The Death of the Easy Beat: Why Classic Stock-Picking Rules No Longer Work

Ivo Welch, pictured, and Andrew Chen tested stock-picking signals that have been reported in top finance journals. (UCLA Anderson)

Key Points

• Ivo Welch and Andrew Chen tested about 200 stock-picking signals that have been reported in top finance journals since 1973.
• Their working paper showed that the average long-short return from tested signals fell from 0.5% a month in pre-2005 data to less than 0.2% a month in markets since 2005.
• Excluding the bottom 10% of stocks by market capitalization shrank the post-2005 returns on the tested strategies to an average of 0.07% a month.

Investment researchers over the last few decades have reported hundreds of stock-picking rules that seemed to beat the market. Those were the good days.

The returns today from betting on most of the publicly-known stock signals have shrunk to a small fraction of a percent, says Ivo Welch, a finance professor at the University of California, Los Angeles’ Anderson Graduate School of Management.

And if you exclude tiny illiquid stocks from your tests, he says, the returns from using any of the hundreds of known stock signals average less than 1% a year. After trading costs and random acts of the gods, there’s little left.

“There’s just nothing there,” Welch tells Barron’s. “The public financial markets are awfully efficient. It’s very hard to make money off something that is well-known.”

Working with Federal Reserve Board economist Andrew Chen, Welch lays out those findings in a July working paper, after testing about 200 stock-picking signals that have been reported in top finance journals since 1973. (Chen also has a website that lets you browse 331 different investment criteria that researchers once reported as profitable.)

Here’s how people can test one investment rule: Let’s say you want to see whether you can beat the market with “value stocks”—those with cheap prices relative to their book values. You’d then buy a portfolio of the cheapest stocks and sell short a portfolio of the most expensive ones, since shortselling lets you profit when they go down. At the end of a month, you’d count your profits—if any—from the two portfolios, then form new portfolios with the next month’s cheap and pricey stocks. Repeat and repeat.

Using databases of historic stock prices and company financials, Welch and Chen tested each of the 200-odd investment signals for their working paper. In pre-2005 financial data, the average long-short return from the signals would have been better than the market’s by an impressive 0.5% a month.

But in markets since 2005, the average investment signal would have yielded long-short returns that were less than 0.2% a month. Welch and Chen picked the 2005 break point as a rough way to capture the market changes from fractional to decimal stock pricing and the rise of high-frequency computerized trading firms.

The two researchers also found that many claims of a new stock-picking signal had been tested in a standard academic database that includes thousands of illiquid, micro-capitalization stocks. Investors can’t really put meaningful money into those tiny stocks.

So, Welch and Chen tested the investing strategies while excluding stocks in the bottom 10% of market capitalizations. That shrank monthly returns by half.

All told, the post-2005 returns on non-micro stocks averaged just 0.07% a month, or 0.84% a year.

And that’s before trading costs. Even in an era of zero commissions, transaction costs can add up from the spread between the prices at which you can buy and sell a stock.

“It’s really hard to make a living against thousands of hedge funds and thousands of investors, even if they’re individually irrational,” says Welch.

The study doesn’t mean that all systematic trading rules are futile. There could still be market-beating returns for quant investors using unpublished, proprietary strategies, or who use “alternative data” beyond the standard company financials. Those investment edges, if they exist, would be closely-held secrets.

But the age of profiting well from a simple, well-known investment strategy seems to be over.

Write to Bill Alpert at william.alpert@barrons.com

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