PMC Market Commentary: May 30, 2014
Over the past couple of decades there has been a significant amount of academic and industry research focused on identifying the primary drivers, or factors, determining equity price movements. Professors Eugene Fama and Kenneth French built on earlier research by others in setting forth their famous three-factor model of stock prices in 1993. Fama and French identified three factors – exposures to the market, size (small caps) and value – as being three key drivers that provide anomalous excess returns over time. The size factor holds that in general, smaller cap stocks outperform large cap issues. The value factor thesis is that stocks that exhibit more favorable valuations – such as those having higher Book Value/Price ratios – tend to outperform stocks that are perceived to be more richly valued.
The Fama-French findings have since spurred additional research attempting to better understand factors resulting in superior excess returns. Mark Carhart introduced the momentum factor in 1997. He showed that stocks that have performed well over the past tend to continue to perform well for a period of time. Specifically, he looked at performance over the past 12 months as being an indicator of performance over the next month. Along with value, momentum has been shown to be pervasive in most asset classes. The momentum factor is often included with the original Fama-French factors in a “four-factor model.”
Other market premia that researchers have identified include liquidity (i.e., stocks with lower liquidity outperform more highly liquid names); quality (i.e., higher quality outperforms lower quality); and defensive (i.e., lower beta stocks outperform higher beta names).
Various theories have been posited as to why these asset pricing anomalies are experienced. Since the efficient market hypothesis holds that all information is contained in stock prices, and that no such premia are exploitable, academics have suggested that behavioral issues are the likely explanation.
A significant implication of this research is that exposure to these factors is increasingly being made available in a portfolio context. Investment managers are able to construct portfolios that have “tilts” toward one or more of these factors in an effort to outperform the benchmark. In the mutual fund world, Dimensional Fund Advisors (DFA) and AQR Capital Management have been at the forefront of the research and implementation of such strategies. In terms of separate accounts, PMC will be building upon its recent introduction of Quantitative Portfolios by introducing factor-tilted versions of the QPs. Finally, there are also several factor-tilted indices with associated exchange-traded funds (ETFs).
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