An Academic Look at Factors

Di Jack Forehand, Validea Capital Management

One of the major challenges that the finance community has faced over the years is how to explain what drives stock returns over time. If the market is efficient, then the only way to generate excess returns is to take more risk. But risk only makes sense to take if you get compensated for it. Determining which risks receive that compensation has been the subject of significant research in the academic community for many years.

When I was in college, the primary model that was taught was the Capital Asset Pricing model. CAPM is a very simple model that does a good job of getting across the point that there is a relationship between return and risk. It measures the risk of any stock using beta as its only risk factor. Beta is a function of both a stock’s volatility and its covariance with the market (how much they move in unison). According to this model, stocks with high betas would have an excess return over the market over time since they are riskier. As much as this model makes sense in theory, there is one major problem with it: it doesn’t work. In practice, stocks with high betas do not outperform the market.

In the early 90s, Eugene Fama and Ken French published their famous 3 factor model which added both value and size as risk factors. They found that small stocks and inexpensive stocks both generate excess return over time, but they do so because they are riskier. Their 3-factor model addressed many of the issues of CAPM and did a much better job of explaining long-term stock returns. Since then, they have improved their model further by adding investment and profitability as two additional factors.

Subsequent to the publication of the Fama and French papers, researchers have continued the search for the factors that best explain long-term stock returns to see if they could improve upon the Fama and French work. We are fortunate today to be joined by someone who has been a leader in that effort.

Dr. Lu Zhang is a professor of Finance and The John W. Galbreath Chair at Ohio State University. His research papers have challenged the status quo of traditional finance and have led to a better understanding of how assets are priced. He has also shown that many of the factors that investors rely on may not hold up as well as we think in the real world. In this interview, we find out why that is and discuss his research into what drives stock returns.

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