Don’t treat the size and value premiums as a free lunch, Swedroe warns.
Today concludes our two-part series on the research aimed to provide explanations for risk. We’ll pick up with more research on the topic.
We looked at three different papers in Part I as we sought to assess the value premium through the lens of risk, and today we turn to a fourth paper: The 2005 study “Understanding Size and the Book-to-Market Ratio: An Empirical Exploration of Berk’s Critique.” The authors concluded that there were various rationales simultaneously active in driving the size and book-to-market (BtM) ratio effects. Among the significant drivers are distress risk and less liquidity, which increases trading risks and costs. Both contribute to higher BtM ratios and higher expected returns.
The fifth paper, the 2005 study, “Asset Pricing and the Illiquidity Premium,” asked the question, Does illiquidity attract a premium in equity markets—is it another risk factor in asset pricing? Stocks that are illiquid not only have lower trading volume but are characterized by wider bid/offer spreads.
The authors analyzed Australian data as an out-of-sample test. They noted that various papers on U.S. markets have found turnover and bid/offer spreads do help explain returns. Their conclusion was that turnover is negatively correlated with returns (low turnover, less liquid, stocks have higher returns).
This is consistent with a risk story. Investors demand higher returns as compensation for the incremental trading risks associated with low turnover stocks. This finding is also consistent with a U.S. study that found that low-turnover stocks display many characteristics commonly associated with value stocks. Specifically, lower trading volume is associated with worse operating performance, higher BtM ratios, lower analyst followings, lower long-term growth estimates and lower stock returns over the prior five years.
Our sixth and final paper is the 2014 study, “Value Premium and Default Risk” which covered the period 1927-2011. The authors found that there was a positive relationship between default risk and the value premium for both large and small firms together with a leverage effect.
The researchers concluded: “The results show a positive association between the default premium and the value premium accompanied with evidence for a leverage effect on the value premium. This lends support to the risk-based explanation for the source of value premium. That is, where the default premium captures systematic risk in the macroeconomy and that the value premium is associated with rational decision making on the part of investors. Value stocks characterized by poor performance, earnings and profitability compared with growth stocks are more vulnerable to the risk of default and lead the investors to require a higher return on value stocks as leverage increases.”