The manager of a big mutual fund is concerned about the mediocre investment results experienced by the fund in recent years. She meets with her equity analyst to consider alternatives to the stock selection techniques employed in the past. The analyst suggests that the current literature has examined the relationship between book-to-market (B/M) ratios and securities returns. A number of studies had concluded that high B/M stocks tended to have higher returns than stocks with low B/M ratios. The analyst also referred to studies analyzing the relationship between security returns and company size as measured by equity capitalization. The studies concluded that when compared to the S&P 500 index, small-capitalization stocks tended to provide above-average returns, while large-capitalization stocks tended to provide below-average returns. It was further noted that little correlation was found to exist between a company's B/M ratio and the size of its equity capitalization.

The mutual fund has used a strategy of complete diversification and the use of market beta as a measure of portfolio risk. The manager of the fund is curious about how these studies might be applied to the stock selection techniques of the fund.

a. Based on the above studies, the analyst suggests that, in order to enhance fund performance, the fund should overweight stocks with low market capitalization and stocks with high book-to-market. Do you agree with the analyst? Explain your reasoning.

b. The mutual fund is restricted from short-selling. Does this constraint have an impact for investing in factor strategies such as momentum?

Answer rating: 100% (QA)

The analysts suggestion to overweight stocks with low market capitalization and high booktomarket BM ratios is based on empirical findings from academ... View the full answer