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This document discusses recent developments in equity factor research, specifically focusing on the work of Fama and French on risk factors. It summarizes their findings that much of the size and value premiums can be explained by the migration of stocks across size and value portfolios over time. For example, small cap stocks becoming large cap stocks through earnings growth. The document proposes that if a model could predict these migrations, it could capture the premiums associated with stocks moving across size and value categories through a long-short investment strategy.

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89 views2 pages

Writing Sample

This document discusses recent developments in equity factor research, specifically focusing on the work of Fama and French on risk factors. It summarizes their findings that much of the size and value premiums can be explained by the migration of stocks across size and value portfolios over time. For example, small cap stocks becoming large cap stocks through earnings growth. The document proposes that if a model could predict these migrations, it could capture the premiums associated with stocks moving across size and value categories through a long-short investment strategy.

Uploaded by

vchathlani
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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VINOD CHATHLANI

Ph: +1 201-687-7182 Email: vinod.chathlani.2012@anderson.ucla.edu

__________________________________________________________________________________ 30th-Apr-2012 Recent developments in Equity Strategy Continual evolution through challenging and improving existing models and theories is a hallmark of financial research and economics. The last 2 decades have revolutionized some of the bedrocks on which the financial economists of the mid 80s based their understanding of the investment world. Notable amongst these are the rise of multi factor models that challenged the notion of explaining average returns through a single factor, the CAPM Beta. The size and value effect (based on market cap and P/B ratios respectively), as first discussed by Fama and French in their revolutionary paper The cross section of Expected stock returns1 is a well-documented and widely accepted model of expected stock returns. This in fact spurred a whole new avenue of research in multi factor models leading to other notable ones like the Carhart four factor model. We now seem to be at a crucial turning point of multifactor model research where there is interest in further dissecting the risk factors to identify the main sources of premiums. Fama and French in their follow up paper on risk factors, Migration2 have found that much of the premium associated with size and value factors arises from stocks migrating across size and value portfolios over time. For instance, most of the size premium seems to arise from small cap stocks becoming big cap stocks on the bedrock of strong earnings growth. They also find 3 sources of the value premium: a) Migration of low P/B stocks to high P/B portfolios (value to neutral or growth) within the size category due to strong earnings growth or acquisition by a larger firm. b) Growth stocks moving to neutral or value c) Slightly higher returns on value stocks that do not migrate across categories.

Note: SG small growth, SN - Small neutral, SV =small value. BG to BV growth to value for big stocks Minus movement away from growth towards value, plus vice-versa, same- same value category as last year, dsize migration of size Source: Financial Analysts Journal, Vol. 63, No. 3 (May - Jun., 2007) 1: The Journal of finance. Vol XLVII No 2 June 1992 2. Financial Analysts Journal, Vol. 63, No. 3 (May - Jun., 2007)

The first panel shows the average returns of a portfolio for moves across the value and size spectrum. For instance, there is a decrease in returns for movements within the same size category away from growth towards value and an increase for an opposite move. Small stocks becoming big show a high increase in returns and vice versa for movement from big to small. The second panel shows the stickiness factor these are the percentage of portfolios in a any of the categories (SG to BV) that made a move to the respective bins (Minus to dsize) over a year. The rightmost panel shows the contribution of this phenomenon to overall portfolio returns. Assuming these findings are robust and statistically significant across time and events, this has the potential to create a new layer of analysis in investment decision making. If a model could be developed that used several fundamental factors and time series of prices/volume to predict the market cap or the P/B movements of a firm, much of the premium shown on the table above could be captured by accumulating small stocks (mcap < NYSE median) that have the highest potential to become large cap in the following year. A long short strategy that goes long on the stocks with high potential future returns and short on a portfolio of stocks with low potential future returns could be a an effective strategy to implement in the equity investing space.

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