In a research paper recently published in the Journal of Portfolio Management, Robeco’s David Blitz, Matthias Hanauer Milan Vidojevic and Pim van Vliet, highlight five major concerns. In this article they point to a number of shortcomings, in particular concerning the low volatility and the momentum effects, as well as robustness issues.
Back in 1993, Fama and French argued that the size and value factors capture a dimension of systematic risk that is not captured by market beta in the Capital Asset Pricing Model (CAPM). They proposed extending the CAPM, which resulted in the 3-factor model. The size effect is where small cap stocks earn higher returns than those with a large market cap. The value effect is the superior performance of stocks with a low price-to-book ratio compared to those with a high price to book.
Over the past two decades, this 3-factor model has been very influential. It has become common practice in the asset pricing literature to look at both 1-factor and 3-factor alphas. However, many such studies also suggested that the 3-factor model is incomplete and that more factors are needed to accurately describe the cross section of stock returns.
Inspired by this mounting evidence that three factors were not enough, in 2015, Fama and French decided to add two additional factors to their 3-factor model, namely profitability (stocks of companies with a high operating profitability perform better) and investment (stocks of companies with high total asset growth have below average returns). Both new factors are concrete examples of what are popularly known as quality factors.
This 5-factor model is likely to become the new standard in asset pricing studies, which significantly raises the bar for new anomalies. However, it still fails to address important questions left unanswered by the 3-factor model and raises a number of new concerns.
Missing Low Volatility and Momentum
The first issue is that, just like its predecessor, the 5-factor model retains the CAPM relationship between risk and return, which implies that, all other things being equal, a higher market beta should result in a higher expected return. This assumption refutes the existence of a low beta or low-volatility premium, despite a wide body of literature showing otherwise.
On this specific matter, Fama and French have argued that the low-beta anomaly is fully accounted for in their 5-factor model. But their conclusion seems premature, since they fail to provide direct evidence that a higher market beta exposure is rewarded with higher returns.
A second concern is that, similar to the 3-factor model, the 5-factor model remains unable to explain the momentum premium, and continues to ignore it. Yet, because momentum is too pervasive and important to ignore, most studies also look at 4-factor alphas, based on the 3-factor model augmented with the momentum factor. For the same reason, many researchers will probably feel the need to add the momentum factor to this new 5-factor model, resulting in a 6-factor variant.
The robustness of the two new factors is also an issue. It is particularly surprising that the investment factor is defined as asset growth, which Fama and French themselves deemed a ‘less robust’ phenomenon, back in 2008. More specifically, the 5-factor model fails to explain a number of variables that are closely related to the two newly selected ones. Another robustness concern is that it is still unclear whether the two new factors were effective before 1963 or evident in other asset classes, while for other factors such as value and momentum this is known to be the case.
A fourth concern is the economic rationale behind the new model. Fama and French initially justified the addition of the size and value factors by arguing that these could be seen as priced risk factors, implying that they might capture the risk of financial distress. Since then, however, studies have shown that the direct relationship between distress risk and return is actually negative. This is consistent with the existence of a low-risk premium. In the case of profitability and investment, Fama and French do not even attempt to explain that these are plausible risk factors.
Instead, their rationale for including these factors is that they should imply expected returns, which they derive from a rewritten dividend discount model. But it remains unclear if the higher expected returns for firms with high profitability or low investment, all else being constant, are due to higher (distress) risk or just a case of mispricing.
Finally, this updated five-factor model is unlikely to settle the main asset pricing debates or lead to consensus. Competing alternative models have actually already been proposed.”
This article was previously published in Robeco Quarterly magazine and updated on 27 March 2018. This article was initially published in December 2016.