In 2015, Nobel prize laureate Eugene Fama and fellow researcher Kenneth French revamped their famous 3-factor model. They added two new factors to analyze stock returns: Profitability and Investment. But this 5-factor model still raises many questions.
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.
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.”
Updated on 27 March 2018. This article was initially published in December 2016.
This report is not available for users from countries where the offering of foreign financial services is not permitted, such as US Persons.
Your details are not shared with third parties. This information is exclusively intended for professional investors. All requests are checked.
Please read this important information before proceeding further. It contains legal and regulatory notices relevant to the information contained on this website.
The information contained in the Website is NOT FOR RETAIL CLIENTS - The information contained in the Website is solely intended for professional investors, defined as investors which (1) qualify as professional clients within the meaning of the Markets in Financial Instruments Directive (MiFID), (2) have requested to be treated as professional clients within the meaning of the MiFID or (3) are authorized to receive such information under any other applicable laws. The value of the investments may fluctuate. Past performance is no guarantee of future results. Investors may not get back the amount originally invested. Neither Robeco Institutional Asset Management B.V. nor any of its affiliates guarantees the performance or the future returns of any investments. If the currency in which the past performance is displayed differs from the currency of the country in which you reside, then you should be aware that due to exchange rate fluctuations the performance shown may increase or decrease if converted into your local currency.
In the UK, Robeco Institutional Asset Management B.V. (“ROBECO”) only markets its funds to institutional clients and professional investors. Private investors seeking information about ROBECO should visit our corporate website www.robeco.com or contact their financial adviser. ROBECO will not be liable for any damages or losses suffered by private investors accessing these areas.
In the UK, ROBECO Funds has marketing approval for the funds listed on this website, all of which are UCITS funds. ROBECO is authorized by the AFM and subject to limited regulation by the Financial Conduct Authority. Details about the extent of our regulation by the Financial Conduct Authority are available from us on request.
Many of the protections provided by the United Kingdom regulatory framework may not apply to investments in ROBECO Funds, including access to the Financial Services Compensation Scheme and the Financial Ombudsman Service. No representation, warranty or undertaking is given as to the accuracy or completeness of the information on this website.
If you are not an institutional client or professional investor you should therefore not proceed. By proceeding please note that we will be treating you as a professional client for regulatory purposes and you agree to be bound by our terms and conditions.