Style Migration and the Cross-Section of Average Stock Returns

Abstract

Stocks experiencing sharp changes in their style characteristics present unique opportunities to examine how investors view style information in making their portfolio allocation decisions. We examine the average returns of such stocks — which we call “style migrants” — and the covariation of the returns of style migrants with same-style stocks to provide new insight into the way investors use equity style information. Our results indicate that investors strongly judge a stock by its style, even when other information indicates that they should not do so. Specifically, we find that stocks experiencing large levels of variability in their size, book-to-market, and momentum characteristics during the prior five years significantly outperform, during the following year, other stocks with more style stability; thus, investors appear to penalize style risk by requiring higher future returns. In addition, these high style risk stocks covary much more with their new style cohorts than other low style risk stocks that have also moved into the same new style category — this is consistent with investors overreacting to style shifts with high style risk stocks, while exhibiting a “style memory” effect for low style-risk stocks. In further tests, we find some evidence that low-skill mutual fund managers tend to exhibit “style-chasing” behavior, and that their trades are correlated with contemporaneous abnormal returns of style migrants — consistent with their trades affecting migrant returns. Overall, our paper provides new evidence about investor behavior by demonstrating that some investors appear to overweight style information when allocating their portfolios, especially for certain high style-risk stocks.