Morningstar - Summer 2019 - 81

it also predicts that any kind of factor, exposure,
or attribute that you can rank on some kind
of popularity scale, such as those James talked
about, will have a premium associated with
buying the unpopular stocks. So, popularity makes
a prediction that you can then look at empirically
that wasn't in the literature before.
Ibbotson: Just to be clear, it's a price premium
when we like it, but it's a return premium when
we don't like it.
Rekenthaler: The PAPM theory is descriptive, in that
the model is evaluating how dimensions of
popularity affect the prices of stocks. But is it also
prescriptive? If somebody doesn't value those
popularity attributes, then securities that have less
of them would be sound purchases, right?

Kaplan: That's right. That's why I like the term
"willing losers," which Rob Arnott coined.8
People who buy a stock because of characteristics
that are popular, for reasons that have nothing to
do with risk and return, they're the willing losers.
They're willing to give up return in exchange to get
the characteristics that they like.

Popularity is a kind of umbrella. It can
include a bunch of factors or characteristics.
James Xiong

Ibbotson: The simplest example would be liquidity.
That's a classic example in classical economics.
Some people really need liquidity and are willing
to pay a higher price and get lower returns
to get that liquidity. Those who take the other side
of this get the higher returns for less liquidity.
Rekenthaler: It sounds as if the pricing for liquidity

or characteristics or attributes that would nearly
universally either be liked or disliked by
investors. There's a large number of premiums
or anomalies that are not necessarily consistent
with the traditional CAPM view of the world,
where more systematic risk always should equate
to more expected return. Across all these
different attributes or dimensions or characteristics, what we see is that the winner is the
investor who is willing to hold the less popular
attribute or characteristic, and the loser

is the person who is overpaying for the liked
or loved attribute.

A Unifying Framework
Kaplan: Popularity provides us a conceptual
framework to understand all these different
premiums-size, value, and so on-that have
been studied for decades. Number one,
popularity is a unifying framework. Number two,

is pretty rational. People who need liquidity will
pay up to get it. The market will settle on the
appropriate price. But all factors need not be rational,
right? The model is agnostic as to whether the
marketplace is making sense when pricing a factor.

Kaplan: Yes. That's why the subtitle of the book
is "A Bridge Between Classical and Behavioral
Finance." The reasons that investors might be
drawn to a stock could be completely irrational-
just because they like the names of the companies.
Rekenthaler: Have you run into criticism from the
strongly classical side or the behavioral side?

8 Quoted in Rostad, K.A. 2013. The Man in the Arena: Vanguard Founder John C. Bogle and His Lifelong Battle to Serve Investors First. New York: John Wiley & Sons.

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Morningstar - Summer 2019

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