Improving Established Multi-factor Stock-picking Models Is Hard
November 3, 2014 - Big Ideas
Is more clearly better in terms of number of factors included in a stock screening strategy? In the October 2014 draft of their paper entitled “Incremental Variables and the Investment Opportunity Set”, Eugene Fama and Kenneth French investigate the effects of adding to an established multi-factor model of stock returns an additional factor that by itself has power to predict stock returns. They focus on size, book-to-market ratio (B/M, measured with lagged book value), and momentum (cumulative return from 12 months ago to one month ago, with a skip-month to avoid systematic reversal). They consider a broad sample of U.S. stocks and three subsamples: microcaps (below the 20th percentile of NYSE market capitalizations); small stocks (20th to 50th percentiles); and, big stocks (above the 50th percentile). They perform factor-return regressions, and they translate regression results into portfolio returns by: (1) ranking stocks into fifths (quintiles) based on full-sample average regression-predicted returns; and, (2) measuring gross average returns from hedge portfolios that are long (short) the equally weighted quintile with the highest (lowest) expected returns. Finally, they perform statistical tests to determine whether whether the maximum Sharpe ratio for quintile portfolios constructed from three-factor regressions is realistically higher than those for two-factor regressions. Using monthly excess returns (relative to the one-month Treasury bill yield) for a broad sample of U.S. stocks during January 1927 through December 2013, they find that: Keep Reading