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Are Zacks Rankings Exploitable?

| | Posted in: Fundamental Valuation

A reader inquired about the Zacks services. The core belief of Zacks Investment Research is: “Earnings estimate revisions are the most powerful force impacting stock prices.” This belief underlies the Zacks “quantitative model to harness the power of earnings estimate revisions – the direction, the degree of change, and surprises – along with other important variables to create the Zacks Rank.” The Zacks Rank feeds a range of information services that Zacks offers to investors. Should investors expect that portfolios built on the Zacks Rank will substantially outperform the market? Based on information available about the Zacks Rank and associated managed accounts/funds, we find that:

Zacks provides portfolio-based performance data for their services in the form of estimated annual/annualized returns. As disclaimed by Zacks, these returns are generally “equal weighted hypothetical portfolios…assuming monthly [or indeterminate event-based] rebalancing and zero transaction costs.” Zacks identifies and generally claims due diligence in avoiding four types of bias in estimating these returns: look-ahead bias, restatement bias, survivor bias and split bias. The general Zacks disclaimer states: “You acknowledge that the service is provided for information purposes only and is not intended for trading purposes…Zacks does not guarantee the sequence, accuracy, completeness or timeliness of the service…”

There is a large body of research finding, with the usual messiness of financial markets research, that actual/expected earnings are important to valuation and that earnings surprises systematically affect stock prices. However, portfolios based on earnings surprises such as those tracked by the Zacks research services generally entail substantial turnover/rebalancing. The frictions (transaction costs, bid-ask spreads and tracking service fees) associated with this turnover are likely material and may offset gross returns. There also may be material and difficult-to-quantify data snooping bias associated with the hypothetical backtesting Zacks uses to estimate performance.

The burden is on prospective subscribers to decide whether realistic trading frictions and data snooping bias offset the hypothetical gross alpha enabled by Zacks research, but Zacks does not provide enough detail (e.g., portfolio turnover and typical stock capitalization statistics) with the performance data to make this decision.

However, prospective subscribers can perhaps get a realistic view of the level of net performance enabled by Zacks research from the historical returns of:

Zacks Investment Management managed accounts, “each derived from the same Zacks Investment Philosophy.” For example, there is a 15-year “performance history of a representative managed separate account” (with and without approximate management fees) for the “Zacks Rank Strategy” (see chart below).

Zacks Investment Management mutual funds, which “use the firms’ philosophy of earnings estimate revisions as the forefront of the stock selection process.” The performance histories of these funds are short. For example, the Zacks Market Neutral Fund (ZMNAX – Class A) seeks “to generate positive returns in both rising and falling equity markets” by exploiting any alpha essentially driven by long (short) positions in stocks with the most (least) attractive earnings estimate revision data. From inception on 7/25/08 through 1/5/10, the total return for this fund is -13.1% (exclusive of any front loads).

The following chart compares annual net returns for the representative Zacks Rank Strategy managed separate account to those for the investable S&P Depository Receipts (SPY), treating 1995 from February and 2009 through June as full years. Notable metrics are:

  • The Zacks Rank Strategy has an arithmetic mean (average) annual return of 8.4%, compared to 8.3% for SPY.
  • The Zacks Rank Strategy has a standard deviation of annual returns of 19.6%, compared to 21.0% for SPY.
  • The Zacks Rank Strategy has a geometric mean (compound) annual return of 6.5%, compared to 6.5% for SPY.
  • The Zacks Rank Strategy beats SPY in nine of 15 years (60%).

Returns for the representative Zacks Rank Strategy managed separate account probably overstate those realized by individuals with modest accounts (“higher fees may apply to smaller accounts”). Individuals managing their own accounts based on the Zacks Rank may be more nimble and flexible than the Zacks managed accounts and mutual funds, but may bear higher trading frictions. Also, if used for a taxable account, the Zacks Rank Strategy managed separate account (and a similar self-managed account) would likely generate substantial short-term tax obligations.

In summary, evidence from Zacks representative managed account and mutual fund results do not support a belief that realistic implementations of Zacks Rank data generate substantial net outperformance.

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