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What Fama and Frenchs Latest Research Doesnt Tell Us

By Michael Edesess June 14, 2011 With the high name recognition and respect that the team of Eugene Fama and Kenneth French en oys in the !orld of finance, anything they pu"lish !arrants attention# $heir latest offering, %i&e, 'alue, and Momentum in (nternational %toc) *eturns, offers some interesting data on glo"al e+uity performance# But they fail to offer any insights that e,plain the reasons "ehind their findings# $he duo of Fama and French is most famous for their 1--2 and 1--. papers documenting strong historical /alue and si&e effects# 0Fama is also famous 1 or infamous, depending on your perspecti/e 1 for his association !ith the efficient mar)et hypothesis#2 $he core o"ser/ation of Fama and French3s seminal papers !as that the returns on small4company and /alue stoc)s 1 those !ith high "oo)4to4mar)et /alue ratios 1 ha/e historically outperformed the mar)et to a greater degree than can "e e,plained "y the capital asset pricing model 0567M2# (3ll go into this and their ne! findings in more detail a little later# First, (3ll offer a primer on their methodology# $hen (3ll descri"e ho! they constructed their study, and the results they o"tained# Finally, (3ll put on my curmudgeon hat and tell you !hat ( thin) is !rong !ith the !hole thing# Regression Fama and French3s latest paper is an e,ercise in running regressions# Most readers of Advisor Perspectives !ill "e familiar !ith the term regression and to a degree !ith the method, "ut it3s !orth a +uic) re/ie! to ensure that !e all ha/e the "asic tools to assess their !or)# *egression analysis is the most used mathematical modeling techni+ue in all of social science, finance included 1 and the most o/erused# *egression is usually e,plained to students in a"out the second year of high school 1 at least it !as in my high school# $here, it !as called least4s+uares fit#

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9ou ha/e data points that graph something li)e this:

9ou try dra!ing a straight line through them and measure its distance from each point, li)e this:

With a little math, you can find the line that minimi&es the sum of the s+uares of those distances# $his gi/es you the least-squares fit:

$his e,ercise is also called ;running a regression#< $he line is called the regression line 1 it represents an inferred underlying linear dependency of the /ertical4a,is /aria"le upon the hori&ontal4a,is /aria"le# 9ou could /isuali&e these points in three dimensions instead, !ith a plane dra!n through them using the same method# $hen the plane !ould e,press a dependence of one of the /aria"les on the other t!o# $he same thing can "e done in higher dimensions !ith more /aria"les, "ut you can3t /isuali&e it#

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$he method gets dicier if the underlying dependency isn3t linear# For e,ample a graph of the gro!th of an asset at compound interest o/er time loo)s li)e this:

="/iously, the line on the right isn3t a good fit to the points on the left# %ince this is !ell )no!n, time4series regressions for asset gro!th generally modify the asset /alues "y ta)ing their logarithms# But if you get the underlying relationship !rong 1 if there e/en is one 1 you can get !ac)y results# Fortunately, statistics deri/ed from the sum of the s+uared distances tell you !hether your fit is good or not# $hey do not, ho!e/er, tell you !hy# The 1992-1993 Fama-French studies $he 567M says that a portion of a stoc)3s return is a linear function of the return on the !hole mar)et 1 specifically, the stoc)3s "eta times the mar)et return# >ence, part of the stoc)3s /aria"ility is due to its correlation !ith the mar)et# $he ;systematic< ris) of this mar)et4related portion is compensated !ith an e,pected return# $he remainder of the stoc)3s return /aria"ility is ;idiosyncratic#< $he ris) of this residual non4mar)et4correlated /aria"ility is not re!arded, "ecause in theory it can "e eliminated through di/ersification# >o!e/er, the classic Fama4French study found e/idence of return /aria"ility in /alue stoc)s and small stoc)s that !as not correlated !ith the mar)et, "ut !as ne/ertheless richly re!arded o/er a long period# $hey posited that stoc) returns should depend on these t!o ne! fundamental factors as !ell as "eta# When they added ;smallness< and ;/alue4ness< to ;mar)etness< as stoc) characteristics, they got a "etter regression line fit# $his introduced the idea that you should regress a portfolio3s returns against three /aria"les: the !hole mar)et, the small stoc) mar)et portfolio, and the /alue stoc) portfolio, to see ho! much of its performance is ;e,plained< "y its statistical dependency on each of these factors#

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(t should "e noted that Fama and French ended "oth papers !ith similar ca/eats, saying in the 1--2 paper that their results ;are not economically satisfying< and as)ing, ;What is the economic e,planation for the roles of si&e and "oo)4to4mar)et e+uity in a/erage returns?< The 2011 paper Fama and French3s 2011 paper, rather disappointingly, does not attempt to e,plain !hy the returns of any stoc) should depend on its degree of ;smallness< and@or ;/alue4ness#< (nstead, it is a continuation of the e,ercise of running data regressions# Fama and French ha/e access to plenty of data# $hey use monthly returns data for 2. countries from Ao/em"er 1--0 to January 2011, grouping the country data into four ma or regions 1 Aorth 6merica, Japan, 6sia 7acific, and Europe 1 and aggregating it to form a glo"al region# $hey ha/e company si&e and "oo)4to4mar)et /alue ratios for all the stoc)s in their data"ase too, allo!ing them to di/ide the stoc)s for each region into si&e and /alue@gro!th categories# >a/ing di/ided the stoc)s into /alue and si&e categories for each region, they construct monthly returns series intended to represent the ;si&e< and ;/alue< components of regional returns# $his construction in/ol/es a series of rather ar"itrary operations# Bi)e the regressions in their 1--2 and 1--. papers, these are, say Fama and French, ;e,amples of empirical asset4pricing modelsC that is, they try to capture the cross4section of e,pected returns !ithout specifying the underlying economic model that go/erns asset pricing#< (n other !ords, it3s an e,ercise in running regressions, not in e,plaining their results# i!e"#alue returns =ne of the o" ecti/es of this paper is to see ho! si&e@/alue characteristics affect stoc) returns !ithin each region, and another is to see ho! much each region3s returns can "e related to global si&e@/alue returns# $o e,plore this +uestion, Fama and French constructed 2D stoc) portfolios in each region, and regressed them against the three factors: mar)et returns, /alue stoc) returns, and small stoc) returns# (f the resulting regression line passes through 0or near2 the origin of the graph, that means the three factors e,plain all of the returns, !ith no residual# (n Fama and French3s language, ;(f !e find a set of e,planatory portfolios that spans the M' Emean4 /arianceF tangency portfolio, !e capture the cross4section of e,pected returns, !hate/er the underlying model generating asset prices#< Aote the final clause# $he result !as that the intercept got pretty close to &ero for each region 0though not at a high le/el of statistical significance2, especially if you left out microcaps# Microcaps e,hi"ited an e,aggerated /alue effect 1 their returns increased su"stantially !ith /alue4 ness e/en after the /alue factor and other factors common to all stoc)s had "een remo/ed# Fama and French did not find as good a fit !hen they regressed regional returns
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against glo"al mar)et, si&e and /alue factors 1 a result they interpret as meaning that the regional mar)ets are not glo"ally integrated# The momentum e$$ect Fama and French added to this paper a factor that does not appear in their earlier papers: the momentum factor# $hey made this addition "ecause of the relati/ely recent o"ser/ation that stoc)s ha/e tended to perform "etter in the su"se+uent month or year if their pre/ious year3s return outperformed the mar)et# Fama and French e/idently thin) their !or) on the momentum factor is important, "ecause in the !or)ing paper /ersion ( do!nloaded they included a comment appealing to professional readers of the draft /ersion: ;GGG$his is important# (s there a !ay to gi/e it more emphasis?< Fama and French3s data e,hi"it the momentum effect, as ha/e other studies, e,cept in Japan# 6dding momentum as a fourth factor creates a "etter fit to returns, in some regions# The %ottom line $he study3s upshot, ultimately, is something of a dog3s "rea)fast of conclusions and non4 conclusions# ( in/ite anyone !ith enough interest in this topic to ha/e read this far to /ie! the complete set in the %ummary and 5onclusions section on pages 2142. of Fama and French3s paper itself# 7erhaps most nota"le 1 not!ithstanding the e,tra4strength microcap /alue effect already mentioned 1 is a tendency they identify for "oth the /alue and momentum effects to e,hi"it themsel/es most strongly in smaller stoc)s, and least strongly in large stoc)s 0!ith e,ceptions for Japan2# $his is perhaps not surprising, since larger stoc)s are su" ected to more mar)et scrutiny and analysis# Whats &rong &ith all o$ this' Bong4li/ed phenomena are often the "y4product of a single accidental moment in history# %ocial studies "egan in a"out 1-DH to call themsel/es ;sciences< and to assume an e,aggerated posture of math4"ased o" ecti/ity in order to lump themsel/es !ith science# 6t the time, the %o/iet Inion3s %putni) launch had ust siphoned all research funding to the physical sciences to ena"le the I#%# to catch up in space# (n Fama and French3s paper, their posture of o" ecti/ity e/en e,tends to not trying to interpret or e,plain their results# =ne reason, of course, could "e that they can3t e,plain them# 6nother is that any e,planation !ould "e sheer speculation, and therefore doesn3t "elong in a scientific paper# $hat too, is another !ay of saying they don3t ha/e a good e,planation#

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$here3s nothing !rong !ith presenting results !ithout e,plaining them, and lea/ing it to others to try to e,plain them# $hat3s the idea of seminal researchC if your findings pro/o)e discussion and get others to interpret them, e/entually leading to a ne! and impro/ed theory, that3s great# *egression formulas alone, ho!e/er 1 e/en if they fit the data !ell 1 are not a theory# $hey are merely here patterns percei/ed in data, "arren of e,planation 1 and possi"ly accidents of randomness# Infortunately, the results of these regressions are "eing treated as if they !ere a theory in and of themsel/es# Without theory, regressions ha/e no lasting or practical implications# Without an e,planation of those results, there is no reason to apply results mined from historical data to predict the future, or e/en to e/aluate historical performance that relies on ma)ing accurate predictions# %ome people, reali&ing that the historical outperformance of /alue stoc)s is not enough to sell the future performance of a /alue stoc) in/estment approach, ha/e tried to concoct ersat& theories to e,plain itC hence, for e,ample, the ;fundamental inde,ing< approach to /alue in/esting# %o far, there are only t!o potentially /ia"le e,planations for the /alue effect# =ne is the "eha/ioral finance e,planation 1 the ;anchoring< or the ;a/aila"ility< heuristic, for e,ample# 6ll you )no! is that it3s a lousy stoc) "ecause it3s got a lo! price, so you predict it !ill "e a lousy stoc) and don3t "uy it 1 )eeping its price lo! e/en though its future rise !ill "e as good as or "etter than that of a gro!th stoc)# $he other e,planation is that small and /alue stoc)s carry ris)s that aren3t captured "y the usual ris) models# But if that is the case, !hy apply "and4aids to the models "y adding small and /alue factors? >o! enlightening is that? (f something is missing from our ris) models 1 and there is 1 that !on3t fi, it# ()hi%it *+ Fama and Frenchs handling o$ the momentum e$$ect (n fact, ( thin) this is an e,ample of !hat Ja/id 5olander et al# mean in their article in the "oo) ;What 5aused the Financial 5risis< 0re/ie!ed in my Advisor Perspectives article of May 242, in !hich they spea) of a ;systemic failure of the economics profession< 0emphasis in original2# 5olander et al# fault academic economic models "ecause they ;fail to account for the actual e/olution of the real4!orld economy< and largely cro!ded out research on the inherent causes of financial crises# Joes this really apply to Fama and French3s paper? 9es, ( thin) it does# Bet3s ta)e their handling, for e,ample, of the so4called momentum effect# $he momentum effect has "een documented o/er short time periods, "ut ;re/ersion to the mean< 1 the opposite of the momentum effect 1 has "een o"ser/ed# (n fact, it must "e o"ser/ed o/er longer periods if there is a momentum effect o/er short periods#
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$he momentum effect says that !hat goes up !ill )eep going up# *e/ersion to the mean says !hat goes up !ill come do!n# $hat means that over some short period momentum !ill not continue "ut !ill re/erse# ="ser/ation of financial crises suggests that momentum is gradual and long4li/ed, "ut re/ersal is sharp and sudden# 9ou !on3t get good long4run performance "y relying on momentum# Where, you may !onder, do Fama and French suggest anything a"out the ine/ita"le long4 term failure of momentum in their paper? $hey merely !oodenly note the momentum effect is discerna"le through the !ea) lens of linear regression 1 in fact a relati/ely unsophisticated methodology, in spite of all the "a""le a"out sophistication in the financial industry# (n my /ie!, the Fama4French paper represents little more than a continuation of the economics profession3s ;systemic failure#<

Michael Edesess is an accomplished mathematician and economist with experience in the investment, energy, environment, and sustainable development fields. e is a !isiting "ellow at the ong #ong Advanced $nstitute for %ross-&isciplinary 'tudies, as well as a partner and chief investment officer of &enver-based "air Advisors. $n ())*, he authored a boo+ about the investment services industry titled ,he -ig $nvestment .ie, published by -errett-#oehler.

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