Professor Roger Ibbotson is one of the most respected and influential researchers of the current era. His book “Stocks, Bonds, Bills, and Inflation” is a classic and often serves as a reference for information about capital market returns. Therefore we always pay attention to his publications. His actual work, “Popularity – A Bridge between Classical and Behavioral Finance”, which is written with Thomas M. Idzorek, Paul D. Kaplan, and James X. Xiong, is now available on SSRN.
In their work, authors explain the term “Popularity” from an asset pricing point and show how “Popularity” can be a broad umbrella under which nearly all market premiums and anomalies (including the traditional value and small-cap) can fall. They develop a formal asset pricing model that incorporates the central idea of “Popularity”, which they call the “popularity asset pricing model” (PAPM). Based on this model, they predict characteristics as a company’s brand, reputation, and perceived competitive advantage to be new equity factors.
It’s a long read, but we at Quantpedia really recommended it for all equity portfolio managers …
Authors: Ibbotson, Idzorek, Kaplan, Xiong
Title: Popularity: A Bridge between Classical and Behavioral Finance
Popularity is a word that embraces how much anything is liked, recognized, or desired. Popularity drives demand. In this book, we apply this concept to assets and securities to explain the premiums and so-called anomalies in security markets, especially the stock market.
assets and securities have a relatively fixed supply over the short or
intermediate term. Popularity represents the demand for a security — or
perhaps the set of reasons why a security is demanded to the extent that
it is — and thus is an important determinant of prices for a given set
of expected cash flows.
A common belief in the finance literature
is that premiums in the market are payoffs for the risk of securities —
that is, they are “risk” premiums. In classical finance, investors are
risk averse, and market frictions are usually assumed away. In the
broadest context, risk is unpopular. The largest risk premium is the
equity risk premium (i.e., the extra expected return for investing in
equities rather than bonds or risk-free assets). Other risk premiums
include, for example, the interest rate term premium (because of the
greater risk of longer-term bonds) and the default risk premium in bond
There are many premiums in the market that may or may
not be related to risk, but all are related to investing in something
that is unpopular in some way. We consider premiums to be the result of
characteristics that are systematically unpopular — that is, popularity
makes the price of a security higher and the expected return lower, all
other things being equal. Preferences that influence relative popularity
can and do change over time. These premiums include the size premium,
the value premium, the liquidity premium, the severe downside premium,
low volatility and low beta premiums, ESG premiums and discounts,
competitive advantage, brand, and reputation. In general, any type of
security with characteristics that tend to be overlooked or unwanted can
have a premium.
The title of this book refers to a bridge
between classical and behavioral finance. Both approaches to finance
rest on investor preferences, which we cast as popularity.
Notable quotations from the academic research paper:
“Popularity as a Concept
Popularity is how much anything is liked, preferred, or desired. We applied the concept to assets and securities. In this way, we were able to give explanations for all the premiums in the markets, especially the stock market.
– Most assets and securities are in relatively fixed supply over the short or intermediate term. Popularity represents the demand or perhaps the excess demand for a security and is thus an important determinant of prices for a set of expected cash flows.
– The “risk” premiums in the market are payoffs for the riskiness of securities. In classical finance, investors are risk averse and market frictions are usually assumed away. Risk is unpopular. The largest risk premium is the equity risk premium—that is, the extra expected return for investing in equities rather than bonds or risk-free assets. Other risk premiums include the interest rate risk and default risk in bond markets.
– The market encompasses many premiums that may or may not be related to risk, but all are related to investing in something that is unpopular in some way. We analyzed premiums on security characteristics that are systematically unpopular, although they can change dynamically over time. Such premiums include the following: – the size premium, – the value premium, – the liquidity premium, – the premium for severe downside risk, – low-volatility and low-beta premiums, – premiums and discounts for environmental, social, and governance investing, – premiums for lack of competitive advantage, poor brand awareness, and poor reputation, and – the premium for any type of security that is being overlooked.
Popularity as a Bridge between Classical and Behavioral Finance
The title of this book refers to popularity as a bridge between classical and behavioral finance. Both approaches to finance rest on investor preferences which we recast as popularity. Preferences, which can be rational or irrational.
Popularity as a Theory
– The CAPM is an elegant and easy-to-use theory for describing investor expected returns in an equilibrium setting. We generalized the CAPM to include all types of preferences in the popularity asset pricing model (PAPM).
– The CAPM assumes that investors are not only rational and risk averse but can also diversify away all unsystematic risk. Thus, only systematic (market) risk in securities is priced. Securities with high systematic risk have lower relative prices and, therefore, higher expected returns.
– NET (New Equilibrium Theory) is a framework in which investors are rational but have preferences for or aversions to various security characteristics beyond undiversifiable market risk, as in the CAPM—even beyond the multiple dimensions of risk modeled in the arbitrage pricing theory.
– In NET, in addition to systematic risk aversion, investors also have a rational aversion to assets that are difficult to diversify, lack liquidity, are highly taxed, and/or are not easily divisible. All these preferences affect the prices and expected returns of assets that embody these characteristics.
– The PAPM provides a theory in a CAPM equilibrium framework by including both risk aversion and popularity preferences on the part of investors. These preferences can be rational, as in NET, or irrational, as in behavioral economics.
– In the PAPM, the various securities have different systematic and unsystematic risks and differing popularity characteristics. Investors also have differing risk aversions and popularity preferences. The characteristics are priced according to the aggregate demand for each of the characteristics. The expected return of each security is determined by its risk and popularity characteristics.
– In our PAPM illustration, one investor, having only risk aversion and no popularity preferences, was purely rational. Although this investor earned excess economic returns, he or she was only part of the equilibrium demand, so aggregate popularity was still a part of PAPM pricing. Securities are priced in this equilibrium framework, and no riskless arbitrage opportunities exist.
Empirical Evidence for Popularity
The concept of a negative return to popularity (what we have simply called “popularity”) has been shown to be consistent with the empirical premiums found in the stock market. But this explanation is after the fact. Direct tests involve trying to identify in advance what characteristics are likely to be popular and which ones are likely to be unpopular and then to test the relative performance of portfolios based on them. We did this test at the company level and at the common stock level.
– We carried out analyses on five characteristics: (1) brand, (2) competitive advantage, (3) reputation, (4) tail risk, and (5) lottery-like stocks. In the analyses, we considered both equally weighted composites and market cap–weighted composites. Of these 10 different views, all 10 are highly consistent to moderately consistent with popularity whereas only 5 of 10 are consistent with the paradigm that more risk equals more return.
– Companies with high brand values are popular. The quartile portfolios containing these companies ended up having significantly lower returns than the quartile portfolios with the lowest brand value over the April 2000–August 2017 period.
– Companies with sustainable competitive advantages are said to have wide economic moats, making them more popular than low-moat or no-moat companies. Portfolios of companies with no moats outperformed portfolios of wide-moat companies over the July 2002–August 2017 period.
– Quartile portfolios of companies with better reputations tended to underperform quartile portfolios of companies with less glowing reputations over the April 2000–August 2017 period.
– Equities that have historically had negative tail-risk events (low or negative coskewness) are unpopular. Quartile portfolios of these stocks significantly outperformed those of stocks with high coskewness over the January 1996–August 2017 period.
– Stocks with lottery-like payoffs are popular because they provide the apparent opportunity for outsized gains. Quartile portfolios of these stocks, specifically those with the highest average of their five best days’ returns, had the lowest risk-adjusted returns among the quartile portfolios based on this measure of lottery-like payoffs over the February 1991–December 2016 period.
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