The Lighter Side Of The Profitability Factor

June 16, 2015

 

Fama-French Internationally

In a working paper, "The Five-Factor Fama-French Model: International Evidence," by Nusret Cakici, the author looks at the performance of the five-factor model in 23 developed stock markets. There is only marginal evidence the factor works globally.

 

In some markets, the factor is effective, but in other regions such as Japan and Asia Pacific, the factor simply doesn't explain returns. Our own internal research on the matter is consistent with this result. A lack of unified results often hints toward a lack of robustness and/or data mining.

 

Only time will tell if the out-of-sample performance of the so-called profitability factor will hold. There are certainly many smart academics and investment houses leveraging the factor as a way to capture higher returns, so we can't rule anything out.

 

However, our advice is to tread lightly in the factor jungle, being sure to always carry a heavy machete to chop away at noisy data and the overfitting problems that accompany them.

 

Inside Behavioral Finance

The baseline theory for understanding asset prices is the efficient market hypothesis (EMH) pioneered by Eugene Fama. Of particular interest is semi-strong market efficiency, which claims that markets prices reflect all publicly available information about securities

 

As the story goes, when mispricings occur in markets, these arbitrage opportunities will be immediately eliminated by professional investors, who exploit these opportunities for a profit. And because of this competitive mechanism, in the EMH view, prices should always reflect fundamental value.

 

The EMH is a great theory, and there significant evidence to suggest it holds in many cases. However, there is a complementary framework—behavioral finance—that helps solve many of the puzzles in the stock market.

 

Behavioral finance is often considered a "new" thing, but the concepts have been around for a long time.

 

Looking At Keynes In A New Way

Consider John Maynard Keynes, who was a shrewd observer of financial markets, and a successful investor in his own right. His investing success, however, was uneven, and at one point he was reportedly wiped out while speculating on leveraged currencies. This led him to share one of the greatest market mantras of all time:

 

“The market can remain irrational longer than you can remain solvent.”

attributed to John Maynard Keynes

 

Keynes’ quip highlights two elements of real-world markets that the efficient market hypothesis doesn't consider: Investors can be irrational. and arbitrage is risky. In academic parlance, "investors can be irrational" boils down to an understanding of psychology, and "arbitrage is risky" boils down to what academics call limits to arbitrage, or market frictions.

 

These two elements—psychology and market frictions—are the building blocks for behavioral finance.

 

First, let's have a discussion of limits to arbitrage. 

 

 

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