Anomalies Tested with Expected (Rather Than Historical) Returns

Are the major known stock return anomalies as exploitable as they seem to investors looking back at historical returns? In their September 2008 paper entitled “Do Anomalies Exist Ex Ante?”, Ginger Wu and Lu Zhang examine a wide range of anomalies (book-to-market, composite issuance, net stock issues, abnormal investment, asset growth, price momentum, earnings surprises, total and discretionary accruals, net operating assets, and failure probability) from the perspective of a forward-looking investor. They employ in their analysis expected returns derived from growth rates of fundamentals (dividends, earnings, sales and equity), rather than backward-looking historical (realized) returns. Using monthly price and return data for a broad sample of stocks, along with contemporaneous firm fundamentals, over the period 1965-2007, they conclude that:

• Expected return estimates for zero-cost anomaly investment strategies (long/short the extremes of the anomaly variable distributions) have similar magnitudes as their average realized returns. However, while the average realized returns are all reliably different from zero, the expected return estimates are nearly all statistically insignificant.
• Only the value-minus-growth strategy shows some ex ante evidence of profitability.
• This evidence casts doubt on the ability of anomalies-based quantitative strategies to generate abnormal returns.

In summary, the well-known stock market anomalies may be much less reliable in rational practice than they appear in hindsight.

It seems that, just as implied volatility is generally higher than realized volatility, returns expected based on fundamental growth are more volatile than realized returns.

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