When to send an investing model into retirement

For a model to retain currency it must include new, emerging risk factors

Here’s a maxim for life as a famous economist: If your theory wins a Nobel Prize, look out — it might already be running into big problems. When the Black-Scholes-Merton option-pricing model won the prize in 1997, it had already required some major tweaks to fit new data; a decade later, it was being blamed for the financial crisis. By the time the real business cycle theory won in 2004, economists were already showing why it wasn’t a good explanation of recessions.

In 2013, Eugene Fama won the Nobel for his work on the efficient markets theory. Should he be worried?

Efficient markets theory says that the only way to earn higher returns than the market average is by taking on more risk. Without a model of risk, the notion of efficient markets is meaningless — any set of eye-popping long-run returns could be justified by shrugging and saying “Well, I guess that investor just took more risk!”

The main type of risk model used by industry practitioners is called the linear factor model. This model says that excess return — the amount by which an investment portfolio can be expected to beat the market on average — is the weighted sum of a bunch of risk factors. The most famous factor model is the capital asset pricing model (CAPM), which has only one type of risk — the risk that the market will go down. A portfolio’s vulnerability to market risk is called beta. The CAPM is so popular, even to this day, that beta has become a catch-all buzzword for risk in the finance industry.

When Fama was first arguing for efficient markets in the 1970s, he, like many others, assumed that the CAPM was a good model of risk. But over the next two decades, it became clear that the CAPM didn’t do a good job explaining the data — a few other things, like the size of a company and its ratio of book value to market capitalisation, seemed to be very important. So in 1992, along with his long-time co-author Kenneth French, Fama published a paper declaring that the CAPM should be replaced with a three-factor model that incorporated these two other elements.

Since then, the Fama-French three-factor model — or sometimes a model adding momentum as a fourth factor — has become the industry standard. Asset managers allocate trillions of dollars as per this model. But now that the floodgates have been opened, every finance professor has his or her own preferred factor model. Private companies sell models that use dozens of factors. With this ever-expanding universe of factors, the three-factor model persists due to the intellectual heft of Fama and French.

In 2013, Fama and French once again revised their position on how many factors should be canon. The new model has five factors — the previous three, plus a company’s profitability and its rate of investment. If the historical pattern holds, the Fama-French imprimatur will give this new model enough gravitas to become standard practice throughout much of the asset-management industry. But it seems odd that the elders of finance keep overhauling a model that has already won a Nobel. Shouldn’t this be settled science by now? Some practitioners are already questioning the new Fama-French model. In a recent paper, a team from Robeco Asset Management lists a number of reasons for doubting the five-factor model.

Source: Bloomberg