beyond the scope of the average investor.   But I wouldn’t be surprised to see investment vehicles popping up in the near future built to follow such a strategy.  Stay tuned…

If you’re interested in reading more about the Dimensions of Popularity theory, here’s a link:

http://www.iijournals.com/doi/full/10.3905/jpm.2014.40.5.068#