Date post: | 21-Jan-2018 |
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Is factor investing a bubble?
René M. Stulz
Agenda
• Present at the creation: A historical perspective
• Are there 447 factors? • Demand and supply for factor
exposures• Risks of factor investing for investors
and the economy• Is there a bubble?
Historical perspective
MIT, 1970s
• Merton develops the ICAPM.• Key insight: Investor welfare does not depend only
on wealth.• Example: Investors may be worse off if interest rate
is low – a bad state of the world. • Implication: Some investors want to hedge against
bad states of the world so that assets whose return is high in bad states of the world have higher expected returns.
Journal of Finance, 1992• Accepted for publication Fama/French,
The cross-section of expected returns.• 17,467 Google citations. • Size and Value explain cross-section
well; beta does not.• Long-short factor portfolios earn
premiums that are compensation for risk.
• Consistent with ICAPM.
Journal of Finance, 1994• Lakonishok, Shleifer, Vishny,
Contrarian investment, extrapolation, and risk
• Argue that factor premiums are not compensation for risk but instead reflect characteristics that investors value.
• Reflect behavioral biases.
Since then: All anomalies (red), unique and published (green)(Hou, Chen, Zhang)
0
50
100
150
200
250
300
350
400
450
500
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
Why so many?
• Good way to get into journals for academics. That’s how they get tenure and raises.
• Most don’t hold up if micro-caps are removed from sample (Hou, Chen, and Zhang).
• Most don’t hold up if one accounts for publication bias and weaken post-publication (Schwert, McLean and Pontiff, Hou, Chen, and Zhang).
• Still, there is a large number of anomalies that survive even then.
Rational or irrational?
• Not much progress in the rational/irrational debate.
• Most anomalies accounted for by recent models:
• Fama-French five-factor model; • Hou, Chen, and Zhang four-factor model.
• Explaining anomalies with anomalies?
Does it matter where premiums come from? • Investors who care less about a risk or a
characteristic than the market as a whole can make themselves better off by bearing more of that risk or holding more of that characteristic than the typical investor.
• It does not matter where the compensation comes from.
• Future premiums are the ones that matter for investors.
Factor premium persistence
• Widespread belief that rational premiums are more robust.
• Not clear because demand and supply affects all factor premiums.
• Good reason to believe that over time demand for stocks that earn higher expected returns increases and supply decreases, so that premiums fall.
Demand and supply of factor exposures
Factor premium
Quantity
Demand from investors
Supply by firms
P2
P1
Limits to demand for factor exposures• There are limits to the demand for factor
exposures:• May require short-sales, but ability to short-sell is
limited. • May require leverage. • May require positions in high transaction cost stocks. • Imposes loss of diversification. • Can have extended periods of poor returns.
Demand shifts
• Demand can shift to the right as limits to arbitrage decrease and hence decrease factor premiums:
• Increases in market liquidity.• Changes in the technology for short-selling. • ETFs.
• Demand can shift to the right or to the left as investors find a risk more or less costly or value a characteristic more or less.
• If academia does its job, demand should shift to the right. As more investors know about compensation for risk or characteristics, demand should shift.
Supply of factor exposures
• Corporations supply factor exposures, but supply can slow moving.
• If a corporation’s exposure to a factor leads to higher cost of capital, supply of factor exposure will fall.
• Example of size. If being small involves a higher cost of capital, it pays for firms to merge. We would see fewer small firms.
• Example of low book-to-market firms. These firms have low cost of equity, so they issue more equity.
• These changes affect the supply of factor exposures.
Fewer listings than in 1975
0
1000
2000
3000
4000
5000
6000
7000
8000
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
No.
of l
istin
gs
number of listings
Average market cap increased sharply in constant dollars
-
1,000,000.00
2,000,000.00
3,000,000.00
4,000,000.00
5,000,000.00
6,000,000.00
7,000,000.0019
7519
7619
7719
7819
7919
8019
8119
8219
8319
8419
8519
8619
8719
8819
8919
9019
9119
9219
9319
9419
9519
9619
9719
9819
9920
0020
0120
0220
0320
0420
0520
0620
0720
0820
0920
1020
1120
1220
1320
1420
15
Average firm marketcapitalization
Fraction of firms with low market cap (<$100 million in 2015 dollars)
0.000
0.100
0.200
0.300
0.400
0.500
0.600
0.700
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
Fraction of firms with lowmarket capitalization
Size effect
1963-2014: 0.58% (t=2.83)1963=1983: 1.16% (t=3.28)1983-2014: 0.21% (t=-0.84)
Source: Hou and van Dijk, Resurrecting the size effect, July 2017
The future
• As demand for factor exposures increases, factor premia must fall.
• Supply response from corporations: they will supply fewer exposures that increase their cost of equity.
• These mechanisms suggest lower factor premiums in the future.
• But: There are limitations to taking advantage of factor premiums: limits to short-sales, limited liquidity, taxes, and so on.
• Realized factor premiums are volatile, so that forecasting factor premiums is hard.
Risks of factor investing
• Fall in factor premium.– Stocks long the exposure increase in value– Short-run dislocation if investors run away from the stocks– Stocks short the exposure decrease in value. – Short-run dislocation if investors close positions quickly.
• Increase in factor premium.– Stocks long the exposure decrease in value.– Stocks short the exposure increase in value.– Whipsaw!
• There is a diversification cost.
Is it a bubble?
• Only in the identification of factors by academics.• In practice, it is a sound approach supported both by theory
and empirics.• Unfortunately, in the investing world, expected alpha is
inversely related to the number of smart asset managers trying to produce alpha.
• If there is too much enthusiasm for factors, there must be some good stock picking opportunities.
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