The Book-to-Market effect is probably one of the oldest effects which have been investigated in financial markets. It compares the book value of the company to the price of the stock – an inverse of the P/B ratio. The bigger the book-to-market ratio is, the more fundamentally cheap is the investigated company. Book-to-Market wasn‘t even considered as a market anomaly at the beginning of the century when Ben Graham famously popularized its use. The ratio lost some of its popularity when the Efficient Market Theory and CAPM became the main Wall Street theories. Still, it gained back its position after several studies have shown the rationality of using it. This anomaly is well-described in the classical Fama and French research paper (1993). Additional details are calculated from data that are presented in the Kenneth French data library (http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html).
Pure value effect portfolios are created as long stocks with the highest Book-to-Market ratio and short stocks with the lowest Book-to-Market ratio. However, this pure value effect has substantial drawdowns with more than 50% drawdown in the 1930s. The value factor is still a strong performance contributor in long-only portfolios (formed as long stocks with the highest Book-to-Market ratio without shorting stocks with low Book-to-Market ratios).
One explanation is that investors overreact to growth aspects for growth stocks, and value stocks are, therefore, undervalued.
According to some academics, the ratio of market value to book value itself is a risk measure. Therefore, the larger returns generated by low MV/BV stocks are simply compensation for risk. Low MV/BV stocks are often those in some financial distress.
Confidence in anomaly's validity
Backtest period from source paper
Notes to Confidence in Anomaly's Validity
Period of Rebalancing
Notes to Indicative Performance
per annum, benchmark performance 9,79%
Notes to Period of Rebalancing
Number of Traded Instruments
Notes to Estimated Volatility
benchmark volatility 20,10%
Notes to Number of Traded Instruments
Notes to Maximum drawdown
benchmark drawdown -85,67%
Notes to Complexity Evaluation
Simple trading strategy
The investment universe contains the top 20% biggest companies (based on market capitalization) on NYSE, AMEX, and NASDAQ. Quintile portfolios are then formed based on the Book-to-Market ratio, and the highest quintile is held for one year (portfolio is weighted based on market cap.), after which the portfolio is rebalanced.
Hedge for stocks during bear markets
No - Long-only value stocks logically can’t be used as a hedge against market drops as a lot of strategy’s performance comes from equity market premium (as the investor holds equities, therefore, his correlation to a broad equity market is very very high). Now, evidence for using a long-short value factor portfolio as a hedge against the equity market is very mixed. Firstly, there are a lot of definitions of value factor (from simple standard P/B ratios to various more complex definitions), and the performance of different value factors differ in times of stress. Also, there are multiple research papers in a tone of work of Cakici and Tan : “Size, Value, and Momentum in Developed Country Equity Returns: Macroeconomic and Liquidity Exposures” that link value factor premium to liquidity and growth risk and show that the implication is that value returns can be low prior to periods of low global economic growth and bad liquidity.
Strategy's implementation in QuantConnect's framework