..Welcome to Finance and Fury. In this episode we will be covering studies by some of the most famous financial economists, Eugene Fama and Kenneth French, F&F for short – two prolific economists who often collaborated and came up with many influential pieces that have shaped the investment world as we know it

  1. There are many famous studies that they have published – but today we will be looking at two – the first is the efficient market hypothesis and the other is the three-factor model
  2. These two are the focus of this episode as the findings of each actually seem to contradict each other – One states that you cannot outperform the market – the other states that you can if you focus on certain factors – So what is right?
    1. This is where we need to do a deep dive into the theory and look at if it is possible to outperform the index or not – based around practical results and what has actually happened

To start with – lets cover the efficient-market hypothesis (EMH) – many of you may be aware of this

  1. is a hypothesis in financial economics that states that asset prices reflect all available information
    1. This means that if all information is priced into assets then the current price it is trading at is the correct price based around market demand – there can be no active decisions made to say, buy an undervalued company
      1. so the fact that a company is not performing well in terms of cashflow means that it should be trading at a lower market value – and a company that the information shows is doing really well should out perform
      2. A direct implication is that it is impossible to beat the market consistently on a risk-adjusted basis – this is because the market prices should only react to new information – as all current inflation is priced into the market
    2. On top of this – it is nearly impossible to predict market prices of an asset in the short term – The idea that financial market returns are difficult to predict goes back before Fama and French – the first written account can be attributed to Bachelier in 1900, then another economics called Mandelbrot in 1963 – Fama however was the one who popularised this due to the influence his 1970 review of the theoretical and empirical research due to it being widely published
      1. The EMH provides the basic logic for modern risk-based theories of asset prices – Suppose that a piece of information about the value of a share (say, about a future merger or a buyout) is widely available to investors. If the price of the stock does not already reflect that information, then investors can trade on it, thereby moving the price until the information is no longer useful for trading.
    3. How efficient markets are (and are not) linked to what is known as the random walk theory – can be described through the fundamental theorem of asset pricing.
      1. Random walk theory suggests that changes in share prices have the same distribution and are independent of each other – having the same distribution essentially means that on average, buying one share compared to the next means that your probability of returns are the same at an absolute level – due to the extreme level of possibilities –
        1. Therefore, it assumes the past movement or trends of a share prices cannot be used to predict its future movement. In short, random walk theory proclaims that shares take a random and unpredictable path that makes all methods of predicting stock prices futile in the long run.
      2. This theorem provides mathematical predictions regarding the price of a share, assuming that there is no arbitrage, that is, assuming that there is no risk-free way to trade profitably – this is why index funds have taken over
      3. Where did this evidence come from – well studies of course –
        1. Research by Alfred Cowles in the 1930s and 1940s suggested that professional investors were in general unable to outperform the market – During the 1930s-1950s empirical studies focused on time-series properties
          1. found that US share prices and related financial series followed a random walk model in the short-term – however there is some predictability over the long-term
        2. Now in theory this is all well and good – there are different forms as well – based around who has the information and when it is priced in – I won’t go too deeply into the theory
          1. But lets assume that this is true – you cannot outperform the market as the prices on the market are correct and you cannot profit from making an active decision
            1. Since these studies were conducted 50 years ago – many and researchers have disputed the efficient-market hypothesis – because there have been people who have outperformed markets over longer periods of time – not always, but more than not – because markets don’t always act rationally – due to the behaviours of the investors on the market
            2. Behavioural economists attribute the imperfections in financial markets to a combination of cognitive biases such as overconfidence, overreaction, representative bias, information bias, and various other predictable human errors in reasoning and information processing. These have been researched by psychologists such as Daniel Kahneman, Amos Tversky and economist Richard Thaler
  • Thaler’s book misbehaving is great – Kahneman’s thinking fast and slow is also really good –
  1. Empirical evidence has been mixed – but as computing power has increased, it has generally not supported EMH

This brings up the more recent works by F&F – a paper written in 1992 – “The cross-section of expected stock returns”, which demonstrated that investors could outperform the market by taking advantage of certain factors

  1. What Is the Fama and French Three Factor Model? – an asset pricing model developed in 1992 that expands on the capital asset pricing model (CAPM) through adding two additional factors – that of size risk and value risk
    1. CAPM aims to measure the expected return of an asset by taking the risk of an asset and comparing this to a risk free asset – but it doesn’t account for the market cap or fundamentals of a company
    2. The updated model considers the fact that value and small-cap shares outperform markets on a regular basis – so including these two additional factors, the model adjusts for this outperforming tendency, which is thought to make it a better tool for evaluating manager performance.
      1. small-cap shares tend to outperform large-cap shares – which make up the majority of an indexes allocation as a percentage
    3. So in total – the three factors used to look at outperformance were – small minus big (SMB), high minus low (HML), and the portfolio’s return less the risk-free rate of return (which is CAPM)
      1. SMB accounts for publicly traded companies with small market caps that generate higher returns, while HML accounts for value share based around a high book-to-market ratio that generated higher returns in comparison to the market.
    4. There is a lot of debate about whether the outperformance tendency is due to market efficiency or market inefficiency
      1. In support of market efficiency – This is the EMH side of the argument – the outperformance is generally explained by the excess risk that value/small-cap shares face – so if you look at a risk adjusted return – this essentially means that you are paying for your additional returns through the risk of additional volatility – many small cap companies face business risk as well – so there is the potential for large losses in the space within the market – but there is also larger upsides
      2. In support of market inefficiency – the outperformance is explained by market participants incorrectly pricing the value of these companies – therefore they can provide excess returns in the long run as the value adjusts and they become a known known – This argument is along the lines of a diamond in the ruff – when it comes to information about companies – lets look at a large and small/microcap example –
        1. where you can have a company like CBA – the earnings are relatively easy to forecast based around their market share, profit on loans and expected capital outlays – these short of large cap companies often do trade around their fair values
        2. But for small cap company – there aren’t many analysis unlike there are covering CBA – there isn’t a lot of public information about these companies – and many often go overlooked until they start to become more dominant market share participants – this is where the theory of outperformance comes from – however this is not without its risks – as these sort of companies can lose far more than a CBA – in terms of absolute loss – This is where a diverse portfolio of shares in the mid/small cap is better than just trying to pick one
      3. To get long term outperformance – Fama and French highlighted that investors must be able to ride out the extra volatility and periodic underperformance that could occur in a short time through these sort of investments
        1. Investors with a long-term time horizon of 15 years or more will be rewarded for losses suffered in the short term – we have just gone through a 3 year period where growth and not value companies have dominated, but over the past 12 months the tables have turned
        2. When researching this – F&F used thousands of random share portfolios to test their model and found that when size and value factors are combined with the beta factor in the CAPM model, they could then explain as much as 95% of the return in a diversified stock portfolio – i.e. the returns of 95% of this can be attributed directly to the value and small cap factors


So these two studies by the same men contradict one another, one says that it is impossible to outperform the market, the other states that it is possible. If you find value companies that are of good value and hold these over the long term.

  1. The Fama and French Three Factor model highlighted that investors must be able to ride out the extra volatility and periodic underperformance that could occur in the short term. Investors with a long-term time horizon of 15 years or more will be rewarded for losses suffered in the short term.
  2. The main factors driving expected returns are sensitivity to the market, sensitivity to size, and sensitivity to value shares, as measured by the book-to-market ratio.
  3. So there does seem to be a way to outperform the market on a long term basis – but it does come with risks – and a lot of work –
  4. The option to avoid this is to look for certain factor investment allocations – many fund managers, ETFs provide this service – of looking at certain sectors of markets

– but it is up to you to make your own decisions

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