By: Barry Feldman, Ph.D.

, CFA , Senior Research Analyst

OCTOBER 1, 2012

Stability Is the Risk Dimension of Equity Style

This study tests the relative ability of the Russell Stability Style Indexes to identify company risk. Three forward-looking measures serve as risk proxies: I/B/E/S analyst earnings forecast dispersion, S&P company credit rating and company expected life - a model-based statistic developed by Northfield. These measures have low mutual correlation and appear to provide a robust representation of risk at the company level. The factor alternatives to stability tested include beta, volatility, valuation, momentum, size and quality. Low- and high-risk company samples are constructed for all measures. Forecast dispersion tests are based on differences in sample identification and misidentification rates. Credit rating and expected life tests are based on differences in sample averages. Stability is found to consistently do best at identifying company risk. Almost all results are highly statistically significant. U.S. and global ex-U.S. markets are tested separately. The sample covers the period from 1996 to 2011 and comprises 39,577 company-year observations.
An equity style index provides an objective approximation of a basic investment strategy. Size (large/small cap) and valuation (growth/value) are currently the two best known and broadly accepted dimensions along which style indexes have been constructed. The Russell 1000 and Russell 2000 Indexes, for example, provide passive large cap and small

Thank you to David Cario, particularly, for his help and for his contributions to this work. Thanks also for comments from Bob Collie, Dan Gardner, Mary Fjelstad, Dave Hintz, William Jacques, Mark Paris, Lori Richards, Mark Thurston, Ian Toner and Catherine Yoshimoto, as well as Larry Pohlman and participants in the Boston Security Analysts Societys 2012 conference Minimum Volatility: One Year Later. Thanks to Rolf Agather for his patience with this effort. Thanks also to Dan diBartolomeo of Northfield Information Systems for making Northfields company expected life data available.

Russell Investments // Stability Is the Risk Dimension of Equity Style

cap investment strategies along the size dimension, and the Russell 3000 Growth and Value Indexes provide passive strategies along the valuation dimension. The importance of these two dimensions of style size and valuation has long been recognized by investors, investment managers, leading practitioners and academic researchers. Russells defensive and dynamic indexes, together called the Russell Stability Indexes, represent a third dimension of style as important as the first two: stability, or relative risk. Stability differs from other styles and factors in that it is designed to identify company risk generally, and not a specific type of risk such as that related to a stocks size, momentum or price volatility. Company risk which is, of course, associated with stock price volatility can also be inferred from information found in company financial statements. Russells stability style methodology turns company volatility and accounting information into a stability probability. High-stability companies form the Russell 3000 Defensive Index. Lowstability companies form the Russell 3000 Dynamic Index. This study tests the ability of Russells stability indexes to identify company risk. Three forward-looking measures serve as risk proxies: analyst forecast dispersion, company credit rating, and a model-based statistic called company expected life. These measures have low mutual correlation and appear to provide a robust representation of company risk. Low- and high-risk company samples are constructed from each of these measures. These samples are then used to test the risk-identification ability of the stability indexes and alternative indexes based on size, valuation, volatility, quality, momentum, beta and three other factors. The defensive and dynamic indexes are found to provide robust identification of company risk and to do so consistently better than all alternatives tested. In the Russell methodology, a companys defensive probability2 is based on a score that increases with lower balance-sheet leverage (the debt/equity ratio, a measure of financial constraint), lower earnings variability (which measures sensitivity to economic/industry and product cycles), and higher return on assets (which is a proxy for the durability of a companys business model). Together, these three accounting variables comprise a component we call quality. In addition, a companys score increases with lower volatility of its stock returns. Volatility may reflect risks not yet reflected in accounting measures, such as uncertainty in growth expectations, and also risks not well captured by accounting measures such as those related to litigation and regulation.3 The quality component of the stability methodology provides an accounting-based perspective on company risk, while the volatility component provides a market-based perspective. The research presented here shows the benefit of combining these complementary perspectives on company risk. Designing new style indexes may require a balancing of design objectives. As it happened, the design changes that increased risk-identification ability also increased manager representativeness. Russell introduced its size indexes in 1984 and its valuation indexes in 1987. Both series were grounded in the study of manager investment practices. These indexes were designed to be representative of the stock habitats of managers pursuing different investment styles.4 The stability indexes were inspired by the long-term observations of Russells manager researchers that the size and valuation styles did not adequately reflect the

A companys style probability is the fraction of its shares assigned to the respective index; the defensive probability is the fraction of shares assigned to the defensive index, while the dynamic probability is one minus the defensive probability.
3 4

For a full description of Russells stability style methodology, see Russell Indexes (2012).

See Christopherson, Cario and Ferson (2009), chapters 25 and 26, Equity style indexes: Tools for better performance evaluation and plan management (originally written in 1989), and Russell style index methodology. See also Haughton and Pritamani (2005).

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observed diversity of manager investment styles.5 The quality component of the stability methodology reflects our initial attempt to represent this additional diversity. In subsequent investigations we determined that combining quality and volatility measures improved index characteristics along several dimensions, including increased representation of the diversity of manager styles and reduced correlation and holdings overlap with the valuation indexes.6 Russell has found that a significant percentage of managers are most appropriately benchmarked to dynamic indexes. Many of these managers seek excess returns via their ability to carefully time their buy and sell decisions. Such opportunities are easier to find in dynamic companies, which tend to have high stock price volatility, and the potential payoff is much greater. Similarly, Russell has identified a substantial fraction of managers who have lowest historical tracking error to a defensive index. It appears that there has always been some interest in low-risk strategies, but that manager interest and institutional mandates have been increasingly influenced by the growing literature on the long-term riskadjusted outperformance of low-risk equity strategies.7
General approach

This study is based on the companies in the Russell Global Large Cap Index over the 16year period 1996 to 2011. Risk-identification ability is tested using low- and high-risk samples based on each style and factor. The stability low-risk sample, for example, is based on companies in the defensive index. Each sample comprises the companies representing approximately 35% of the relevant equity universe by market capitalization that have highest style or factor strength. The companies in each sample are then analyzed to determine their risk status according to each risk proxy (analyst forecast dispersion, company credit rating, and company expected life). These results are equally weighted to obtain sample averages. Results and statistical tests are based on these averages.
Key findings

Three independent sets of tests are conducted. With respect to identifying low-risk companies, stability does better than all alternatives in all tests, with the exception that company size does better when risk status is determined by credit rating. With respect to identifying high-risk companies, stability does better than all alternatives when forecast dispersion is used to determine risk status; it does better than all alternatives except volatility when credit rating is used to determine risk status; and it does better than all alternatives except quality and leverage when expected life is used to determine risk status. Tests show that almost all estimates of stabilitys relative risk identification power are highly statistically significant.

5 6

See Hintz (2010) and Thurston (2011).

The idea of a risk dimension to equity style has deep roots. Starting in the original 1949 edition of The Intelligent Investor, Benjamin Graham distinguishes between defensive and enterprising investors and focuses on practical investment strategies for these two investor types. Defensive investors are envisioned as the major class of investors that place chief emphasis on the avoidance of any serious mistakes or losses (1949, p. 4). Grahams enterprising investor is willing to put considerable time and effort into identifying potentially promising investment options from among those that might appear overly risky. While defensive investors are advised to invest in the stocks of large, prominent and conservatively financed companies (1973, p. 114), enterprising investors should be interested in bargain issues, special situations and carefully chosen growth stocks (1973, p. 156). Graham is remembered today chiefly as the father of value investing. Indeed, for Graham, value investing was not a matter of style. All Graham investment strategies pay close attention to relative price. He rejected pricing overly reflective of future expectations as speculation. In relation to the new Russell style model, Graham investors could be considered either defensive value or dynamic value investors.
7

These include Clarke, de Silva and Thorley (2006) on minimum variance, Blitz and van Vliet (2007) on low volatility, Brendan, Bradley and Wurgler (2010) on low volatility and Asness, Frazzini and Pedersen (2012) on risk parity.

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Plan of this paper

Section I of this paper reviews the risk proxies used to represent company risk. Section II describes the construction of the study sample. Section III presents comparisons based on forecast dispersion. Section IV presents comparisons based on credit rating. Section V presents comparisons based on company expected life. Section VI considers the robustness of the results and summarizes additional tests based on forecast dispersion. The conclusion follows.

I. Proxies for company risk

Analyst forecast dispersion, based on I/B/E/S collected analyst forecasts, is the primary company risk proxy used in this study and the only risk proxy for non-U.S. companies. Han and Manry (1997) appear to have first studied company performance outcomes associated with high forecast dispersion. Since then, a broad body of research has validated the use of forecast dispersion as a risk indicator, and, particularly, of the risk of earnings surprises. Diether, Malloy and Scherbina (2002) gained wide attention for their finding that high forecast dispersion predicted underperformance and for their interpretation of forecast dispersion as a proxy for investor disagreement. Ramnath, Rock and Shane (2008) provide a review of the forecast dispersion research literature. Investor herding is a recognized bias in analyst forecasts which affects dispersion as well. We assume that such biases are not systematically associated with any of the risk indicators studied here. The use of additional risk proxies should address concern regarding possible forecast dispersion biases. The use of credit ratings as an equity risk proxy is motivated by recent research on the interrelation between equity risk and credit risk. Gntay and Hackbarth (2010), for example, show that credit spreads and forecast dispersion are tightly related. Similarly, Zhang, Zhou and Zhu (2009) show that equity volatility explains credit default spreads. As credit default spread data are difficult to obtain, are available only for the largest companies and have short histories, S&P credit ratings are used instead. Company expected life, described in DiBartolomeo (2010), is estimated from risk model forecast volatility and capital structure information. Expected life is the expiration date of a synthetic option that equates the estimated option value of a company with its current market capitalization. Kantos (2011) offers compelling evidence that this company expected life statistic is a better proxy for credit risk than are standard credit ratings.

II. Construction of the study sample

The potential sample universe is the companies in the Russell Global Large Cap Index over the period 1996 to 2011. U.S. and global ex-U.S. companies are analyzed separately. For the analysis based on forecast dispersion, there are 15,370 company-year observations in the U.S. sample and 24,207 observations in the global ex-U.S. sample. Expected life and credit rating data are available only for the U.S. sample. There are 15,323 observations in the expected life subsample and 10,882 observations in the credit rating subsample. Samples are constructed as of June 30 of every year in order to be consistent with the reconstitution methodology of the Russell Global Indexes. The data assessment date for factor and variable values is May 31. Prices are official index prices, and the shares used to calculate market capitalization are the free-float shares available for public trading, as estimated by Russell. This approach allows for comparison of U.S. and global ex-U.S. results and better comparison of forecast dispersion results with credit rating and expected life tests.

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The sample used in this study is further limited by the requirement that a company in the sample in a particular year have at least two current analyst earnings forecasts as of June 30. Table 1 shows the sample size by year and region and also reports the percentage coverage of Russell Indexes membership. In addition to not meeting the requirement that they have at least two analyst forecasts for the current time period, approximately 50 companies are excluded over the entire study period because of a zero mean analyst forecast, which prevents computation of forecast dispersion based on the ratio of forecast standard deviation to forecast mean. U.S. coverage is very high and steady over time. Global ex-U.S. coverage steadily rises over the study period.

Table 1 / Total number of companies by year and region

U.S. sample % Russell 1000 membership 97.3% 96.5% 95.7% 95.4% 96.3% 96.1% 94.8% 94.2% 96.0% 95.7% 97.0% 97.6% 96.7% 96.7% 97.2% 97.7% 96.3%

Year 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Total

Number 973 965 957 954 963 961 948 942 959 957 964 998 972 938 957 962 15,370

Global ex-U.S. sample % RGI Global exU.S. Large Cap Number membership 1328 72.4% 1469 76.9% 1319 75.9% 1303 75.6% 1239 1305 1220 1256 1333 1480 1686 1768 1765 1781 1921 2034 24,207 78.0% 79.4% 80.1% 81.7% 81.5% 81.8% 82.2% 83.1% 83.5% 83.6% 85.5% 88.9% 81.0%

Total sample % RGI Global Large Cap Number membership 2301 81.2% 2434 83.6% 2276 83.2% 2257 82.9% 2202 2266 2168 2198 2292 2437 2650 2766 2737 2719 2878 2996 39,577 85.1% 85.7% 85.9% 86.6% 87.0% 86.8% 87.0% 87.8% 87.8% 87.7% 89.1% 91.6% 86.3%

Source: Russell Investments

Low- and high-risk samples are constructed in the same way for the company risk proxies and for the styles and factors to be tested for their risk-identification ability. All stocks in the sample universe for a given year are ranked by the measure under consideration. The stocks that score highest are selected until they comprise 35% of the sample by market capitalization. Similarly, the stocks that score lowest and comprise 35% of market capitalization are also selected. These are the high- and low-risk samples for this measure. Capitalization weighting in sample selection, and selecting for 35% of market capitalization, ensure comparability of results with the Russell style methodology. 8 Capitalization weighting in sample construction is also clearly more representative than equal weighting of the types of portfolios likely to be held by both institutional investors and mutual fund managers.

See Russell Indexes (2012) for a description of the Russell style methodology. Christopherson, Cario and Ferson (2009), Ch. 26, provides more detail.

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Risk samples are constructed for the following styles and factors: stability, valuation, quality, two types of volatility, momentum, capitalization, beta, earnings variability, leverage and return on assets. This large set of alternatives allows both for the comparison of stability to other recognized risk factors and for the evaluation of various aspects of the stability style methodology. The last three factors are used to determine the quality score used in the stability index methodology. This allows assessing qualitys gain in risk-identification ability over its component factors. The two types of volatility studied are (a) an average of 52-week and 60-month scored volatility and (b) one year of daily volatility. This allows comparison of the risk-identification ability of the stability representation of volatility with the more common approach based on daily volatility. Momentum is calculated as the total return over the period from 12 months prior to one month prior to the data assessment date. Capitalization is determined as of May 31 of each year. Beta is based on 36 months of data prior to and including the data assessment date. The Russell 1000 is used as the market benchmark for U.S. stocks. The Russell Global exU.S. Large Cap Index is used as the market benchmark for global ex-U.S. stocks.9

Table 2 / Low- and high-risk sample construction for styles, factors and risk proxies

Style, factor or risk proxy Stability Quality Volatility Valuation Leverage EPS variability Return on assets Beta Daily 1 yr. volatility Company size Momentum Forecast dispersion Credit rating Expected life Source: Russell Investments

Low risk leg Defensive High quality Low volatility Growth Low leverage Low EPS variability High ROA Low beta Low 1 yr. volatility Large capitalization High momentum Low forecast dispersion Low credit rating score High expected life

High risk leg Dynamic Low quality High volatility Value High leverage High EPS variability Low ROA High beta High 1 yr. volatility Small capitalization Low momentum High forecast dispersion High credit rating score Low expected life

For the purposes of this study, risk samples for the styles and factors to be tested are assigned as low risk or high risk, based on forecast dispersion testing results. Each style or factor can be understood to have two legs, such as defensive and dynamic for the stability style. The leg found to be better at identifying low forecast dispersion companies is categorized as low risk, and the leg better at identifying high forecast dispersion companies is categorized as high risk. Assignments are shown in Table 2. These categorizations are consistent with testing based on credit rating and expected life, except for valuation and momentum, which show some reversal and little risk-discrimination ability relative to these risk proxies. Table 3 reports sample sizes for all risk samples summed over all years for both U.S. and global ex-U.S. samples.

MSCI EAFE is used instead of the RGI Global ex-U.S. Large Cap Index for time periods before 2000 where the required return history of the latter is not available. Tests show no little difference in the beta samples based on these indexes in subsequent years.

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Table 3 / Total company-year observations for each style or factor

U.S. sample Stability Quality Volatility Valuation Leverage EPS variability Return on assets Beta Daily 1 yr. volatility Company size Momentum Forecast dispersion Credit rating Expected life Source: Russell Investments Low risk leg 3,115 4,196 3,369 4,818 6,062 5,264 4,304 6,029 4,380 497 5,811 3,807 1,175 5,461 High risk leg 7,674 6,639 8,460 5,782 5,397 7,190 7,415 6,230 8,042 14,033 6,493 7,145 8,555 6,176

Global ex-U.S. sample Low risk leg 5,953 8,068 4,962 8,072 10,358 8,482 8,040 8,513 7,039 889 8,911 6,347 --High risk leg 11,088 8,770 12,574 8,774 7,134 9,970 10,117 9,290 12,186 21,616 10,236 12,122 ---

III. Forecast dispersion

Descriptive statistics

Forecast dispersion is defined in this study as the volatility of I/B/E/S-collected analyst earnings forecasts divided by the absolute value of the mean analyst forecast. These forecasts are for the current fiscal year (FY1). Results based on alternative definitions are discussed in Section VI. Table 4 reports descriptive statistics for forecast dispersion and log (base 10) forecast dispersion. It can be seen that forecast dispersion has very high skew and kurtosis. Log forecast dispersion has more typical skew and kurtosis levels, although the standard Jarque-Bera normality test statistics still reject normality of log forecast dispersion at very high statistical significance levels.10 The extreme non-normality of the sample is not surprising for a statistic that cannot take negative values. This suggests, however, that simple averages may not be a sound basis for comparison of riskidentification ability. The difference between the non-log transformed mean and median underline this concern. As a result, tests are based on the ability of samples to identify companies in the low and high forecast dispersion samples. This approach has the advantage that it is easy to study incorrect identification as well for example, the frequency with which a low-risk sample includes a high forecast dispersion company.

10

There are approximately 400 cases in which I/B/E/S reports zero forecast volatility. In these cases, the 5 th percentile forecast dispersion values for the U.S. and global ex-U.S. samples are substituted before taking logs.

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Table 4 / Forecast dispersion distributional characteristics by region

Mean Median Standard deviation Skew Kurtosis Jarque-Bera test

U.S. sample Forecast Log10 forecast dispersion dispersion 11.00% -1.47 2.84% -1.55 0.63 0.53 29.83 0.86 1297.62 1.43 1.08E+09 3234

Global ex-U.S. sample Log10 forecast Forecast dispersion dispersion 24.92% -0.98 9.92% -1.00 2.10 0.44 80.40 0.70 8612.09 2.60 7.53E+10 8893

Source: Russell Investments

Summary statistics on number of forecasts and their distribution among companies and over time are shown in Table 5. The median number of forecasts and the maximum number of forecasts per company are similar across samples. The growth over time in the total number of samples for global ex-U.S. companies is the result of the increasing coverage shown in Table 1.

Table 5 / Number of analyst forecasts by year and region

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Average

Median number of company forecasts 14 14 13 14 13 13 11 12 12 12 12 12 11 12 14 15 12.8

U.S. sample Maximum number of company forecasts 41 45 43 41 39 40 39 42 43 40 41 35 34 44 47 54 41.8

Total number of forecasts 14,768 14,514 13,879 14,050 13,638 13,666 11,630 12,079 13,051 12,877 12,555 12,555 11,436 12,022 13,763 14,884 13,210

Global ex-U.S. sample Median Maximum number of number of company company forecasts forecasts 13 42 14 43 13 14 13 13 14 12 12 11 11 12 12 13 13 15 12.8 40 44 43 48 46 51 45 42 43 49 43 45 47 58 45.6

Total number of forecasts 19,504 23,187 18,676 18,871 17,673 18,875 18,152 17,608 17,480 18,179 20,885 23,259 23,628 25,141 27,734 32,499 21,334

Source: Russell Investments

Results are presented first for identification rates over time and then for aggregate identification rates over the entire sample. Statistical significance tests are performed on aggregate identification rates. There are two aspects of identification ability: first, the ability

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of style and factor sample to properly identify the target risk type, and second, the ability of style and factor sample to avoid identifying the non-targeted risk type.
Forecast dispersion over time

Figure 1 shows the percentage of each low-risk sample that is also classified as low forecast dispersion for each year from 1996 to 2011. For both the U.S. sample (shown on the left panel of Figure 1) and the global ex-U.S. sample (shown on the right panel of Figure 1), the defensive sample almost always has the highest percentage of low forecast dispersion companies. The light-blue line represents high-capitalization companies, and for the U.S. in several years, including 2004 to 2006, this sample does better than the defensive sample. Note, however, that the high-capitalization sample does very poorly from 2007 on. Also apparent for the U.S. and global ex-U.S. results in Figure 1 is the growth over time in the percentage of low forecast dispersion companies in the defensive sample. Trend analysis shows an average growth of 1.37% a year with a 95% confidence interval of +/0.48%. In the global ex-U.S. sample the growth rate is 1.32% a year with a 95% confidence interval of +/- 0.56%. High quality, low volatility, and low beta also show positive and statistically significant growth rates over time; but with lower growth rates and lower levels of statistical significance.

Figure 1 / Percentage of low risk style and factor samples classified as low forecast dispersion
U.S. Sample 70% 70% Global ex-U.S. Sample

60%

60%

50%

50%

40%

40%

30%

30%

20%

20%

10%

10%

0% 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

0% 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Defensive High ROA

High quality Low beta

Low volatility Low daily volatility

Growth High capitalization

Low leverage High momentum

Low EPS variability

Source: Russell Investments

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Figure 2 shows the percentage of each high-risk sample classified as high forecast dispersion for each year from 1996 to 2011. In this case, it can be seen that the dynamic sample clearly does the best in identifying high forecast dispersion companies, in nearly all years in both the U.S. and global ex-U.S. samples. In Figure 2 it can also be seen that identification rates are trending down for dynamic and several other styles and factors in the global ex-U.S. samples. Analysis shows these trends to be of moderate statistical significance for all styles and factors except growth. The trend for dynamic is downward at 0.75% a year with a 95% confidence interval of +/- 0.45%.

Figure 2 / Percentage of high-risk style and factor samples classified as high forecast dispersion
U.S. Sample 80% 80% Global ex-U.S. Sample

70%

70%

60%

60%

50%

50%

40%

40%

30%

30%

20%

20%

10%

10%

0% 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

0% 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Dynamic High leverage High daily volatility

Low quality High EPS variability Low capitalization

High Volatility Low ROA Low momentum

Growth High beta

Source: Russell Investments

Now consider incorrect identifications, as, for example, when a company in the defensive sample turns out to be a high forecast dispersion company. Figure 3 reports the percentage of high forecast dispersion companies identified by the low-risk style and factor samples. In the U.S., except for high-capitalization companies in 1996, 2001 and 2003, dynamic has lower identification rates of low-risk companies than any other style or factor. Moreover, the dynamic identification rate shows a consistent downward trend. This trend is a decline of 1.11% per year with a 95% confidence level of +/- 0.35%. Figure 3 also shows that in the global ex-U.S. sample, defensive consistently identifies the smallest percentage of high-risk companies. The global ex-U.S. identification rate is trending downward, but this trend is not statistically significant (-0.29%.yr. +/- 0.50%).

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Figure 3 / Percentage of low-risk style and factor samples classified as high forecast dispersion
U.S. Sample 70% 70% Global ex-U.S. Sample

60%

60%

50%

50%

40%

40%

30%

30%

20%

20%

10%

10%

0%
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

0%
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
2010

Defensive Low leverage Low daily volatility

High quality Low EPS variability High capitalization

Low volatility High ROA High momentum

Growth Low beta

Source: Russell Investments

Figure 4 / Percentage of high-risk style and factor samples classified as low forecast dispersion
U.S. Sample 40% 40% 35% 30% 25% 20% 15% 10% 5% 0% 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2011 Global ex-U.S. Sample

35% 30% 25% 20% 15% 10% 5%

0%

Dynamic High leverage High daily volatility

Low quality High EPS variability Low capitalization

High volatility Low ROA Low momentum

Growth High beta

Source: Russell Investments

The percentage of low-risk companies found over time in U.S. and global ex-U.S. high-risk style and factor samples is shown in Figure 4. In the U.S., the dynamic samples generally have the lowest percentage of low-risk companies. In 2001 and 2002, however, low momentum did visibly better. Also, in 2002, high beta did better, and in 2009, low volatility did better. The dynamic low-risk company identification rate is declining at 0.46% a year in

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the U.S. sample, with a 95% confidence level of +/- 0.23%. In the global ex-U.S. sample, dynamic samples consistently have the lowest percentage of low forecast dispersion companies. The dynamic low-risk identification rate for the global ex-U.S. sample increased rapidly over the period from 1996 to 2005 and has since declined. However, the positive trend is still statistically significant at 0.44% per month +/- 0.32%.
Aggregate forecast dispersion results

Here we report the statistical significance of the aggregate performance differences between stability and the other styles and factors observed in the time trend charts in the preceding section. The aggregate performance differences are based on percentages for the entire 16 years of the study history 1996 to 2011. For each U.S. and global ex-U.S. style and factor sample, the percentage of low and high forecast dispersion companies is the sum of such companies over all years of the study divided by the total number of companies in the sample over these years.11 Table 6 reports on the ability of the low-risk styles and factors to identify low-risk companies. For each low-risk sample and region, the percentage of low forecast dispersion companies, the performance difference in comparison to the stability sample, the t-statistic for the statistical significance of the performance difference, and the associated p-value are reported. It can be seen that defensive identifies a higher percentage of low forecast dispersion companies than all other styles and factors in both the U.S. and global ex-U.S. regions. With the exception of the U.S. high capitalization sample and the global ex-U.S. low volatility sample, the t-statistic for these differences is greater than 1.96, the 95% statistical significance level (equivalent to a p-value of 0.05 or lower). The final column shows that except for U.S. high capitalization and global ex-U.S. low volatility, all differences have p-values of lower than 0.001.

11

The aggregate percentages are not quite the same as the average of annual percentages shown in Figures 1 to 4. The percentages are very close for the U.S. samples. For the global ex-U.S. samples, however, recent years are somewhat more heavily weighted, due to the growth of Russell Global ex-U.S. Large Cap index membership, as shown in Table 1. This heavier weighting of more recent years allows the use of a simple statistical test for difference in proportions based on the t-test for the difference in means. This test can be used despite the nonnormality of the forecast dispersion observations reported in Table 3, because sample overlap is Bernoullidistributed and thus almost normally distributed in the sample sizes reported here.

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Table 6 / Average percentage low forecast dispersion companies and statistical significance, 19962011: low-risk styles and factors

U.S. Region Pct. low forecast dispersion companies 47.0% 37.4% 40.0% 31.0% 27.0% 36.9% 37.3% 32.5% 38.9% 43.5% 27.1% Pct. relative to defensive -9.6% -7.0% -16.0% -20.0% -10.1% -9.7% -14.5% -8.1% -3.5% -19.9% t-statistic for difference 8.24 5.72 14.36 19.17 9.08 8.40 13.53 6.99 1.47 18.91 Pct. low forecast dispersion companies 50.5% 42.0% 49.1% 36.4% 32.8% 41.6% 39.8% 37.5% 44.4% 37.6% 31.0%

Global ex-U.S. Region Pct. relative to defensive -8.6% -1.5% -14.1% -17.7% -8.9% -10.7% -13.0% -6.2% -13.0% -19.6% t-statistic for difference 10.09 1.53 16.70 22.32 10.58 12.62 15.58 7.01 7.22 23.98

Low risk samples Defensive High quality Low volatility Growth Low leverage Low EPS variability High ROA Low beta Low 1 yr. volatility Large capitalization High momentum

p-value 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.142 0.000

p-value 0.000 0.126 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000

Source: Russell Investments

Table 7 / Average percentage high forecast dispersion companies and statistical significance, 19962011: high-risk styles and factors

U.S. Region Pct. high forecast dispersio n compani es 64.7% 63.0% 58.7% 53.3% 53.9% 61.6% 60.4% 37.1% 58.6% 47.9% 52.5%

Global ex-U.S. Region

High risk samples Dynamic Low quality High volatility Value High leverage High EPS variability Low ROA High beta High 1 yr. volatility Small capitalization Low momentum

Pct. high forecast dispersion companies 64.2% 58.2% 58.6% 52.6% 49.2% 59.9% 58.5% 57.0% 59.4% 47.8% 59.2%

Pct. relative to dynamic -5.9% -5.6% -11.6% -15.0% -4.3% -5.7% -7.1% -4.8% -16.3% -4.9%

t-statistic for differenc e 7.27 7.28 13.50 17.09 5.37 7.16 8.58 6.21 23.07 5.97

p-value 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000

Pct. relative to dynamic -2.1% -6.3% -10.5% -11.0% -3.4% -4.9% -5.9% -6.5% -16.9% -4.9%

t-statistic for difference 3.10 10.14 15.29 15.10 5.29 7.47 8.83 10.36 29.28 7.31

p-value 0.002 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000

Source: Russell Investments

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Table 7 reports the same statistics for the ability of the high-risk samples to identify high forecast dispersion companies. Dynamic does better in identifying high-risk companies than all other high-risk styles and factors tested. Again, the t-statistics and statistical significance levels of these differences are all very high. All differences are significant at the 0.002 level or better. For the high-risk samples, both the percentages and the differences with dynamic are similar for the U.S. and global ex-U.S. regions. Results for incorrect identifications are reported next. Table 8 shows the percentage of high forecast dispersion companies in low-risk style and factor samples. All other style and factor samples include a higher percentage of high-risk companies than the defensive samples. These differences are all significant at the 0.002 p-level or better.

Table 8 / Average percentage high forecast dispersion companies and statistical significance, 19962011: low-risk styles and factors

U.S. Region Pct. high forecast dispersion companies 20.8% 28.6% 26.8% 38.3% 44.0% 28.7% 29.7% 37.3% 28.5% 27.0% 42.9% Pct. relative to defensive 7.8% 6.1% 17.5% 23.2% 7.9% 8.9% 16.6% 7.8% 6.2% 22.1% t-statistic for difference 7.57 5.72 16.39 21.92 8.01 8.63 16.14 7.62 3.11 20.87 Pct. high forecast dispersion companies 22.6% 28.4% 26.4% 36.6% 40.8% 29.8% 31.3% 58.9% 30.3% 32.8% 43.0%

Global ex-U.S. Region Pct. relative to defensive 6.3% 3.7% 15.1% 18.2% 7.5% 9.4% 14.3% 7.2% 9.9% 21.5% t-statistic for difference 8.10 4.27 18.56 23.10 9.59 11.85 17.82 8.89 6.18 26.30

Low risk samples Defensive High quality Low volatility Growth Low leverage Low EPS variability High ROA Low beta Low 1 yr. volatility Large capitalization High momentum

p-value 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.002 0.000

p-value 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000

Source: Russell Investments

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Table 9 reports the percentage of low forecast dispersion companies included in high-risk style and factor samples. Dynamic has a smaller percentage of high-risk companies than all other styles and factors. The differences are all statistically significant at p-values lower than 0.001.

Table 9 / Average percentage low forecast dispersion companies and statistical significance, 19962011: low-risk styles and factors

High risk samples Dynamic Low quality High volatility Value High leverage High EPS variability Low ROA High beta High 1 yr. volatility Small capitalization Low momentum

Pct. low forecast dispersion companies 12.6% 16.0% 16.1% 19.2% 22.3% 16.1% 16.2% 16.4% 15.8% 23.7% 22.5%

U.S. Region Pct. t-statistic relative to for dynamic difference 3.5% 3.5% 6.7% 9.8% 3.5% 3.6% 3.8% 3.2% 11.1% 9.9% 5.90 6.36 10.58 14.75 6.08 6.37 6.42 5.81 19.61 16.00

p-value 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000

Global ex-U.S. Region Pct. low Pct. t-statistic forecast relative dispersion to for companies dynamic difference 18.7% 21.7% 1.7% 3.39 22.8% 3.8% 7.92 27.9% 6.6% 12.39 28.9% 7.7% 13.60 22.1% 23.2% 43.5% 23.0% 32.9% 39.0% 2.6% 3.4% 3.2% 3.5% 11.8% 12.6% 5.38 6.90 6.40 7.38 24.60 23.95

p-value 0.001 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000

Source: Russell Investments

IV. Credit rating as a company risk proxy

The most recent S&P annual credit rating as of June 30 of each year is obtained for companies in the U.S. sample. Of the 15,370 company-years of observations in the forecast dispersion sample, credit ratings were obtained for 10,882. The ratings are letter grades ranging from AAA to SD. These ratings are also assigned numerical scores ranging from 2 for AAA to 29 for SD. The average credit rating score is 10.5, midway between BBB and BBB+. Descriptive statistics are reported in Table 10. The Jargue-Bera test strongly rejects sample normality (p < 0.001).

Table 10 / Descriptive statistics for credit rating sample, 19962011

Mean Median Standard deviation Skew Kurtosis Jarque-Bera test Source: Russell Investments

Credit rating 10.51 10.00 3.09 0.18 0.66 257.95

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Figure 5 charts the average credit rating of each low-risk sample by year. Lower average credit score indicates a higher average credit rating. Note that averages for the low forecast dispersion sample are charted as well. It can be seen that defensive has a higher average credit rating than all other samples, except for larger capitalization. Consistent results over time, not shown, are found for the high-risk samples. The strong influence of company size on credit rating is well known. Kaplan and Urwitz (1979) and Blume, Lim and MacKinlay (1998) analyze the determinants of S&P credit ratings using multivariate probit models. Both found that company size had a higher statistical significance than any other company characteristic as a predictor of assigned credit rating. (Kaplan and Urwitz used total assets as a proxy for company size.)

Figure 5 / Average scored credit rating of companies in U.S. low-risk samples, 1996 2011

Avg. S&P scored credit rating: AAA=2 to D =27

14 12 10 8 6 4 2 0 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Defensive Growth High ROA Large capitalization Average Source: Russell Investments

High quality Low leverage Low beta High momentum

Low volatility Low EPS variability Low 1 yr. volatility Low forecast dispersion

Table 11 reports average credit scores over all years and the statistical significance of differences with the stability sample. The statistical significance testing of sample differences is based on the widely used Mann-Whitney nonparametric test, which is not sensitive to non-normality in the samples. Regarding low-risk samples, all differences with defensive are highly statistically significant. Differences with dynamic in the high-risk samples, except for the volatility samples, are highly statistically significant. Both volatility measures do better than dynamic, but only the difference with the composite 52-week and 60-month measure is statistically significant.

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Table 11 / Average credit scores over 19962011 and statistical significance of differences for U.S. style and factor samples; lower scores imply lower credit risk

U.S. styles and factors Stability Quality Volatility Valuation Leverage EPS variability Return on assets Beta Daily 1 yr. volatility Company size Momentum Forecast dispersion

Average credit score 8.10 9.25 8.59 11.14 9.80 9.68 9.57 9.75 8.88 5.71 10.97 9.31

Low risk samples Score Mann relative Whitney to test defensive statistic 1.16 0.49 3.04 1.70 1.58 1.47 1.66 0.79 -2.39 2.87 1.21 -13.28 -7.87 -31.35 -21.48 -20.81 -16.74 -23.60 -12.21 18.15 -35.94 -15.71

p-value 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000

Average credit score 11.93 11.22 12.03 10.09 11.06 11.28 10.98 11.56 11.99 10.96 10.36 11.43

High risk samples Score Mann relative Whitney to test dynamic statistic -0.71 0.10 -1.84 -0.87 -0.65 -0.95 -0.37 0.06 -0.97 -1.57 -0.50 13.06 -1.60 32.48 14.58 11.56 17.35 5.58 -1.16 20.47 25.95 8.78

p-value 0.000 0.110 0.000 0.000 0.000 0.000 0.000 0.245 0.000 0.000 0.000

Source: Russell Investments

V. Company expected life as risk proxy

Expected life is a model-based estimate of the expected years to bankruptcy. It is supplied as an integer-valued quantity by Northfield. Table 12 reports descriptive expected-life statistics for companies in the U.S. sample over the years 1996 to 2011 based on 15,323 company-years of observations. Average company expected life from 1996 to 2010 is 14.62 years. The median expected life is 14 years. The skew and kurtosis of the expected life distribution appear moderate, but the Jarque-Bera test still decisively rejects ( p<0.000) the hypothesis of normality in distribution because of the large sample size.

Table 12 / Descriptive expected-life statistics, 19962011

Mean Median Standard deviation Skew Excess kurtosis Jarque-Bera test statistic Source: Russell Investments

Company expected life (in years) 14.63 14.00 5.69 0.64 1.28 2.10E+03

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Figure 6 charts average expected life over time for low-risk samples. These samples are all formed on the same basis as the samples in the prior tests, and each comprises the approximately 35% of companies by market cap with the highest or lowest style or factor scores. Defensive almost always has the highest average expected life of all low-risk alternatives except expected life itself. The exception to this statement is seen in the years 1996 to 1998. High quality and its individual factor components (low leverage, low earnings variability and high return on assets) have almost equal or somewhat longer expected lives during this period. The expected life differential between defensive and the alternatives appears largest in the period from 2008 onward. Also evident, but not directly relevant for this study, is the upward jump in expected life between 2004 and 2005 and the clear downward leg between 2005 and 2009. Most relevant for this study is the consistently superior risk-identification ability of defensive over time.

Figure 6 / Average expected company life by low-risk sample and year, 19962011

Average Expected Company Life in Years

30 25 20 15 10 5 0 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Defensive Low volatility Low leverage High ROA Low 1 yr. volatility High momentum Sustainability

High quality Growth Low EPS variability Low beta Large capitalization Low forecast dispersion Average

Source: Russell Investments

Table 13 reports average expected life over the period 1996 to 2010 for the low- and highrisk samples, based on each style and factor. Among the low-risk samples, defensive, at 17.17 years, has higher average expected life than all alternatives except expected life itself. High-quality is a close second at 16.76 years. On the high-risk side, both the high quality and high leverage samples have shorter average expected life than defensive, and thus must be considered better at identifying high risk as represented by short expected life.

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Table 13 / Expected average company life, U.S. low- and high-risk samples, 1996 2011

Stability Quality Volatility Valuation Leverage EPS variability Return on assets Beta Daily 1 yr. volatility Company size Momentum Forecast dispersion Expected life

Low risk samples 1996-2011 Average expected Standard Number of life deviation companies 17.17 6.32 3,109 16.76 5.64 4,169 15.42 6.46 3,369 14.49 5.65 4,813 16.94 6.19 6,022 15.89 5.70 5,248 16.02 5.62 4,279 14.86 6.03 6,021 15.18 6.19 4,377 15.95 6.42 497 14.22 5.11 5,793 16.01 5.63 3,798 19.74 4.65 5,461

High risk samples 1996-2011 Average expected life 13.22 12.79 13.78 14.57 11.66 13.59 13.74 14.02 13.87 14.53 14.60 13.54 10.06 Standard deviation 5.04 5.17 5.21 5.76 4.59 5.63 5.60 5.34 5.25 5.65 5.93 5.51 3.28 Number of companies 7,647 6,636 8,421 5,770 5,395 7,181 7,399 6,201 8,003 13,986 6,472 7,112 6,176

Source: Russell Investments

Table 14 reports the statistical significance of risk sample performance in comparison to the stability samples, and for selected samples against the volatility sample as well. The MannWhitney nonparametric test is again used to obtain test statistics for differences in averages that do not depend on the normality of sample distributions. Considering the low-risk samples, all comparisons except defensive vs. low leverage and low volatility vs. low daily volatility are statistically significant, and generally, highly so. Regarding the high-risk comparisons, the superior risk-identification ability of high quality and low leverage in comparison to defensive is highly statistically significant as well. In all other comparisons with defensive, defensive shows a similar advantage. Returning briefly to Table 13, it is also notable that forecast dispersion is not an exceptional predictor of expected life. The mean-adjusted correlation (see Section VI) between log forecast dispersion and expected life over this period is -0.21. (The correlation with untransformed forecast dispersion is lower.) The sign is in the expected direction lower forecast dispersion should predict greater expected life but the magnitude of the correlation is obviously low. Expected life and forecast dispersion appear to be sensitive to different aspects of company risk.

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Table 14: Statistical significance tests of expected life sample differences, U.S. lowand high-risk samples, 19962011

Low risk samples Comparison Stability vs. Quality Stability vs. Volatility Stability vs. Valuation Stability vs. Leverage Stability vs. EPS variability Stability vs. ROA Stability vs. Beta Stability vs. Daily volatility Stability vs. Capitalization Stability vs. Momentum Stability vs. Forecast dispersion Volatility vs. Beta Volatility vs. Daily volatility Source: Russell Investments Mann-Whitney test statistic 2.54 12.26 18.93 1.46 9.32 7.88 17.49 14.41 4.33 21.88 7.60 3.48 1.17 p-value 0.011 0.000 0.000 0.144 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.001 0.244

High risk samples Mann-Whitney test statistic 6.01 -6.67 -13.16 17.85 -2.68 -4.19 -8.53 -7.39 -15.89 -12.82 -2.23 -2.46 -0.84 p-value 0.000 0.000 0.000 0.000 0.007 0.000 0.000 0.000 0.000 0.000 0.026 0.014 0.402

Tests based on company expected life as a company risk proxy tell a broadly similar story to those based on forecast dispersion and credit ratings. The exceptional performance of leverage among the high-risk samples may be due to the important role leverage plays in the expected life methodology. This exceptional performance is also likely behind the superior performance of high quality in comparison to dynamic.

VI. Robustness of results

Comparison of results using different risk proxies

Stability clearly does well at identifying company risk levels, regardless of the risk proxy used in this study. The logical first issue to consider in evaluating these three separate sets of tests is the similarity of the risk proxies. The more dissimilar the risk proxies, the greater the additional robustness of the results presented here. Table 15 presents correlations between the three company risk proxies. Log base 10 values of forecast dispersion described in Section II are used for these correlations. A given change in log forecast dispersion at different risk levels can be expected to represent much more of an equal change in risk than the corresponding change of the untransformed values. This should and does, in fact, raise the magnitude of correlations with forecast dispersion. The correlations are based on differences from the annual mean of each risk proxy. This controls for the differences in annual averages seen in the data. Such differences would tend to be lower if annual averages moved independently. It can be seen that the correlations are quite low in absolute magnitude. Further, they are in the theoretically correct directions. Lower values of forecast dispersion are positively associated with lower credit rating scores (that is, better credit ratings) and are also associated with longer expected life. Longer expected life is associated with lower credit score (higher credit rating). Rank-order correlations are almost identical in value. It is evident, then, that these three company risk proxies are indeed very different, statistically as well as conceptually.

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Table 15: Company risk proxy correlations based on differences from annual means, 19962011

Log10 forecast dispersion Log10 forecast dispersion Credit rating Expected life Source: Russell Investments 1.00 0.37 -0.21

Credit rating 1.00 -0.31

Expected life

1.00

Robustness of Forecast Dispersion Results

The tests based on forecast dispersion as a proxy for company risk (see Section II) are based on the percentages of low- and high-risk companies found in style and factor samples. This approach avoids the possible biases that might result from using simple averages to assess sample performance, but leaves open the possibility that these essentially percentile-based results are not actually representative. An alternative approach would be to use means based on log-transformed forecast dispersion. The pattern of logtransformed means for the samples examined here is very similar to the pattern for the percentages reported here for included companies of the correct risk type. Non-parametric testing of these differences results in statistical-significance levels similar to those reported here. The results presented here are based on analyst forecasts for the current fiscal year (oneyear-ahead or FY1 forecasts). Analysis of mean differences based on using both twoand three-year-ahead forecasts yields similar results.12 There may be some concern about the inclusion of forecast dispersion levels based on as few as two analyst reports. This appears to be the general practice in forecast dispersion studies. Requiring at least five forecasts had little impact on results. Further restrictions, based only on low-risk styles and factors, were also used in the first analyses. These restrictions included requiring positive mean forecasts and positive mean five year earnings. The intent of these restrictions was to limit the sample to apparently healthy companies, in order to make it harder to identify lower-risk companies. These restrictions also had little effect on results.

12

There are two widely used methods of calculating forecast dispersion. The method used here is to divide forecast volatility by the absolute value of the forecast mean. The other method is to divide by share price. Dividing by share price may be a more theoretically consistent normalization. The problem with this normalization is that swings in market valuation can then have systematic effects on dispersion levels. It seems that many researchers, including Diether, Malloy and Scherbina (2002), avoid share price normalization, perhaps for this reason. Aggregate results based on share price normalized forecast dispersion are very similar to the results reported here. The time series results differ qualitatively only during the period of the technology bubble.

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Conclusion
Three sets of tests based on three weakly correlated proxies for company risk all find that stability does better than all alternatives tested in the identification of company risk. Almost all results are highly statistically significant and consistent over time; they hold for U.S. and global ex-U.S. companies and are not sensitive to the details of risk proxy construction or analytic method. The tests additionally validate three aspects of the stability style methodology: (1) combining quality and volatility results in better risk identification than is achieved by either measure alone; (2) quality provides better risk identification than any of the individual factors that define quality do alone; and (3) the combination of 52-week and 60-month volatility used in the stability style methodology is a better market-based risk-identification measure than either one-year daily volatility or a 36-month market beta. A concise interpretation of the results reported here is that that stability effectively represents the risk dimension of equity style. Note that this is a statement about the classification of companies, and not necessarily of the practices of investment managers. Managers stock holdings are not the only relevant element in the determination of their investment risk profiles.

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References
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For more information about Russell Indexes call us or visit www.russell.com/indexes. Americas: +1-877-503-6437; APAC: +65-6880-5003; EMEA: +44-0-20-7024-6600 Disclosures
Russell Investments is a Washington, USA Corporation, which operates through subsidiaries worldwide and is a subsidiary of The Northwestern Mutual Life Insurance Company. Russell Investments is the owner of the trademarks, service marks and copyrights related to its respective indexes. Indexes are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance and are not indicative of any specific investment. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an as is basis without warranty. This is not an offer, solicitation or recommendation to purchase any security or the services of any organization. Copyright Russell Investments 2012. All rights reserved. First use: October 2012. CORP-8008-09-2014

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