Fama and French: The Five-Factor Model Revisited

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Re: Fama and French: The Five-Factor Model Revisited

Post by Fryxell »

vineviz wrote: Sun Jan 23, 2022 4:33 pm
km91 wrote: Sun Jan 23, 2022 4:23 pm No such intuition for the other factors exists and any description of the factors needs to rely on the historical data. If we can't clearly describe the factors outside of the context of the academic research, chances are they probably aren't persistent
I guarantee you that 99% of investors can't articulate why stocks are riskier than bonds any more clearly than academics have articulated why the other factors exist. Heck, 99% of investors can't even properly identify the risk-free asset, much less explain what an equity risk premium is or how to calculate it.

"I don't understand it therefore it can't exist" is a pretty weak argument, if you ask me.
There’s no a-priori reason why stocks should deliver a premium above long-term bonds.
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Re: Fama and French: The Five-Factor Model Revisited

Post by Fryxell »

sycamore wrote: Sun Jan 23, 2022 8:11 pm
Northern Flicker wrote: Sun Jan 23, 2022 4:45 pm Here is a small-cap value fund that predates the Fama & French (1993) publication.

https://www.portfoliovisualizer.com/bac ... ion1_1=100
Vanguard's Small Cap Value NAESX goes back a bit further to 1985, but I'm not sure if NAESX was one of those funds whose strategy changed over time.
Yes, that was a very different fund.
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Re: Fama and French: The Five-Factor Model Revisited

Post by hillclimber »

vineviz wrote: Sun Jan 23, 2022 4:33 pm I guarantee you that 99% of investors can't articulate why stocks are riskier than bonds any more clearly than academics have articulated why the other factors exist.
Here is a layman level explanation on why stocks are riskier than bonds:


The risk with stocks is that the CEO does stupid stuff and wastes your money. However, if the business does well, you get dividends, buybacks, and earnings growth. Also, every few years, the stock market goes down 10% or more.

Most of the people I know personally at least implicitly understood these concepts and could express them if given time to think it through.
vineviz wrote: Sun Jan 23, 2022 4:33 pm "I don't understand it therefore it can't exist" is a pretty weak argument, if you ask me.
Why are you being so belligerent right now? No one is arguing, just expressing skepticism.
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Re: Fama and French: The Five-Factor Model Revisited

Post by nisiprius »

sycamore wrote: Sun Jan 23, 2022 8:11 pm
Northern Flicker wrote: Sun Jan 23, 2022 4:45 pm Here is a small-cap value fund that predates the Fama & French (1993) publication.

https://www.portfoliovisualizer.com/bac ... ion1_1=100
Vanguard's Small Cap Value NAESX goes back a bit further to 1985, but I'm not sure if NAESX was one of those funds whose strategy changed over time.
NAESX is not small cap value, it's just small caps.

The name of PRSVX today is "T. Rowe Price Small-Cap Value Fund;" it would be interesting to know what its name was in 1988, and how T. Rowe Price described its strategy back then. Here's their summary today:
Invests in small-company stocks that firm believes do not reflect their underlying value. Intensive in-house research considers, among many factors: low price/earnings, price/book value, and price/cash flow ratios and solid financial characteristics.

Small companies tend to be riskier than large companies.
Here's the comparison with the Fama-French research series for small-cap value:

Image
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Re: Fama and French: The Five-Factor Model Revisited

Post by rkhusky »

vineviz wrote: Sun Jan 23, 2022 9:38 am
rkhusky wrote: Sun Jan 23, 2022 8:13 am Not seeing much of an extra diversification or SCV premium for that 20 year period.
If you go around excluding data that isn't consistent with your hypothesis you're less likely to every have to change your mind, I guess.
If you want to see how things are changing over time, you don't average over the whole time period. Or do you believe that there is a "true" constant premium and correlation coefficient around which all the historical data dances? And by averaging over longer and longer periods, we get better and better estimates of these "true" values?
vineviz wrote: Sun Jan 23, 2022 9:38 am Even excluding those two years (again, why?) the correlation of SCG is still higher than SCV from 2002 to present.
If you consider a correlation of 0.92 significantly higher than a correlation of 0.91. And we know that correlation isn't all that matters. Otherwise, cash or bonds would be better diversifiers. One also needs to consider return. And I would think that the average annual return advantage of SCG of 11.00% vs the 9.58% return of SCV outweighs the 0.01 correlation advantage of the latter in determining which was the better diversifier in the 20 year period between 2002 - 2021.

And if we go back to the full dataset, which is more important for determining a better diversifier, the 0.91 vs 0.77 correlation of SCG vs SCV or the 10.40% vs 9.98% return of SCG vs SCV? Well, turning to PV, if we compare a portfolio of 50/50 SCG/TSM with a portfolio of 50/50 SCV/TSM, the results (with rebalancing bands) are:

SCG/TSM: CAGR = 9.49%, STD = 17.23%, Sharpe = 0.52
SCV/TSM: CAGR = 9.33%, STD = 16.76%, Sharpe = 0.52

So, they are equally good diversifiers over 1999 - 2021. The higher return of SCG defeats the correlation in term of the portfolio return, at the expense of higher volatility.

How about over the last 20 years (2002 - 2021)?:

SCG/TSM: CAGR = 10.47%, STD = 16.70%, Sharpe = 0.61
SCV/TSM: CAGR = 9.75%, STD = 16.72%, Sharpe = 0.57

SCG was the better diversifier.
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Re: Fama and French: The Five-Factor Model Revisited

Post by rkhusky »

hillclimber wrote: Mon Jan 24, 2022 1:37 am
vineviz wrote: Sun Jan 23, 2022 4:33 pm I guarantee you that 99% of investors can't articulate why stocks are riskier than bonds any more clearly than academics have articulated why the other factors exist.
Here is a layman level explanation on why stocks are riskier than bonds:

The risk with stocks is that the CEO does stupid stuff and wastes your money. However, if the business does well, you get dividends, buybacks, and earnings growth. Also, every few years, the stock market goes down 10% or more.
Here is my explanation:
With a bond, you know exactly what you are going to get in the future (apart from defaults). But you don't whether there might have been a better bond for you to have chosen over the coming years. So, you know what you are getting, but you don't know what the competition will get.

With a stock, you don't know what you are going to get in the future. And you don't know if some other stock might have have been better. So, you don't know what you are going to get and you don't know what the competition will get.

Bonds have 1 form of uncertainty. Stocks have 2 forms of uncertainty.

And with a bond, you can dial the risk up or down by looking at the term and the credit quality. So, you have some control.

With a stock, dialing the risk up or down is very uncertain. You may think that a large cap stock is safer than a small cap stock, but we've seen lots of large caps crash over the years. So, you have much less control over safety regarding stocks.
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Re: Fama and French: The Five-Factor Model Revisited

Post by vineviz »

rkhusky wrote: Mon Jan 24, 2022 7:41 am If you want to see how things are changing over time, you don't average over the whole time period. Or do you believe that there is a "true" constant premium and correlation coefficient around which all the historical data dances? And by averaging over longer and longer periods, we get better and better estimates of these "true" values?
I've looked at data from 1927 to present, 1964 to present, 1999 to present: no the correlations aren't constant; yet, the correlation of SCV with the market is lower than SCG most of the time and on average in all time periods.

rkhusky wrote: Mon Jan 24, 2022 7:41 am SCG/TSM: CAGR = 9.49%, STD = 17.23%, Sharpe = 0.52
SCV/TSM: CAGR = 9.33%, STD = 16.76%, Sharpe = 0.52
Sharpe ratio is not a measure of diversification.
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Re: Fama and French: The Five-Factor Model Revisited

Post by ParlayBogle »

Bond holders get paid before stock holders. That's a pretty straightforward explanation of why they are less risky.
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Re: Fama and French: The Five-Factor Model Revisited

Post by rkhusky »

vineviz wrote: Mon Jan 24, 2022 8:25 am
rkhusky wrote: Mon Jan 24, 2022 7:41 am SCG/TSM: CAGR = 9.49%, STD = 17.23%, Sharpe = 0.52
SCV/TSM: CAGR = 9.33%, STD = 16.76%, Sharpe = 0.52
Sharpe ratio is not a measure of diversification.
Never said it was. But it is a factor in making something a good diversifier. I don't care about correlation or diversification except for how they affect my return. If they increase return and lower volatility, it is good. If they lower return and increase volatility, it is bad. Otherwise, you have to trade-off return and volatility, and the Sharpe Ratio is one way to do that. In this case, I agree with the Sharpe ratio - they are equivalently good diversifiers of TSM over this period.

If lack of correlation is all you are after, cash and bonds had negative correlation with TSM over 1999 - 2021.
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Re: Fama and French: The Five-Factor Model Revisited

Post by vineviz »

rkhusky wrote: Mon Jan 24, 2022 8:59 am
vineviz wrote: Mon Jan 24, 2022 8:25 am
rkhusky wrote: Mon Jan 24, 2022 7:41 am SCG/TSM: CAGR = 9.49%, STD = 17.23%, Sharpe = 0.52
SCV/TSM: CAGR = 9.33%, STD = 16.76%, Sharpe = 0.52
Sharpe ratio is not a measure of diversification.
Never said it was. But it is a factor in making something a good diversifier.
No, it is not a factor. If you want to argue that SCG>SCV in terms of diversification, which is what I think you're trying to do, you can't use Sharpe as the measure.
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Re: Fama and French: The Five-Factor Model Revisited

Post by rkhusky »

vineviz wrote: Mon Jan 24, 2022 9:17 am
rkhusky wrote: Mon Jan 24, 2022 8:59 am
vineviz wrote: Mon Jan 24, 2022 8:25 am
rkhusky wrote: Mon Jan 24, 2022 7:41 am SCG/TSM: CAGR = 9.49%, STD = 17.23%, Sharpe = 0.52
SCV/TSM: CAGR = 9.33%, STD = 16.76%, Sharpe = 0.52
Sharpe ratio is not a measure of diversification.
Never said it was. But it is a factor in making something a good diversifier.
No, it is not a factor. If you want to argue that SCG>SCV in terms of diversification, which is what I think you're trying to do, you can't use Sharpe as the measure.
I am not arguing that. I am saying that if I have a choice in choosing between two diversifiers, I will consider the return difference and volatility difference that comes with using each of them in my portfolio.
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Re: Fama and French: The Five-Factor Model Revisited

Post by vineviz »

rkhusky wrote: Mon Jan 24, 2022 9:24 am I am not arguing that. I am saying that if I have a choice in choosing between two diversifiers, I will consider the return difference and volatility difference that comes with using each of them in my portfolio.
The problem is that in real life you don't get to choose assets based on their future returns.
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Re: Fama and French: The Five-Factor Model Revisited

Post by vanbogle59 »

vineviz wrote: Mon Jan 24, 2022 9:33 am in real life you don't get to choose assets based on their future returns.
Drop the mike.
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Re: Fama and French: The Five-Factor Model Revisited

Post by willthrill81 »

rkhusky wrote: Mon Jan 24, 2022 9:24 am
vineviz wrote: Mon Jan 24, 2022 9:17 am
rkhusky wrote: Mon Jan 24, 2022 8:59 am
vineviz wrote: Mon Jan 24, 2022 8:25 am
rkhusky wrote: Mon Jan 24, 2022 7:41 am SCG/TSM: CAGR = 9.49%, STD = 17.23%, Sharpe = 0.52
SCV/TSM: CAGR = 9.33%, STD = 16.76%, Sharpe = 0.52
Sharpe ratio is not a measure of diversification.
Never said it was. But it is a factor in making something a good diversifier.
No, it is not a factor. If you want to argue that SCG>SCV in terms of diversification, which is what I think you're trying to do, you can't use Sharpe as the measure.
I am not arguing that. I am saying that if I have a choice in choosing between two diversifiers, I will consider the return difference and volatility difference that comes with using each of them in my portfolio.
Two variables having had the same Sharpe ratio does not mean that their risk/volatility has been the same for a long-term investor. For instance, the start date sensitivity, which is based on rolling 10 year returns, of SCV has been about 40% less than TSM since 1970.
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Re: Fama and French: The Five-Factor Model Revisited

Post by rkhusky »

vineviz wrote: Mon Jan 24, 2022 9:33 am
rkhusky wrote: Mon Jan 24, 2022 9:24 am I am not arguing that. I am saying that if I have a choice in choosing between two diversifiers, I will consider the return difference and volatility difference that comes with using each of them in my portfolio.
The problem is that in real life you don't get to choose assets based on their future returns.
Who said that? We all know that we invest based on past performance.

2002 - 2021
50/50 portfolios

SCG/TSM: CAGR = 10.47%, STD = 16.70%, Sharpe = 0.61
SCV/TSM: CAGR = 9.75%, STD = 16.72%, Sharpe = 0.57
Last edited by rkhusky on Mon Jan 24, 2022 11:04 am, edited 2 times in total.
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Re: Fama and French: The Five-Factor Model Revisited

Post by rkhusky »

willthrill81 wrote: Mon Jan 24, 2022 10:05 am For instance, the start date sensitivity, which is based on rolling 10 year returns, of SCV has been about 40% less than TSM since 1970.
So, you are saying that SCV is less risky than TSM, which means that SCV should return less than TSM over the long term?
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Re: Fama and French: The Five-Factor Model Revisited

Post by Nathan Drake »

rkhusky wrote: Mon Jan 24, 2022 11:01 am
willthrill81 wrote: Mon Jan 24, 2022 10:05 am For instance, the start date sensitivity, which is based on rolling 10 year returns, of SCV has been about 40% less than TSM since 1970.
So, you are saying that SCV is less risky than TSM, which means that SCV should return less than TSM over the long term?
Start date sensitivity is not a measure of risk

Having higher expected returns has the tendency of reducing recovery periods because volatility is higher. Upside volatility is a good thing
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Re: Fama and French: The Five-Factor Model Revisited

Post by willthrill81 »

rkhusky wrote: Mon Jan 24, 2022 11:01 am
willthrill81 wrote: Mon Jan 24, 2022 10:05 am For instance, the start date sensitivity, which is based on rolling 10 year returns, of SCV has been about 40% less than TSM since 1970.
So, you are saying that SCV is less risky than TSM, which means that SCV should return less than TSM over the long term?
That would be contrary to the last 50+ years of data we have. SCV has had higher long-term returns than TSM and lower start date sensitivity (i.e., more consistent 10 year returns). Interpret that how you will, but it was what it was.
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Re: Fama and French: The Five-Factor Model Revisited

Post by rkhusky »

willthrill81 wrote: Mon Jan 24, 2022 11:05 am
rkhusky wrote: Mon Jan 24, 2022 11:01 am
willthrill81 wrote: Mon Jan 24, 2022 10:05 am For instance, the start date sensitivity, which is based on rolling 10 year returns, of SCV has been about 40% less than TSM since 1970.
So, you are saying that SCV is less risky than TSM, which means that SCV should return less than TSM over the long term?
That would be contrary to the last 50+ years of data we have. SCV has had higher long-term returns than TSM and lower start date sensitivity (i.e., more consistent 10 year returns). Interpret that how you will, but it was what it was.
Possible interpretations:

SCV will return a lot less than TSM in the future until the long term average drops below TSM.

Higher SCV returns are illusory.

Start date sensitivity is not a measure of risk.

Investors are irrational.

Investors don't care about start date sensitivity.
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Re: Fama and French: The Five-Factor Model Revisited

Post by vineviz »

rkhusky wrote: Mon Jan 24, 2022 10:54 am
vineviz wrote: Mon Jan 24, 2022 9:33 am
rkhusky wrote: Mon Jan 24, 2022 9:24 am I am not arguing that. I am saying that if I have a choice in choosing between two diversifiers, I will consider the return difference and volatility difference that comes with using each of them in my portfolio.
The problem is that in real life you don't get to choose assets based on their future returns.
Who said that? We all know that we invest based on past performance.
You're saying it, whether you realize it or not. It's implicit in your use of Sharpe to make the diversification claim you made earlier.

SCV has a lower correlation with TSM and higher variance than SCG. The only way to make SCG come out as the "better" diversifier in your rubric is for SCG to have higher expected returns.

Using Sharpe ratio as an optimization metric has a well-documented problem in that it functions very much like a "past performance" optimizer .
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Re: Fama and French: The Five-Factor Model Revisited

Post by rkhusky »

vineviz wrote: Mon Jan 24, 2022 11:15 am
rkhusky wrote: Mon Jan 24, 2022 10:54 am
vineviz wrote: Mon Jan 24, 2022 9:33 am
rkhusky wrote: Mon Jan 24, 2022 9:24 am I am not arguing that. I am saying that if I have a choice in choosing between two diversifiers, I will consider the return difference and volatility difference that comes with using each of them in my portfolio.
The problem is that in real life you don't get to choose assets based on their future returns.
Who said that? We all know that we invest based on past performance.
You're saying it, whether you realize it or not. It's implicit in your use of Sharpe to make the diversification claim you made earlier.

SCV has a lower correlation with TSM and higher variance than SCG. The only way to make SCG come out as the "better" diversifier in your rubric is for SCG to have higher expected returns.

Using Sharpe ratio as an optimization metric has a well-documented problem in that it functions very much like a "past performance" optimizer .
I am all about higher returns with little change in volatility. If all you care about is correlations, might I suggest cash under the mattress. It has a very low correlation with TSM.

Anyway, here is what was said:
rkhusky wrote: Mon Jan 24, 2022 8:59 am
vineviz wrote: Mon Jan 24, 2022 8:25 am
rkhusky wrote: Mon Jan 24, 2022 7:41 am SCG/TSM: CAGR = 9.49%, STD = 17.23%, Sharpe = 0.52
SCV/TSM: CAGR = 9.33%, STD = 16.76%, Sharpe = 0.52
Sharpe ratio is not a measure of diversification.
Never said it was. But it is a factor in making something a good diversifier. I don't care about correlation or diversification except for how they affect my return. If they increase return and lower volatility, it is good. If they lower return and increase volatility, it is bad. Otherwise, you have to trade-off return and volatility, and the Sharpe Ratio is one way to do that. In this case, I agree with the Sharpe ratio - they are equivalently good diversifiers of TSM over this period.

If lack of correlation is all you are after, cash and bonds had negative correlation with TSM over 1999 - 2021.
Note the
Otherwise, you have to trade-off return and volatility, and the Sharpe Ratio is one way to do that.
I'm not a slave to Sharpe. I look at the return and the volatility and make a judgement. In this case, the return difference was small and the volatility difference was small. And the Sharpe ratio was the same. So, looks about the same to me.
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Re: Fama and French: The Five-Factor Model Revisited

Post by Apathizer »

rkhusky wrote: Mon Jan 24, 2022 11:33 am I am all about higher returns with little change in volatility.
You're unlikely to get that. Higher volatility is generally a trade-off for higher returns. Higher volatility doesn't necessarily mean higher returns as is the case with small-growth. SG is more volatile with lower returns than the TSM while SV is more volatile but has higher returns than the TSM. You don't seem to understand that.
Last edited by Apathizer on Mon Jan 24, 2022 2:21 pm, edited 1 time in total.
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Re: Fama and French: The Five-Factor Model Revisited

Post by rkhusky »

Apathizer wrote: Mon Jan 24, 2022 11:56 am
rkhusky wrote: Mon Jan 24, 2022 11:33 am I am all about higher returns with little change in volatility.
You're unlikely to get that. Higher volatility is generally a trade-off for higher returns. Higher volatility, doesn't necessarily higher returns as is the case with small-growth. SG is more volatile with lower returns than the TSM while SV is more volatile but has higher returns than the TSM. You don't seem to understand that.
Reality sometimes doesn't follow what we expect.

2002 - 2021
50/50 portfolios

SCG/TSM: CAGR = 10.47%, STD = 16.70%, Sharpe = 0.61
SCV/TSM: CAGR = 9.75%, STD = 16.72%, Sharpe = 0.57

Adding SCG to TSM gave higher return and lower volatility than adding SCV, over this 20 year period. I would go with SCG over SCV as a diversifier if I expected this to continue.
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Re: Fama and French: The Five-Factor Model Revisited

Post by willthrill81 »

rkhusky wrote: Mon Jan 24, 2022 12:15 pm
Apathizer wrote: Mon Jan 24, 2022 11:56 am
rkhusky wrote: Mon Jan 24, 2022 11:33 am I am all about higher returns with little change in volatility.
You're unlikely to get that. Higher volatility is generally a trade-off for higher returns. Higher volatility, doesn't necessarily higher returns as is the case with small-growth. SG is more volatile with lower returns than the TSM while SV is more volatile but has higher returns than the TSM. You don't seem to understand that.
Reality sometimes doesn't follow what we expect.
Of course. We expect stocks to have higher returns than bonds, but that's not always the case. Bonds trounced stocks from 2000-2009. But that doesn't mean that we use only single, isolated periods to form our investment strategies.
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Re: Fama and French: The Five-Factor Model Revisited

Post by vineviz »

rkhusky wrote: Mon Jan 24, 2022 11:33 am I am all about higher returns with little change in volatility. If all you care about is correlations, might I suggest cash under the mattress. It has a very low correlation with TSM.
Diversification is about more than correlations, obviously.

My main point here is that when you're talking about Sharpe ratio you're talking about something OTHER than diversification. And mostly what you're talking about is high past performance.
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Re: Fama and French: The Five-Factor Model Revisited

Post by rkhusky »

vineviz wrote: Mon Jan 24, 2022 12:19 pm
rkhusky wrote: Mon Jan 24, 2022 11:33 am I am all about higher returns with little change in volatility. If all you care about is correlations, might I suggest cash under the mattress. It has a very low correlation with TSM.
Diversification is about more than correlations, obviously.

My main point here is that when you're talking about Sharpe ratio you're talking about something OTHER than diversification. And mostly what you're talking about is high past performance.
Understood.
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Re: Fama and French: The Five-Factor Model Revisited

Post by Northern Flicker »

km91 wrote: Sun Jan 23, 2022 8:14 pm
Northern Flicker wrote: Sun Jan 23, 2022 7:53 pm
km91 wrote: This makes absolutely no sense. How can the factor command a risk premium in the market, yet none of the market participants are able to explain it. Sellers of the factor are paying a premium to buyers, but don't know why they're paying it?
The same critique applies to the market factor (equity risk premium).
Huh? We don't why equity risk commands a premium to the risk free asset?
Actually the uncertainty about the source of the value premium carties over to the market factor. If the market is efficient, and the market prices in risk premia for the risk of individual stocks (when they are held in a diversified portfolio) then the market premium is the aggregation if that in the whole market while the value premium would be determined from aggregating across stocks defined as value stocks.

If the behavioral story of a value premium is correct, and investors overpay for growth, then that also affects how the market establishes a risk premium for the whole market since growth is part of the whole market.
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Re: Fama and French: The Five-Factor Model Revisited

Post by rkhusky »

willthrill81 wrote: Mon Jan 24, 2022 12:17 pm
rkhusky wrote: Mon Jan 24, 2022 12:15 pm
Apathizer wrote: Mon Jan 24, 2022 11:56 am
rkhusky wrote: Mon Jan 24, 2022 11:33 am I am all about higher returns with little change in volatility.
You're unlikely to get that. Higher volatility is generally a trade-off for higher returns. Higher volatility, doesn't necessarily higher returns as is the case with small-growth. SG is more volatile with lower returns than the TSM while SV is more volatile but has higher returns than the TSM. You don't seem to understand that.
Reality sometimes doesn't follow what we expect.
Of course. We expect stocks to have higher returns than bonds, but that's not always the case. Bonds trounced stocks from 2000-2009. But that doesn't mean that we use only single, isolated periods to form our investment strategies.
Yep. Didn't come back to even until 2016. 2000 would have been a bad year to lump sum into stocks. Of course, the fundamental differences between stocks and bonds are quite a bit larger than between value stocks and growth stocks or between small stocks and big stocks.
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Re: Fama and French: The Five-Factor Model Revisited

Post by Apathizer »

rkhusky wrote: Mon Jan 24, 2022 2:35 pm
willthrill81 wrote: Mon Jan 24, 2022 12:17 pm
rkhusky wrote: Mon Jan 24, 2022 12:15 pm
Apathizer wrote: Mon Jan 24, 2022 11:56 am
rkhusky wrote: Mon Jan 24, 2022 11:33 am I am all about higher returns with little change in volatility.
You're unlikely to get that. Higher volatility is generally a trade-off for higher returns. Higher volatility, doesn't necessarily higher returns as is the case with small-growth. SG is more volatile with lower returns than the TSM while SV is more volatile but has higher returns than the TSM. You don't seem to understand that.
Reality sometimes doesn't follow what we expect.
Of course. We expect stocks to have higher returns than bonds, but that's not always the case. Bonds trounced stocks from 2000-2009. But that doesn't mean that we use only single, isolated periods to form our investment strategies.
Yep. Didn't come back to even until 2016. 2000 would have been a bad year to lump sum into stocks. Of course, the fundamental differences between stocks and bonds are quite a bit larger than between value stocks and growth stocks or between small stocks and big stocks.
True, but there have been extended periods when bonds out performed the TSM. Other periods TSM and bonds had similar returns while SV out performed both.

That's the point of diversifying across all markets and likely positive risk factors. Since we can't predict the future all we can do is apply our best understanding of markets to determine an approach most likely to produce the best returns.
Last edited by Apathizer on Tue Jan 25, 2022 10:16 pm, edited 1 time in total.
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Re: Fama and French: The Five-Factor Model Revisited

Post by rkhusky »

Apathizer wrote: Mon Jan 24, 2022 6:59 pm That's the point of diversifying across all markets and factors. Since we can't predict the future, all we can do is apply our best understanding of markets to determine an approach most likely to produce the best returns.
Exactly. Sometimes Small Growth will outperform. Sometimes Small Value will outperform. Sometimes Large Growth will outperform. Sometimes Large Value will outperform. And the correlations between them range from 0.61 - 0.89. So, diversify by investing in all of them with TSM.

If you really want to tilt to one part of the market, you don't want to invest in all the factors, because they will cancel out and you will be left with TSM. And most people don't invest in factors anyway, they invest in half-factors, i.e. the long portion of the factor.

The correlation with the market and the return of various market segments over the last 20 years is below:
(note that the annualized return for TSM was 9.78%):
1/1/2002 - 12/31/2021
(correlation with TSM, annualized return)

LCG - 0.95, 10.71%
LCV - 0.95, 8.37%
SCG - 0.92, 11.00%
SCV - 0.91, 9.58%

If you weren't invested in growth during this period, you missed out on a lot of return, which will take years to make up. Best not to make bets on one part of the market, and just invest in it all.
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Re: Fama and French: The Five-Factor Model Revisited

Post by muffins14 »

rkhusky wrote: Tue Jan 25, 2022 7:38 am
Apathizer wrote: Mon Jan 24, 2022 6:59 pm That's the point of diversifying across all markets and factors. Since we can't predict the future, all we can do is apply our best understanding of markets to determine an approach most likely to produce the best returns.
Exactly. Sometimes Small Growth will outperform. Sometimes Small Value will outperform. Sometimes Large Growth will outperform. Sometimes Large Value will outperform. And the correlations between them range from 0.61 - 0.89. So, diversify by investing in all of them with TSM.

If you really want to tilt to one part of the market, you don't want to invest in all the factors, because they will cancel out and you will be left with TSM. And most people don't invest in factors anyway, they invest in half-factors, i.e. the long portion of the factor.

The correlation with the market and the return of various market segments over the last 20 years is below:
(note that the annualized return for TSM was 9.78%):
1/1/2002 - 12/31/2021
(correlation with TSM, annualized return)

LCG - 0.95, 10.71%
LCV - 0.95, 8.37%
SCG - 0.92, 11.00%
SCV - 0.91, 9.58%

If you weren't invested in growth during this period, you missed out on a lot of return, which will take years to make up. Best not to make bets on one part of the market, and just invest in it all.
You are making exactly the opposite point of the poster you are quoting, and I think you know that.

Firstly, you know well that the TSM is not "all the factors", it is one of them, the market factor. This is by definition, like "how many ounces is a gallon".

Secondly, Growth and Value are not two factors that cancel each other out in the TSM. There is one factor, HmL, or value minus growth. The TSM has zero because it has equal parts growth and value, by definition.

Thirdly, this poster is recommending to diversify across all factors, which explicitly means NOT investing in only the TSM. Correspondingly it means not investing in equal parts growth and value, nor following market cap for small and growth. The poster is implying to have non-zero loadings on the factors in the portfolio, which means more value than growth, and more small compared to the TSM. Factor diversification implies non-zero (and positive) allocations to the factors, not zero allocations to the factors.

I think you know all of this, and are just using their quote and stating the exact opposite of their original intention as some tongue-in-cheek humor or something
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Re: Fama and French: The Five-Factor Model Revisited

Post by rkhusky »

muffins14 wrote: Tue Jan 25, 2022 8:12 am Firstly, you know well that the TSM is not "all the factors", it is one of them, the market factor.
Depends on what you mean by "all the factors". There are purportedly hundreds of factors in the "factor zoo".

And factor investing doesn't just mean small/value. In that sense, large and growth are factors too. (Although, these are really half-factors, but most people only invest in the long side anyway.) So, tilting to large and/or growth is also factor investing.
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Re: Fama and French: The Five-Factor Model Revisited

Post by muffins14 »

rkhusky wrote: Tue Jan 25, 2022 8:37 am
muffins14 wrote: Tue Jan 25, 2022 8:12 am Firstly, you know well that the TSM is not "all the factors", it is one of them, the market factor.
Depends on what you mean by "all the factors". There are purportedly hundreds of factors in the "factor zoo".

And factor investing doesn't just mean small/value. In that sense, large and growth are factors too. (Although, these are really half-factors, but most people only invest in the long side anyway.) So, tilting to large and/or growth is also factor investing.
To my knowledge it doesn't depend on what I mean by all the factors. The TSM is by definition the market portfolio, and everything else is relative to that portfolio. I would also argue the majority of people who would say they are factor investors only meaningfully care about size and value, and then a large but non-majority also care about momentum, CmA, and RmW. I don't think many if any retail factor investors are seeking out more than that in any meaningful way. When people say "there are hundreds of factors lol look how dumb they are" they are typically trying to belittle the approach by over-generalizing.

Yes tilting to large and growth is factor investing in that it uses factors to achieve some outcome. But in some sense it's like anti-factor investing. That strategy would mean one prefers a lower expected value of long-term returns because they get some other utility from choosing those investments that is not related to the value of the investment. One example might be an extremely tax-sensitive situation, where one gets more utility from growth stocks where they avoid paying taxes on the higher dividends of value stocks.
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Re: Fama and French: The Five-Factor Model Revisited

Post by rkhusky »

muffins14 wrote: Tue Jan 25, 2022 9:05 am Yes tilting to large and growth is factor investing in that it uses factors to achieve some outcome. But in some sense it's like anti-factor investing. That strategy would mean one prefers a lower expected value of long-term returns because they get some other utility from choosing those investments that is not related to the value of the investment.
"lower expected value of long-term returns" is really what it is all about. People saw an over-performance of SCV in the past and expect it to occur in the future. And have convinced themselves of that with some hand-waving arguments about the market mispricing risk. That's all it is. It doesn't have anything to do with factor models or asset pricing models, which provide no advantage to big, small, value, growth.
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Re: Fama and French: The Five-Factor Model Revisited

Post by vineviz »

muffins14 wrote: Tue Jan 25, 2022 9:05 am
To my knowledge it doesn't depend on what I mean by all the factors. The TSM is by definition the market portfolio, and everything else is relative to that portfolio. I would also argue the majority of people who would say they are factor investors only meaningfully care about size and value, and then a large but non-majority also care about momentum, CmA, and RmW. I don't think many if any retail factor investors are seeking out more than that in any meaningful way. When people say "there are hundreds of factors lol look how dumb they are" they are typically trying to belittle the approach by over-generalizing.
Correct on all counts.

The "hundreds of factors" objection is a strawman, overlooking the fact that many of the "hundreds" actually describe the same risk factors. It is morereasonable to count Book to price, Earnings to price, Dividend to price, Cash flow-to-price, Sales to price, and Enterprise book-to-price as six different factors, for instance, or to consider them six possible specifications of the same "value" factor?
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Re: Fama and French: The Five-Factor Model Revisited

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rkhusky wrote: Tue Jan 25, 2022 9:46 am And have convinced themselves of that with some hand-waving arguments about the market mispricing risk.
You have it complete backwards, actually. The factors work when markets do NOT misprice risk, and informed factor investors know that the factors likely mean they are taking on MORE risk in exchange for the higher expected return. We're assuming the market isn't dumb, in other words.
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Re: Fama and French: The Five-Factor Model Revisited

Post by rkhusky »

vineviz wrote: Tue Jan 25, 2022 10:50 am
rkhusky wrote: Tue Jan 25, 2022 9:46 am And have convinced themselves of that with some hand-waving arguments about the market mispricing risk.
You have it complete backwards, actually. The factors work when markets do NOT misprice risk, and informed factor investors know that the factors likely mean they are taking on MORE risk in exchange for the higher expected return. We're assuming the market isn't dumb, in other words.
I don't agree. The factor model only requires that there be some anomaly in the data. It doesn't matter why the anomaly is there. For example, if it was noticed that returns of stocks whose name starts with Q behaved differently than stocks whose name starts with Z, one could add the ZmQ (or QmZ) factor to the model. If the anomaly was persistent and favored one of the two, then a non-zero premium would result. If the anomaly was not persistent or fluctuated sufficiently between the two, then the premium would end up close to zero and probably removed from the model.
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Re: Fama and French: The Five-Factor Model Revisited

Post by vineviz »

rkhusky wrote: Tue Jan 25, 2022 11:52 am
vineviz wrote: Tue Jan 25, 2022 10:50 am
rkhusky wrote: Tue Jan 25, 2022 9:46 am And have convinced themselves of that with some hand-waving arguments about the market mispricing risk.
You have it complete backwards, actually. The factors work when markets do NOT misprice risk, and informed factor investors know that the factors likely mean they are taking on MORE risk in exchange for the higher expected return. We're assuming the market isn't dumb, in other words.
I don't agree. The factor model only requires that there be some anomaly in the data. It doesn't matter why the anomaly is there. For example, if it was noticed that returns of stocks whose name starts with Q behaved differently than stocks whose name starts with Z, one could add the ZmQ (or QmZ) factor to the model. If the anomaly was persistent and favored one of the two, then a non-zero premium would result. If the anomaly was not persistent or fluctuated sufficiently between the two, then the premium would end up close to zero and probably removed from the model.
The model is what it is. What I objected to was your characterization of how "factor investors" interpret the model. Few are convinced of what you suggest, that the market is systematically mispricing risk. Instead, they are proceeding - for the most part -under a belief that the market is ACCURATELY pricing risk.
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Re: Fama and French: The Five-Factor Model Revisited

Post by km91 »

vineviz wrote: Tue Jan 25, 2022 12:22 pm
rkhusky wrote: Tue Jan 25, 2022 11:52 am
vineviz wrote: Tue Jan 25, 2022 10:50 am
rkhusky wrote: Tue Jan 25, 2022 9:46 am And have convinced themselves of that with some hand-waving arguments about the market mispricing risk.
You have it complete backwards, actually. The factors work when markets do NOT misprice risk, and informed factor investors know that the factors likely mean they are taking on MORE risk in exchange for the higher expected return. We're assuming the market isn't dumb, in other words.
I don't agree. The factor model only requires that there be some anomaly in the data. It doesn't matter why the anomaly is there. For example, if it was noticed that returns of stocks whose name starts with Q behaved differently than stocks whose name starts with Z, one could add the ZmQ (or QmZ) factor to the model. If the anomaly was persistent and favored one of the two, then a non-zero premium would result. If the anomaly was not persistent or fluctuated sufficiently between the two, then the premium would end up close to zero and probably removed from the model.
The model is what it is. What I objected to was your characterization of how "factor investors" interpret the model. Few are convinced of what you suggest, that the market is systematically mispricing risk. Instead, they are proceeding - for the most part -under a belief that the market is ACCURATELY pricing risk.
Yet a qualitative explanation of what the additional risk being taken when tilting towards a factor seems impossible to provide outside of the context of the model. I'm beating a dead horse here but how could the market accurately price SCV risk since the 70's yet not come up with a clear explanation of it in that time? The premium exists in the data, I don't doubt the rigor that lead FF to their conclusion, but I don't see how the market could collectively price this risk for decades but have little understanding of the economic fundamentals that produce it. I'd love to hear an explanation why ranking companies based on financial ratios then shorting the bottom and buying the top introduces an additional risk into the portfolio
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Re: Fama and French: The Five-Factor Model Revisited

Post by Nathan Drake »

km91 wrote: Tue Jan 25, 2022 12:40 pm
vineviz wrote: Tue Jan 25, 2022 12:22 pm
rkhusky wrote: Tue Jan 25, 2022 11:52 am
vineviz wrote: Tue Jan 25, 2022 10:50 am
rkhusky wrote: Tue Jan 25, 2022 9:46 am And have convinced themselves of that with some hand-waving arguments about the market mispricing risk.
You have it complete backwards, actually. The factors work when markets do NOT misprice risk, and informed factor investors know that the factors likely mean they are taking on MORE risk in exchange for the higher expected return. We're assuming the market isn't dumb, in other words.
I don't agree. The factor model only requires that there be some anomaly in the data. It doesn't matter why the anomaly is there. For example, if it was noticed that returns of stocks whose name starts with Q behaved differently than stocks whose name starts with Z, one could add the ZmQ (or QmZ) factor to the model. If the anomaly was persistent and favored one of the two, then a non-zero premium would result. If the anomaly was not persistent or fluctuated sufficiently between the two, then the premium would end up close to zero and probably removed from the model.
The model is what it is. What I objected to was your characterization of how "factor investors" interpret the model. Few are convinced of what you suggest, that the market is systematically mispricing risk. Instead, they are proceeding - for the most part -under a belief that the market is ACCURATELY pricing risk.
Yet a qualitative explanation of what the additional risk being taken when tilting towards a factor seems impossible to provide outside of the context of the model. I'm beating a dead horse here but how could the market accurately price SCV risk since the 70's yet not come up with a clear explanation of it in that time? The premium exists in the data, I don't doubt the rigor that lead FF to their conclusion, but I don't see how the market could collectively price this risk for decades but have little understanding of the economic fundamentals that produce it. I'd love to hear an explanation why ranking companies based on financial ratios then shorting the bottom and buying the top introduces an additional risk into the portfolio
Individual security analysis is nothing new. It takes into account things like industry/sector risks, management risks, earnings risks, etc.

By filtering on stocks with similar “Value” attributes you are selecting companies that the market is heavily discounting due to a wide variety of heightened perceived risks.

Why are you claiming that the market doesn’t have an understanding of these economic fundamentals? Just because it wasn’t employed at the macro level?
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Re: Fama and French: The Five-Factor Model Revisited

Post by vineviz »

km91 wrote: Tue Jan 25, 2022 12:40 pm Yet a qualitative explanation of what the additional risk being taken when tilting towards a factor seems impossible to provide outside of the context of the model.
IMHO, it only seems "impossible" to participants who wish there to be no explanation.

Both this thread and the finance literature are full of such explanations.
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Re: Fama and French: The Five-Factor Model Revisited

Post by km91 »

vineviz wrote: Tue Jan 25, 2022 1:00 pm
IMHO, it only seems "impossible" to participants who wish there to be no explanation.

Both this thread and the finance literature are full of such explanations.
I'm skeptical but there's no motivated reasoning going on here. In fact I would love for my skepticism to be proven wrong, now would be the perfect time to buy value since it's dirt cheap on a number of valuation metrics. Hand waving at the "finance literature" that requires a Phd in stats to parse is not a compelling explanation in my opinion. Over and over again the market has proven very smart people with very sophisticated models to be wrong. Add to the fact that the factors haven't performed well on the out of sample data leads me to believe there is a bit more model risk here than some would like to admit, so I try to approach the assumptions of the model from first principles. Maybe an explanation of the factors comes easier to those with a financial stake in them
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Re: Fama and French: The Five-Factor Model Revisited

Post by Nathan Drake »

km91 wrote: Tue Jan 25, 2022 1:33 pm
vineviz wrote: Tue Jan 25, 2022 1:00 pm
IMHO, it only seems "impossible" to participants who wish there to be no explanation.

Both this thread and the finance literature are full of such explanations.
I'm skeptical but there's no motivated reasoning going on here. In fact I would love for my skepticism to be proven wrong, now would be the perfect time to buy value since it's dirt cheap on a number of valuation metrics. Hand waving at the "finance literature" that requires a Phd in stats to parse is not a compelling explanation in my opinion. Over and over again the market has proven very smart people with very sophisticated models to be wrong. Add to the fact that the factors haven't performed well on the out of sample data leads me to believe there is a bit more model risk here than some would like to admit, so I try to approach the assumptions of the model from first principles. Maybe an explanation of the factors comes easier to those with a financial stake in them
Factors have performed well, out of sample
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Re: Fama and French: The Five-Factor Model Revisited

Post by Northern Flicker »

km91 wrote: Yet a qualitative explanation of what the additional risk being taken when tilting towards a factor seems impossible to provide outside of the context of the model. I'm beating a dead horse here but how could the market accurately price SCV risk since the 70's yet not come up with a clear explanation of it in that time...
The market does not try to price SCV. You have it backwards. The market prices stocks. You don't know which stocks are the value stocks until the market has priced them. You also don't know the market cap of a stock until you know its price.

The market prices risk by incorporating a risk premium into the discount rate used to discount future cash flows back to a present value. Factor models have increased our understanding of equity risk by providing a systematic framework for understanding risks beyond market risk instead of just lumping them into alpha under CAPM as a catch-all for risks other than market risk.

It really just boils down to whether you wish to take additional equity risks beyond market risk to try to boost the expected return of one's equity portfolio. It really is taking more risk. Periods of value underperformance are a testament to that. There is no imperative to do so.

Holding the market portfolio, and diversifying away all factors but the market factor and diversifying away all alpha is a very rational option. You diversify away all alpha. Factor-tilted portfolios have residual alpha. And there is no model risk-- the market portfolio gives you the market return. I do think that the robustness of factor models has been oversold. If you invest in a large market index fund implemented by full replication of the index, the sources of potential tracking error are miniscule to nil.

Here are a couple of quality-tilted portfolios to contemplate.

https://www.portfoliovisualizer.com/fac ... sion=false
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Re: Fama and French: The Five-Factor Model Revisited

Post by muffins14 »

I was a physicist, so I appreciate the yearning for understanding the root cause of things, or the underlying theory of why things are the way they are. Sometimes, we just aren't there yet -- Theory hasn't caught up with experimental evidence. The two go hand-in-hand over time. New anomalies are discovered, then we try to explain them with theory. Maybe the theory has new implications. People will test the new theory by collecting new data and some theories will still valid, while some must be ruled out with some confidence. Theories evolve. the cycle continues.

We could be at a point in finance/factor mmodels where it is difficult to describe from first principles what the unique risk of small-cap value stocks is that is unique to market risk, but we can measure the effect that risk has on returns. We know some things

it seems that SCV portfolios have higher negative skew than larger or growthier portfolios, and some people don't like that skew and want to avoid it
It seems that SCV is has higher returns than LCG in times when inflation is higher rather than lower
it seems that SCV companies pay more for their financing than growth companies
it seems that SCV companies are less "popular" than LCG companies, especially among retail investors


so there's some data -- come up with some hypotheses for why that is the case and what it means for you
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Re: Fama and French: The Five-Factor Model Revisited

Post by rkhusky »

vineviz wrote: Tue Jan 25, 2022 12:22 pm The model is what it is. What I objected to was your characterization of how "factor investors" interpret the model. Few are convinced of what you suggest, that the market is systematically mispricing risk. Instead, they are proceeding - for the most part -under a belief that the market is ACCURATELY pricing risk.
I question whether all (or even most) SCV investors are doing so under the belief that they are investing in a more risky asset. Many posters seem to think they are guaranteed to get a higher return, which, if true, means there is no additional risk. And that goes for any time period. If you are guaranteed to outpeform if you only wait long enough, then there is no additional risk. Many seem to think that higher risk automatically means higher return, when instead investors should demand higher return for taking higher risk. How are SCV investors demanding higher return for taking more risk?
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Re: Fama and French: The Five-Factor Model Revisited

Post by vineviz »

rkhusky wrote: Tue Jan 25, 2022 3:08 pm I question whether all (or even most) SCV investors are doing so under the belief that they are investing in a more risky asset. Many posters seem to think they are guaranteed to get a higher return, which, if true, means there is no additional risk.
I think everyone you'd consider a "factor proponent" in this thread has made it clear that this is NOT the way we see it. At what point will you consider that perhaps what you think we believe isn't what we actually believe?

Anyone who says they are using SCV stocks for diversification, for instance, MUST de facto believe that there is any additional systematic risk factor involved.
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Re: Fama and French: The Five-Factor Model Revisited

Post by imak »

For those looking to take a deep dive from first principles on CAPM, anomalies and rational/behavioral explanations of Fama-French factors, the Nobel prize committee's 2013 compilation article detailing the contributions of Fama, Hansen & Shiller is an excellent reference.

"Understanding Asset Prices"
https://faculty.fuqua.duke.edu/~rb7/bio ... _nobel.pdf
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Re: Fama and French: The Five-Factor Model Revisited

Post by Northern Flicker »

rkhusky wrote: Tue Jan 25, 2022 3:08 pm
vineviz wrote: Tue Jan 25, 2022 12:22 pm The model is what it is. What I objected to was your characterization of how "factor investors" interpret the model. Few are convinced of what you suggest, that the market is systematically mispricing risk. Instead, they are proceeding - for the most part -under a belief that the market is ACCURATELY pricing risk.
I question whether all (or even most) SCV investors are doing so under the belief that they are investing in a more risky asset. Many posters seem to think they are guaranteed to get a higher return, which, if true, means there is no additional risk. And that goes for any time period. If you are guaranteed to outpeform if you only wait long enough, then there is no additional risk. Many seem to think that higher risk automatically means higher return, when instead investors should demand higher return for taking higher risk. How are SCV investors demanding higher return for taking more risk?
You can demand a higher expected return for taking more risk with equities. You can only demand an actual higher return with fixed income instruments.
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Re: Fama and French: The Five-Factor Model Revisited

Post by km91 »

Northern Flicker wrote: Tue Jan 25, 2022 4:40 pm
You can only demand an actual higher return with fixed income instruments.
I work in credit, which explains why I find the factors compelling yet baffling. We need to explain every risk, how else could we set the price?
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