Re: Challenge to the Fama French Three Factor Model
Posted: Tue Oct 09, 2012 7:11 pm
I certainly agree that, to the extent an investor has a particular interest in SD (or is otherwise different from the "representative investor"), then they can profitably tilt away from the market portfolio.Jerry_lee wrote:1. You are right that SD is an incomplete measure of risk in a multifactor world. But investors still care about SD, and some care almost exclusively about it (for them, tilted portfolios are ideal). Further, there are plenty of discussions about additional small/value risks (timing of losses matter as much as magnitude), and most of us have lived through those in '07-'08. Multi-factor models simply give us a richer appreciation of all the ways markets reward risk, allowing us to pick and choose amongst them as our circumstances dictate. Larry might be focused on minimizing one-in-a-generation downturns with low beta/high tilt allocations, I might prefer a balance of large/small/growth/value and shorter term debt without the low beta emphasis, while you might which to hold mostly economically healthy companies (TSM) and take additional interest rate and credit risk. Each of these decisions has pros/cons, and we should seek to understand them and choose the avenue that is best for us.
One problem I often see is a statement essentially to the effect: SD is a terrible yardstick, 3F is much better, this can be shown by a tilted portfolio lowering SD risk. Having said SD is inadequate, it does not seem proper to then use it
The second problem is the notion that tilting is good for everyone. Not everyone can have a particular issue with SD.
This is DFA's summary of the French statement I referenced: "Can investors build a better portfolio by combining asset classes that have low correlations? It is possible, explains Ken French, but not in the way that most investors attempt it. Some think they can enhance diversification by eliminating mid caps and concentrating on only large and small cap stocks because these asset classes are less correlated. Ken explains that portfolio variance is determined not only by correlation, but also by variance of the individual asset classes and, critically, by their weighting in the portfolio. He emphasizes that throwing out mid caps is equivalent to doubling up on the risk of large and small caps, which is the opposite of diversification." French's statement is a video at http://www.dimensional.com/famafrench/2 ... ssion.htmlJerry_lee wrote:2. When I think of diversification, I look to its multiple meanings. Security diversification is once consideration, asset class diversification is another (and you may restrict your definition of "asset classes" as distinct portfolios such as stocks/bonds/TIPS/cash with maybe regional considerations), and diversification by sources of risk/return is yet another. You are right, nothing in the FF research tells us HOW to invest according to the 3F or 5F model. No such paper such as Portfolio Selection exists in the multi-factor world. So it is up to investors to read the research, and apply it according to their circumstances and interpretations.
I would be very careful to take interview or video snipits out of context or depend on them exclusively. In the case of French, I believe he was comparing a TSM portfolio (almost no small/micro cap exposure) to S&P/Micro Cap portfolio (almost no mid cap exposure) held in the same factor adjusted allocations (TSM = 85% S&P/15% Micro). In this case, focusing on security diversification, TSM is more diversified (3,000 vs 2,500 names), and you might think excluding mid-caps is more problematic than small/micro given the relatively larger % of the former on a cap weighted market basis.
The FF 3F model says, in essence, that the returns of a portfolio can be entirely explained by exposure to the three factors. To the extent the model is accurate, it does not leave a place for any additional benefits from lack of correlation between large and small or value and growth.Jerry_lee wrote:But, it is no great stretch to understand that there are multiple risks that drive returns, and these risks are not perfectly correlated. Actually, over intermediate/long periods, pure long/short return factors have negative correlation's and positive expected returns, so holding asset classes that target those risk/return dimensions fully does provide a multi-factor diversification benefit. We cannot deny that size risk or value risk has historically provided a return diversification during periods when the equity risk premium is negative, nor that when the ERP is above average, we have also seen zero or negative value and size returns. We don't need academic studies to understand that there is a portfolio benefit to holding multiple distinct risks (with positive expected returns) vs isolating one or two.
It is of course only a model, not a complete description of reality. However, if low correlations added to the explanatory power, one would expect additional terms that capture the additional correlation factor. I've never seen a formal model with such a factor. Do you know of one?
If markets are efficient, the market portfolio is always on the efficient frontier. As I'm fond of quoting, Fama has repeatedly said TSM is efficient. It holds multiple distinct risks in appropriate proportions. Tilting might be a good idea if you want to take additional risk in the hope of higher returns. Tilting might be a free lunch ex ante, but only if markets are not efficient.