A Multi-Factor Strategy for Index Enhancement

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One of the most powerful biases that drives stock behavior is also one of the most difficult to capture — investors’ tendency to overpay for stocks that have the possibility of a very large payoff. These stocks are described as having high positive “skew.” More popularly, they can be thought of as “lottery” stocks. “Safety” stocks, those with relatively small chance of a very large loss, display a similar, though not identical, return pattern and also fall into the positive skew group. For both lottery stocks and safety stocks, disproportionately higher expectations for future returns translate to higher current valuations and, consequently, lower future stock performance. QMA’s study proposes a multi-factor approach to outperforming an index by avoiding both of these types of stocks. We focus on a combination of three factors — value, volatility and a specific type of quality — that in our experience characterize firms with positively skewed return expectations.

Authors: Roy Henriksson, PhD, Chief Investment Officer; Joshua Livnat, CPA, PhD, Managing Director and Head of Research; Patrick Pfeifer, CFA, Vice President and Senior Quantitative Analyst; Margaret Stumpp, PhD, Senior Advisor

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