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I think this should be a come-to-Jesus moment for those who've taken the F-F model as the gospel truth. Fama and French admit that their original three-factor model was not motivated by theory. They chose value and size because they worked better than other characteristics in back-tests. Grounded in the efficient-market hypothesis, they came up with risk-based stories for these patterns. Small-cap stocks provided excess returns because they're more vulnerable to the business cycle. Value stocks did so because they were distressed.
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Fama and French add to the puzzle by finding that the value premium can be explained away as a combination of profitability and investment intensity. An efficient-market theorist would argue that profitable firms and firms with low capital intensity must therefore be riskier in unique ways in order to have commanded return premiums.
Accordingly, Warren Buffett, who famously favors profitable firms with low capital requirements, must then have exploited the special kinds of risks these firms have. And someone who invested in firms with low profitability and huge ongoing investments must have earned lower returns because of such stocks' lower risks. This story defies common sense. I think Buffett's explanation for his success is better: Investors are not perfectly rational and tend to undervalue wonderful firms. By the gold standard of science--the ability to predict patterns in data yet unseen--Buffett's framework passes with flying colors, even if it was never published in a prestigious academic journal.
I am waiting for the 99 factor model which takes into account factors such as
Liquidity: returns provided in exchange for restricted liquidity Size of investment: returns provided by an investment large enough to change the fundamentals in the industry Temporal offset: returns provided in exchange for deferred profitability Media bias: returns provided from a persistent bias in the media towards/against a company or a sector Rising tide: returns provided by large inflow of money into the same basket of funds in an index Nimbleness: returns provided for ability to move investment quickly from one position to another providing an advantage over passive money in investments with diminishing returns
etc., etc., bringing a yawn to people who have traded and exploited one or more of these factors for decades.
Such a model will also conclude that there is no state of "efficient" at any time in the markets but inefficiency in one contributing factor at any time rotates into inefficiency in another providing the incentive needed for the markets to be actively traded and hence provide price discovery. This will be shown to be consistent with the natural laws of entropy.
The study will also attribute the popularity of previous papers with less factors on the incorrect use of averages as the guiding principle and the unthinking adoption by cults promoted by false prophets posing as men/women of science.
Comments
Liquidity: returns provided in exchange for restricted liquidity
Size of investment: returns provided by an investment large enough to change the fundamentals in the industry
Temporal offset: returns provided in exchange for deferred profitability
Media bias: returns provided from a persistent bias in the media towards/against a company or a sector
Rising tide: returns provided by large inflow of money into the same basket of funds in an index
Nimbleness: returns provided for ability to move investment quickly from one position to another providing an advantage over passive money in investments with diminishing returns
etc., etc., bringing a yawn to people who have traded and exploited one or more of these factors for decades.
Such a model will also conclude that there is no state of "efficient" at any time in the markets but inefficiency in one contributing factor at any time rotates into inefficiency in another providing the incentive needed for the markets to be actively traded and hence provide price discovery. This will be shown to be consistent with the natural laws of entropy.
The study will also attribute the popularity of previous papers with less factors on the incorrect use of averages as the guiding principle and the unthinking adoption by cults promoted by false prophets posing as men/women of science.