Morningstar Advisor - February/March 2012 - (Page 64)

Gray Matters Exhibit 5 Excess Return Volatility Against Number of Stocks: It requires more stocks to reach the same diversification after 1997 for both small- and large-stock portfolios. Small-Cap Portfolio 16% 16% Excess Return Volatility Excess Return Volatility Small (1997–2010) Small (1997–2010) Small (1979–1996) Small (1979–1996) This increase and convergence of betas suggests that diversification benefits during the second period (1997–2010) were reduced for all types of portfolios (small, large, growth, or value), a situation that remained (at least) through the end of our study period. This unambiguously means that there is increased risk of unexpected negative events for investors. To further demonstrate the reduced diversification benefits since 1997 for both large-cap and small-cap stocks, we examine the excess return volatility for portfolios of large- and small-cap stocks while varying the number of stocks in the respective portfolios. For both the largest- and smallest-cap stock quintiles, we constructed 26-week, equal-weighted portfolios containing a different number (five to 50) of randomly selected stocks (without replication), similar to the empirical methodology of Kamara, Lou, and Sadka (2010)4. Using daily returns, we calculated the annual excess return volatility of each portfolio relative to the market, defined as the difference between the portfolio’s standard deviation of return and the standard deviation of return of a value-weighted portfolio made up of all the stocks in the sample. To examine changes over time, we again subdivided our sample into two periods, 1979–1996 and 1997–2010. For each period, we calculated the average annual excess volatility for each portfolio. Exhibit 5 shows that for both large and small portfolios, diversification benefits are dramatically diminished in the second period (1997–2010). In other words, an investor who wishes to maintain the same excess return volatility level after 1997 would need to meaningfully increase the number of stocks he or she holds, for portfolios of both large- and small-cap stocks. Rising Fragility 12 12 Passively managed index funds and ETFs have seen accelerating growth of their assets in recent decades, and passive funds now hold more than half of the level of assets held by actively managed mutual funds. The increased level of trading associated with passive investing, however, comes with important consequences for investors. It means an increased trading commonality among index constituents through the interactions of market participants. Such trading commonality then gives way to a rise in systematic fluctuations in overall demand. This, in turn, leads to a fundamental impact on the overall market and investors’ portfolios. The rise in systematic risk emanates, in part, from an increase in trading commonality across time and across stocks associated with growth in passive investing. Though perhaps not the only explanation for rising systematic risk, our results provide strong evidence that the observed increase in trading commonality since 1997 has indeed led to lower cross-sectional dispersion of volume changes and, therefore, greater systematic risk since then. As evidence, we report that both pairwise and cross-correlations between return volatility and volume volatility have significantly increased since 1997. Furthermore, we show that the diversification benefits of equity investing have decreased for all styles of stock portfolios (small, large, growth, or value). Altogether, our results suggest that the U.S. equity market has become more fragile over recent decades. K James X. Xiong, Ph.D, CFA, is senior research consultant at Morningstar Investment Management. Rodney N. Sullivan, CFA, is editor of the Financial Analysts Journal at CFA Institute, Charlottesville, Va. 8 8 4 4 0 0 Number of Stocks Number of Stocks 20 20 40 40 Large-Cap Portfolio Excess Return Volatility Excess Return Volatility 8% 8% Large (1997–2010) Large (1997–2010) Large (1979–1996) Large (1979–1996) 4 4 0 0 Number of Stocks Number of Stocks 20 20 40 40 growth stocks during the first half of the decade, beginning in 2000. During the second half of the decade, the average betas across all four size and style categories together began a steady rise, exceeded one, and have remained elevated ever since. 4 Avraham Kamara, Xiaoxia Lou, and Ronnie Sadka. 2010. “Has the U.S. Stock Market Become More Vulnerable Over Time?” Financial Analysts Journal, Vol. 66, No. 1: 41–52. 64 Morningstar Advisor February/March 2012

Table of Contents for the Digital Edition of Morningstar Advisor - February/March 2012

Morningstar Advisor - February/March 2012
Contents
Contributors
Letter From the Editor
Make a Difference Stories, Not Debates
How Concerned Are You About Europe?
Analytical and Independent
What to Ask When a Fund Manager Leaves
Past, Present, Future
Have Financials Gotten Cheap Enough?
Four Picks for the Present
Investment Briefs
Tactical Funds Miss Their Chance
Specialty Retail: Ad Hoc Opportunity
How Europe Is Making Its Crisis Worse
Impact on U.S. Economy Will Be Minimal
European Banks: Bargains or Value Traps?
Don’t Count the Euro Out Yet
Europe on the Brink
GoodHaven Realizes Its Vision
How Index Trading Increases Market Vulnerability
Nonlisted REITS: Handle With Care
Safety Picks for the Many Moods of Mr. Market
On the Prowl for Large- Blend Index-Beaters
Our Favorite Mutual Funds
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
The Math That Matters

Morningstar Advisor - February/March 2012