Swedroe: 4 Seemingly Unrelated Factors

August 28, 2017

Among some of the most well-documented stock market anomalies are four apparently unrelated factors: profitability (firms with high expected profitability exhibit higher future returns), distress risk (limited liability produces skewness in returns), lotteryness (individual investors who exhibit lottery demand are willing to accept lower returns in exchange for a small chance to receive a big payoff) and idiosyncratic volatility.

Turan Bali, Luca Del Viva, Neophytos Lambertides and Lenos Trigeorgis contribute to the literature on these anomalies through their May 2017 study, “Seemingly Unrelated Stock Market Anomalies: Profitability, Distress, Lotteryness and Volatility.”

The Study

The authors explain: “Growth, distress, and lotteryness involve real options that might increase the idiosyncratic skewness of the distribution of the firm’s equity returns. If investors prefer stocks with embedded real options and have preferences for more positive idiosyncratic skewness, then high idiosyncratic skewness offered by firms with such real options might entice investors to accept lower expected returns.”

Thus, they considered a measure of growth options and related measures of profitability—controlling for asset growth in interaction with volatility—as well as distress and lotteryness, as potential drivers of idiosyncratic skewness, and examined whether their impact is priced in the cross section of equity returns.

The authors explain: “High-growth (and likely low current profitability) firms, which tend to belong in high skewness subsets, would benefit more from high convexity (being out-of-the-money options on the firm’s assets) in more volatile environments as they have more optionality to benefit and less (fixed scale) commitment to lose from demand variability.”

Their study covered 12,709 U.S. listed firms during the period 1983 to 2015. Following is a summary of their findings:


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