Swedroe: Passive Investing's Foundations

December 08, 2014

Noteworthy Findings

Among their other interesting findings, Fama and French discovered that “controlling for investment, value stocks behave like stocks with robust profitability, even though unconditionally value stocks tend to be less profitable.”

They also found that the value, profitability and investment factors are negatively correlated with both the market and the size factor, providing important information regarding the potential benefits from portfolios that diversify exposure across factors.

In addition, Fama and French found that “the lethal combination for microcaps is low profitability and high investment; low profitability alone doesn’t appear to be a problem.” However, they also concluded that this problem doesn’t hold for large stocks with low profitability and high investment. Note that passive portfolios can benefit from this knowledge by simply screening out stocks with these characteristics.

Furthermore, with this new model, momentum isn’t needed to explain the variation in returns of diversified portfolios, just as the well-known value factor isn’t required either.

Returning to the question we posed earlier, knowing what we know today, which model would they have chosen?

Fama and French concluded that, since HML seems to be a redundant factor in the sense that its high average return is fully captured by its exposure to other factors, in “applications where the sole interest is abnormal returns our tests suggest that a four-factor model that drops HML performs as well as (no better and no worse than) the five-factor model. But if one is also interested in measuring portfolio tilts toward value, profitability, and investment, the five-factor model is the choice.”

Final Takeaways

Only time will tell if the new model replaces the Fama-French model. However, with their endorsement, it does seem like a good possibility.

In summary, Kewei Hou, Chen Xue and Lu Zhang believe that the q-factor model’s performance—combined with its clear economic intuition—suggests it can be used in practical applications, such as evaluating mutual fund performance, measuring abnormal returns in event studies, estimating costs of capital for capital budgeting and stock valuation, and obtaining expected return estimates for optimal portfolio choice.

Investment companies can also use it to adjust the structure of the financial products they offer to investors, going beyond traditional styles such as size and book-to-market. While we have seen investment products focus on the profitability factor, as of yet, I’m not aware of any products that are focused on the investment factor.

Stay tuned.

Larry Swedroe is the director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.


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