Multifactor Models and Market Efficiency

(BKM 11, 12, 13)

BUFN 740: Capital Markets
Topic 4
BUFN 740: Capital Markets Topic 4 1
Multifactor Asset Pricing Models
CAPM is a model that can be used to (1) explain why certain firms
have certain returns; and (2) estimate expected return (discount
rate). But it does not work.

The empirical failure of CAPM leaves room for improvement

Maybe we should not use the market portfolio return as the only
systematic factor
The market portfolio might not be representative
2 BUFN 740: Capital Markets Topic 4
Multifactor Asset Pricing Models (Cont.)
Some potential choices

Add a bunch of macro economic variables, e.g., change of
industrial production, change in interest rates, as factors since
they are by definition systematic risk that cannot be diversified
away

Or just regard those pervasive anomalies as additional factors
3 BUFN 740: Capital Markets Topic 4
Fama and French (1993): Three Factor Model
The factors in the Fama and French (1993, JFE) three-factor
model:
MKT(t): The return on the market (value-weighted) in excess
of the T-bill rate
SMB(t) (Small minus Big): The return on small-cap stocks
(bottom 50%) minus the return on large-cap stocks (top 50%)
HML(t) (High minus Low): The returns on high book-to-
market stocks (top 30%) minus those on low book-to-market
stocks (bottom 30%)


i f i i i i i
i f i i i i
r r a b MKT s SMB h HML e
E r r a b E MKT s E SMB h E HML


4 BUFN 740: Capital Markets Topic 4
The Value Premium
Growth stock: High market value relative to accounting
measures of value
Growth: high stock price reflects capitalized growth
opportunities
Value stock: Low market value relative to accounting measures
Value: physical assets-in-place can be acquired at low prices
Value stocks earn higher returns than growth stocks on average
(e.g., Fama and French 1992, 1993), the difference is called the
value premium
The value premium reliable around the globe: Fama and French
(1998)
5 BUFN 740: Capital Markets Topic 4
Lakonishok, Shleifer, and Vishny (1994): Behavioral
Overreaction
Fama and French (1992) believe that the value premium exists
because value firms are more risky, probably reflecting distress
risk
Lakonishok, Shleifer, and Vishny (1994): Not a risk story, but
due to behavioral overreaction
Growth stocks are priced too high because they are
glamorous
Value stocks are priced too low because they are out of favor
Naive investors extrapolate past performance too far into the
future
Value strategies bet against naive investors, outperform the
market
6 BUFN 740: Capital Markets Topic 4
Momentum: A Fourth Factor
The original Fama-French model augmented with a momentum
factor has become a common four-factor model used to evaluate
abnormal performance of a stock portfolio.


Momentum may be related to liquidity.

7 BUFN 740: Capital Markets Topic 4
Efficient Market Hypothesis (EMH)
Do security prices reflect information ?
EMH and Competition
Stock prices fully and accurately reflect publicly available
information.
Once information becomes available, market participants
analyze it.
Competition assures prices reflect information.
Why look at market efficiency?
Implications for business and corporate finance
Implications for investment


8 BUFN 740: Capital Markets Topic 4
Figure 11.1 Cumulative Abnormal Returns Before Takeover
Attempts: Target Companies
9 BUFN 740: Capital Markets Topic 4
Figure 11.2 Stock Price Reaction to CNBC Reports
10 BUFN 740: Capital Markets Topic 4
Efficient Market Hypothesis
Forms of the EMH
Weak
Semi-strong
Strong
Types of stock analysis
Technical Analysis - using prices and volume information to
predict future prices.
Weak form efficiency & technical analysis
Fundamental Analysis - using economic and accounting
information to predict stock prices.
Semi strong form efficiency & fundamental analysis

11 BUFN 740: Capital Markets Topic 4
Active or Passive Management
Active Management: against EMH
Security analysis
Timing
Passive Management: consistent with EMH
Buy and Hold
Index Funds
Even if the market is efficient a role exists for portfolio
management:
Appropriate risk level
Tax considerations
Other considerations such as investment horizon

12 BUFN 740: Capital Markets Topic 4
Empirical Tests of Market Efficiency
Event studies

Assessing performance of professional managers

Testing some trading rule

How to test?
Examine prices and returns over time

13 BUFN 740: Capital Markets Topic 4
Return Over Time
0 +t -t
Announcement Date
14 BUFN 740: Capital Markets Topic 4
How Tests Are Structured
Returns are adjusted to determine if they are abnormal.
Market Model approach
a. R
t
= a
t
+ b
t
R
mt
+ e
t

(Expected Return)

b. Excess Return =
(Actual - Expected)
e
t
= Actual - (a
t
+ b
t
R
mt
)
Or use Fama-French three factors
15 BUFN 740: Capital Markets Topic 4
How Tests Are Structured (contd)
Returns are adjusted to determine if they are abnormal.
Market Model approach
c. Cumulate the excess returns over time:



-t
0 +t
16 BUFN 740: Capital Markets Topic 4
Weak-Form Tests
Serial Correlation

Momentum

Returns over Long Horizons: reversal

Interpretations:
First overreaction and the correction







17 BUFN 740: Capital Markets Topic 4
Cumulative Return Relative to Losers
18 BUFN 740: Capital Markets Topic 4
Time Series Predictability
The tests of MEH come down to two questions: (1) Can we
predict security returns? (2) If we can, why?
Time series predictability
Higher dividend ratios or earnings-price ratios predict higher
returns in the future
The rational (EM) interpretation
The irrational (behavioral) interpretation
Credit spreads can predict market returns
Again two interpretations

Time series predictability is difficult: Many investors avoid
macro bets

BUFN 740: Capital Markets Topic 4 19
Cross-sectional Predictability: Anomalies
The value effect: firms with higher dividend-price ratios, book-
to-market ratios, earnings-to-price ratios, or lower past long-
term returns earn higher future returns
Size effect
Momentum effect
Post-earnings announcement drift
Investment effect: firms with higher asset growth, investment,
accrual, or net (total) new issues of equity earn lower returns
Distress risk effect
Cross-sectional predictability is easier than time-series


20 BUFN 740: Capital Markets Topic 4
Figure 11.3 Average Annual Return for 10 Size-Based
Portfolios, 1926 2008
21 BUFN 740: Capital Markets Topic 4
Figure 11.4 Average Return as a Function of Book-To-
Market Ratio, 19262008
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Figure 11.5 Cumulative Abnormal Returns in
Response to Earnings Announcements
23 BUFN 740: Capital Markets Topic 4
Interpreting the Evidence
Risk Premiums or Inefficiencies
Disagreement here

Data Mining or Anomalies

Behavioral Explanations
Information Processing Errors
Behavioral Biases
Limits to Arbitrage

24 BUFN 740: Capital Markets Topic 4
Information Processing
Forecasting Errors
Memory bias: This time is different!

Overconfidence
Trading is hazardous to your health!

Conservatism
Post earnings announcement drift

Sample Neglect and Representativeness
Earnings extrapolation

25 BUFN 740: Capital Markets Topic 4
Behavioral Biases
Framing
You have been given 10,000. Now choose between
A={10,000, 0.5} and B={5,000, 1}.
You have been given 20,000. Now choose between C={-
10,000, 0.5} and D={-5,000, 1}.

Mental Accounting
House money effect and not dip into capital

Regret Avoidance
Herding behavior of institutional investors

26 BUFN 740: Capital Markets Topic 4
Prospect Theory
People are risk averse over gains, but risk-seeking over loses.
Sell winners too soon but hold on losers for too long
BUFN 740: Capital Markets Topic 4 27
Limits to Arbitrage
Fundamental Risk
Royal Dutch Petroleum and Shell
LTCM

Implementation Costs

Model Risk
Am I stupid or the market is stupid?

28 BUFN 740: Capital Markets Topic 4
Technical Analysis
Dow theory: primary (long-term) trend, secondary (intermediate)
trend, and tertiary (minor) trend
BUFN 740: Capital Markets Topic 4 29
Technical Analysis
Moving average: break point when price crosses the moving
average

BUFN 740: Capital Markets Topic 4 30
Technical Analysis
Breadth: compare the number of advances with the number of
declines
BUFN 740: Capital Markets Topic 4 31
Technical Analysis
Volume declining/Number declining
Volume advancing/Number advancing

Trin statistic: information in addition to breadth

Trin is the ratio of average volume in declining issues to average
volume in advancing issues.

Ratios above 1 are considered bearish.


BUFN 740: Capital Markets Topic 4 32
Technical Analysis
Consumer sentiment index: The ratio of the average yield on 10 top-rated
corporate bonds divided by the average yield on 10 intermediate-grade
corporate bonds.
Should you buy or sell when the sentiment is high?
BUFN 740: Capital Markets Topic 4 33
Sentiment Indicators: Put/Call Ratio
Calls are the right to buy.
A way to bet on rising prices

Puts are the right to sell.
A way to bet on falling prices



A rising ratio may signal investor pessimism and a coming
market decline.

Contrarian investors see a rising ratio as a buying
opportunity!

BUFN 740: Capital Markets Topic 4 34
Stock Market Analysts
Some analysts may add value, but:

Difficult to separate effects of new information
from changes in investor demand

Findings may lead to investing strategies that are
too expensive to exploit
35 BUFN 740: Capital Markets Topic 4
Mutual Fund Performance
The conventional performance benchmark today is a four-factor
model, which employs:

the three Fama-French factors (the return on the market
index, and returns to portfolios based on size and book-to-
market ratio)

plus a momentum factor (a portfolio constructed based on
prior-year stock return).
36 BUFN 740: Capital Markets Topic 4
Figure 11.7 Estimates of Individual Mutual Fund
Alphas, 1993 - 2007
37 BUFN 740: Capital Markets Topic 4
Table 11.1 Performance of Mutual Funds Based on
Three-Index Model
38 BUFN 740: Capital Markets Topic 4
Consistency, the hot hands phenomenon

Carhart weak evidence of persistency

Bollen and Busse support for performance persistence
over short time horizons

Berk and Green skilled managers will attract new funds
until the costs of managing those extra funds drive alphas
down to zero.
Mutual Fund Performance
39 BUFN 740: Capital Markets Topic 4
Figure 11.8 Risk-adjusted Performance in Ranking
Quarter and Following Quarter
40 BUFN 740: Capital Markets Topic 4
So, Are Markets Efficient?
The performance of professional managers is broadly consistent
with market efficiency.

Most managers do not do better than the passive strategy.

There are, however, some notable superstars:
Peter Lynch, Warren Buffett, John Templeton, George Soros
41 BUFN 740: Capital Markets Topic 4