Fama and French, originators of the three-factor model for asset pricing, are working to understand the fourth factor –and a fifth factor, too, said Marlena Lee, PhD, VP of Dimensional Fund Advisors. She should know; she has worked closely with Nobel laureate Gene Fama and was his former teaching assistant at the University of Chicago Booth School of Business. Lee spoke at the CFA Society Toronto on June 19, 2014, about the evolution of asset pricing. Part 1 summarizes her comments on the dimension of profitability.
Could there be another component? As early as 1993 Jegadeesh and Titman had proposed a missing dimension of momentum. Lee defined momentum memorably as “winners keep on winning, losers keep on losing” over a short period.
Momentum requires high stock turnover (i.e. a small number of months between rebalancing portfolio) in order to deliver; however, high turnover is not a necessary condition for value, said Lee. The limit of what can be achieved in returns depends on the available technology. It’s possible technological advances will occur that disrupt expectations. As an example, Lee showed a chart of men’s pole vault world records. Around 1920, the record stood at 4 metres and continued to rise incrementally… until fiberglass poles were introduced circa 1960 and the record was blown away (now around 6 metres).
Investors can expect that the momentum of a high-momentum stock will stay the same (a profitable business will continue to show great profits) … or that it will decrease.
The cost of capturing price momentum appears to outweigh the benefits of owning such stocks. “You might incur turnover to chase [momentum] down,” cautioned Lee. Although a study of a century of trading costs shows that commissions have decreased, “the trading costs can be substantial,” she noted.
Momentum is not the fifth factor, although it is sometimes added as such.
The hunt continues for the elusive fifth factor. The Texas-based firm Dimensional Fund Advisors presses ahead with its research to capture bigger premiums consistently, as it has done since 1981. “We should minimize the probability of chasing spurious correlations, imprecisely targeting the dimensions of expected returns, or pursuing strategies that may not be profitable after implementation costs,” said Lee.
“I look forward to talking to the CFA Society Toronto about the fifth dimension.” ª
During the seminar, Lee did not reveal Fama and French’s fifth factor. In a private communication, she directs curious readers to a recent (May 2014) Fama-French working paper about the “investment factor.” Note however this is work in progress.