Saturday, March 22, 2014

Improving on the Four-factor (beta, size, value, momentum) Asset Pricing Model


Swedroe: Improving On Fama-French
In 1993, the Fama-French three-factor (beta, size and value) model replaced the single-factor capital asset pricing model (CAPM) and became the standard model in finance, explaining more than 90 percent of the variation of returns of diversified portfolios.

While the model was a big improvement over the CAPM, it couldn’t explain some major anomalies. In 1997, Mark Carhart augmented the three-factor model with a fourth factor: momentum. By addressing one of the biggest anomalies, the momentum factor made a large contribution to the explanatory power of the factor model.

The four-factor model has been the workhorse model since.

But like all models, even the four-factor model had problems—there were many anomalies that it couldn’t explain. Kewei Hou, Chen Xue and Lu Zhang, authors of the September 2012 study, “Digesting Anomalies: An Investment Approach,” proposed a new four-factor model that goes a long way toward explaining many of the anomalies that neither the Fama-French three-factor nor the four-factor models explain. They called it the q-factor model. The four factors are:
  • The market excess return (beta)
  • The difference between the return on a portfolio of small-cap stocks and the return on a portfolio of large-cap stocks
  • The difference between the return on a portfolio of low-investment stocks and the return on a portfolio of high-investment stocks. Note that the investment factor is highly correlated with the value premium, suggesting that this factor plays a similar role to that of the value factor.
  • The difference between the return on a portfolio of high return on equity stocks and the return on a portfolio of low return on equity stocks. Note that the profitability factor has a high correlation with the momentum factor, meaning it would play a similar role to the momentum factor in analyzing performance.
Among their important findings was that the investment and profitability (return on equity) factors are almost totally uncorrelated, meaning that they are independent, or unique, factors.
Professors Fama and French, in a June 2013 paper, “A Five-Factor Asset Pricing Model,” took a close look at the new model, to see if these new factors—investment and profitability—added explanatory power. In other words, if they knew in 1993 what they know today, which model would they have chosen? The following is a summary of their findings:
  • While a five-factor (beta, size, value, profitability and investment) doesn’t fully explain the cross section of returns (there are still anomalies), it provides a good description of average returns....

HT: Barron's Focus on Funds Funds Roundup post.