BAM Intelligence. 1 of 7 11/6/2017, 12:02 PM

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1 1 of 7 11/6/2017, 12:02 PM BAM Intelligence Larry Swedroe, Director of Research, 6/22/2016 For about ree decades, e working asset pricing model was e capital asset pricing model (CAPM), wi beta specifically market beta being its sole factor. Then, in 1993, e Fama-French ree-factor model which added size and value replaced e CAPM as e workhorse model. By eliminating two major anomalies (e outperformance of small stocks and of value stocks), it improved e model s explanatory power from about two-irds of e differences in returns of diversified portfolios to more an 90%. Thus, it was a major advance. In 1997, momentum was added as a four factor. It too improved e explanatory power of e asset pricing model by eliminating anoer large anomaly. The next major advance came from Robert Novy-Marx in In his paper, The Oer Side of Value: The Gross Profitability Premium, he proposed a fif factor, which also improved e model s explanatory power while eliminating anoer important anomaly e outperformance of stocks wi higher profitability. Since en, what might be called e battle of e factor models has occurred, wi parsimony considered a major virtue e fewer factors needed, e better. Kewei Hou, Chen Xue and Lu Zhang auors of e October 2012 study, Digesting Anomalies: An Investment Approach proposed a new four-factor model, e q-factor model. It included market beta, size, investment and profitability, and went a long way to explaining many anomalies. In 2015, Eugene Fama and Kenne French proposed a new five-factor model, using eir original ree factors and adding somewhat different definitions of investment and profitability. Mispricing Factors Robert Stambaugh and Yu Yuan, auors of e January 2016 paper Mispricing Factors, add to e literature by proposing anoer four-factor model at includes two mispricing factors in addition to e factors of market beta and size. The auors note: Factor models can be useful wheer expected returns reflect risk or mispricing. By incorporating ese mispricing factors, ey are better able to accommodate 11 well-known anomalies. These anomalies, which represent violations of e Fama-French ree-factor model, are: 1. Net Stock Issues: Net stock issuance and stock returns are negatively correlated. It s been shown at smart managers issue shares when sentiment-driven traders push prices to overvalued levels.

2 2 of 7 11/6/2017, 12:02 PM 2. Composite Equity Issues: Issuers underperform nonissuers, wi composite equity issuance defined as e grow in e firm s total market value of equity minus e stock s rate of return. It s computed by subtracting e 12-mon cumulative stock return from e 12-mon grow in equity market capitalization. 3. Accruals: Firms wi high accruals earn abnormally lower average returns an firms wi low accruals. Investors overestimate e persistence of e accrual component of earnings when forming earnings expectations. 4. Net Operating Assets: The difference on a firm s balance sheet between all operating assets and all operating liabilities, scaled by total assets, is a strong negative predictor of long-run stock returns. Investors tend to focus on accounting profitability, neglecting information about cash profitability, in which case, net operating assets (equivalently measured as e cumulative difference between operating income and free cash flow) captures such a bias. 5. Asset Grow: Companies at grow eir total assets more earn lower subsequent returns. Investors overreact to changes in future business prospects implied by asset expansions. 6. Investment-to-Assets: Higher past investment predicts abnormally lower future returns. 7. Distress: Firms wi high failure probability have lower, raer an higher, subsequent returns. 8. O-Score: An accounting measure of e likelihood of bankruptcy. Firms wi higher O-scores have lower returns. 9. Momentum: High (low) recent (in e past year) past returns forecast high (low) future returns over e next several mons. 10. Gross Profitability Premium: More profitable firms have higher returns an less profitable ones. 11. Return on Assets: More profitable firms have higher expected returns an less profitable firms. The Process Stambaugh and Yuan construct eir two mispricing factors by average rankings wiin two clusters of anomalies whose long/short return spreads exhibit e greatest co-movement. Anomalies one rough seven are in e first cluster of factors, and anomalies eight rough 11 are in e second. They en average a stock s rankings wi respect to e available anomaly measures wiin each of e two clusters. Thus, each mon, a stock has two composite mispricing measures. The auors constructed eir mispricing factors by applying a 2 3 sorting procedure sorting all stocks by P1 (and en P2) and assigning em to ree groups, using as breakpoints e 20 and 80 percentiles of e combined NYSE, AMEX and Nasdaq universe. They chose 20 and 80 percentile breakpoints raer an at e 30 and 70 percentiles because mispricings tend to occur more in e extremes of e deciles. They en created value-weighted portfolios. Combining ese

3 3 of 7 11/6/2017, 12:02 PM two factors (P1 and P2) wi e market and size factors creates a four-factor model. Stambaugh and Yuan s approach was motivated by e fact at anomalies in part reflect mispricing and at mispricing has common components across stocks, often characterized as sentiment. A mispricing interpretation is consistent wi evidence at anomalies are stronger among stocks for which price-correcting arbitrage is deterred by greater risks and impediments. This is often referred to as limits to arbitrage. Results Their study covers e period 1967 rough Following is a summary of eir findings: A four-factor model wi two mispricing factors, in addition to market and size, accommodates a large set of anomalies better an notable four- and five-factor alternative models. Their four-factor model s overall ability to accommodate a wide range of anomalies exceeds at of bo e fourfactor q-model from Hou, Xue and Zhang and e five-factor model from Fama and French. The Fama-French fivefactor model leaves all but one of e 11 anomalies wi economically and statistically significant alphas. The q-factor model does somewhat better, leaving seven anomalies wi significant alphas. Of e nine positive alphas in e four-factor anomaly model, all but one are lower an any of e corresponding alphas for e oer models. The sole exception is e return on assets anomaly, for which e q-model produces a smaller alpha. That is unsurprising, given at e q-model includes a profitability factor. In addition, only two of e four-factor anomaly model t-statistics exceed 2.0 (a ird has a t-statistic of 1.90) and e alphas for e asset grow and distress anomalies flip to negative values (wi t-statistics of and -1.03). The relative performance of e models was similar when ey expanded e universe of anomalies to e larger set of 73 anomalies examined previously by Hou, Xue and Zhang. Bo e q-model and e four-factor anomaly model do a good job of pricing e factors in e Fama-French fivefactor model. In contrast, e Fama-French model doesn t perform well in explaining e returns of e anomalybased model, and doesn t fare as well in explaining e returns of e q-model. Short-leg betas (loadings on e anomalies) are generally larger in absolute magnitude an eir long-leg counterparts. This is consistent wi a limits-to-arbitrage argument for persistent mispricing ere is more uncorrected overpricing an uncorrected underpricing. Given at many investors are less willing or able to short stocks an to buy em, overpricing resulting from high investor sentiment gets corrected less by arbitrage an underpricing resulting from low sentiment. Arbitrage asymmetry is consistent wi e relationship between investor sentiment and anomaly returns. The short leg of e long/short anomaly spread is significantly more profitable following high investor sentiment, whereas e long-leg profits are less sensitive to sentiment. Replacing book-to-market wi a single composite mispricing factor (anomalies one rough 11), raer an by clusters, produces a better-performing ree-factor model (superior to e Fama-French ree-factor model). Their size factor reveals a small-firm premium of 46 basis points per mon, nearly twice e premium of 25 basis points implied by e familiar size factor in e Fama-French ree-factor model. This result is consistent wi e findings from e 2015 study Size Matters, If You Control Your Junk. The study s auors found at e size premium becomes substantially greater when controlling for oer stock characteristics potentially associated wi mispricing. In a test of robustness, eir results were basically e same when ey split e time period into two basically equal subperiods. Implications Stambaugh and Yuan note at because higher idiosyncratic volatility (IVOL) implies greater arbitrage risk, mispricings should get corrected less among stocks wi high IVOL. That s exactly what ey found, providing

4 4 of 7 11/6/2017, 12:02 PM furer support for eir results. For investors, it s important to note at e auors finding at ere is more uncorrected overpricing an uncorrected underpricing doesn t mean a mutual fund would have to short a stock at s overpriced to benefit. It can benefit by avoiding purchasing e overpriced stocks, creating a filter to screen out stocks wi e characteristic at creates e mispricing. Thus, passively managed long-only mutual funds can put is knowledge to work. Dimensional Fund Advisors (DFA) is likely e most well-known firm at has long used screens to eliminate certain stocks from its eligible buy list. (Full disclosure: My firm, Buckingham, recommends DFA funds in constructing client portfolios.) Summary Through eir research, financial economists continue to advance our understanding of how financial markets work and how prices are set. The Fama-French ree-factor model was a significant improvement on e CAPM. Mark Carhart moved e needle furer by adding momentum as a four factor. And e creators of e q-factor model made furer significant advancements, which in turn motivated e development of e competing Fama- French five-factor model. Now we have a new four-factor model at incorporates anomalies and appears to have greater ability to explain e differences in returns of diversified portfolios an some prominent alternatives. The competition to find superior models is what helps advance our understanding not only of e markets, but of our understanding about which factors to focus on when selecting e most appropriate investment vehicles and developing portfolios. This commentary originally appeared May 11 on ETF.com By clicking on any of e links above, you acknowledge at ey are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding ird-party Web sites. We are not responsible for e content, availability or privacy policies of ese sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or rough em. The opinions expressed by featured auors are eir own and may not accurately reflect ose of e BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice. 2016, The BAM ALLIANCE Tweet Like 3 Share Share 7

5 5 of 7 11/6/2017, 12:02 PM Larry Swedroe, Director of Research Director of Research Larry Swedroe is director of research for e BAM ALLIANCE. Previously, Larry was vice chairman of Prudential Home Mortgage. Larry holds an MBA in finance and investment from NYU, and a bachelor s degree in finance from Baruch College. To help inform investors about e evidence-based investing approach, he was among e first auors to publish a book at explained evidence-based investing in layman s terms The Only Guide to a Winning Investment Strategy You ll Ever Need. He has auored six more books: What Wall Street Doesn t Want You to Know (2001) Rational Investing in Irrational Times (2002) The Successful Investor Today (2003) Wise Investing Made Simple (2007) Wise Investing Made Simpler (2010) The Quest for Alpha (2011) He also co-auored four books: The Only Guide to a Winning Bond Strategy You ll Ever Need (2006), The Only Guide to Alternative Investments You ll Ever Need (2008), The Only Guide You ll Ever Need for e Right Financial Plan (2010) and Investment Mistakes Even Smart Investors Make and How to Avoid Them (2012). Larry also writes blogs for MutualFunds.com and Index Investor Corner on ETF.com. Categories Business Planning Strategies Education Planning Family/Marital Changes Institutional Services Investment Strategies Legacy and Estate Planning Managing Special Needs Trusts News Philanropic Strategies