The Value Line Anomaly &
"Implementation Shortfall"

Value Line is a service that ranks stocks from 1 to 5 for timeliness. As a group, each rating has historically outperformed the next lowest rated group (the ones have outperformed the twos, which outperformed the threes, etc.). The impressive performance of the rating system led many to refer to it as the "Value Line Anomaly" or the "Value Line Enigma."

Some researchers have argued that Value Line's outperformance resulted from their use of earnings surprises and price momentum while others have suggested that the model portfolio's outperformance resulted from assuming higher risk. Regaining the Edge is an article in Worth magazine (2/97) about Value Line's recent performance and its new strategy.

The initial Value Line results were so impressive that Value Line was the subject of a complimentary 1973 article in the Financial Analysts Journal by highly respected economist Fischer Black titled "Yes, Virginia, There is Hope: Tests of the Value Line Ranking System." In the article, Black confessed that previously he had been a strong believer in the efficient market hypothesis and passive management. Yet his research of Value Line's rating system, confirmed that the system did produce significant excess returns over a five year period. Excess returns would have resulted even after taking two percentage points out for round trip transactions costs (turnover in the rankings is high).

In an attempt to match the returns of the top rated stocks, Value line established a mutual fund. The results of the Value Line Centurion fund (which invested in 100 Group 1 stocks and the top 100 of 300 Group 2 stocks) may serve as an important lesson for investors. Not only didn't the real-money fund keep pace with the paper returns from the top rated stocks (which continued to outperform on paper), it didn't even outperformed the market. On the other hand, Value Line continues to be one of the highest ranked newsletters by the Hulbert Financial Digest which does account for costs.

According to David J. Leinweber ("Using Information From Trading in Trading Portfolio Management," The Journal of Investing, Summer 1995), from 1979 to 1991, the ValueLine paper portfolio had an annualized return of 26.2%, but the real ValueLine fund had an annualized return of only 16.1%. In other words, while Value Line seems to have an ability to pick stocks well, the paper returns weren't realizable by the mutual fund (and likely Value Line subscribers). As Robert S. Salomon Jr. states in Value Line's self-defeating success" (Forbes - 6/15/98), "Value Line's rankings are a prisoner of their own success: They work so well that too many people try to act on them."

Some have theorized that the failure of the Value Line fund to keep up with the model portfolio demonstrates what is known as "implementation shortfall." Transactions costs can significantly reduce returns particularly in portfolios with high turnover. Investors must also account for the bid-ask spread and mutual funds typically have the added burden of not being 100% invested because of the need to maintain cash reserves. Its also important to note that a court order in the 1960's mandated a delay between publication of Value Line rating changes and trading in the portfolio. Investors may interpret this as an example of how difficult it may be to profit from an anomaly.

The term "Implementation Shortfall" was coined by Andre Perold. Perold has written extensively on implementation shortfall and how to measure it. Strategies that seem to offer an investor an advantage may not work in real world conditions because of transactions costs and other costs. Perold has also argued that the larger a portfolio is, the harder it is to exploit any informational advantage. Plexus Group is a consulting firm that specializes in these issues and advises institutional investors on controlling costs. The Plexus Group web site includes further information on the topic.

The difference between paper portfolios and real-money portfolios is an entirely seperate issue from the question of whether past outperformance will continue in the future. Investors that attempt to implement strategies going forward based on back-tested models must deal with both "implementation shortfall" and the performance persistence issue. Strategies that continue to outperform with real money after being initially discovered via back-testing are perhaps the exception rather than the rule.

Anomalies, Calendar, Fundamental, Technical, and Other anomalies.

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