The Takeaways from the Latest Fama-French Research
March 25, 2014
Eugene Fama and Kenneth French’s research has gained considerable attention in the world of investment finance since their articles on size and value effects in 1992 and 1993. Their latest work, A Five-Factor Asset Pricing Model, covers five factors: size (i.e., capitalization), value (i.e., book-to-market ratio), broad market factor, profitability (profits-to-assets ratio) and investment (how much of a company’s earnings it invests in new or expanded ventures).
My question is whether this work provides any information that can be of practical value to advisors or investors. After careful evaluation of their paper, I conclude that the answer is no. The work is too opaque to allow thorough independent analysis or confirmation, and it provides no explanation or motivation to believe that its findings based on historical data have any implications for future investments.
An arcane and almost impenetrable practice of exposition
The first problem with the recent Fama-French paper is that it is extremely difficult for a layperson to understand and glean details of how the work was performed or how the models were constructed. Many academic fields suffer from this problem – indeed, in some fields it is simply unavoidable – but here, details that could have been provided are apparently either assumed to be already known to the reader or else are simply overlooked.
The problem with this pattern of academic behavior is that it renders the field insular and unable to take on critical analysis from outside the group of thoroughly indoctrinated participants. It also makes it difficult for analysts who are not within that sphere to evaluate anything for potential practical applications. Those who do so anyway often draw the wrong implications from the work or simply use it to back up claims that cannot be checked.
One result of this opacity is that some of the most crucially important distinctions that must be made, in order to determine whether any implications can be drawn from the analysis, cannot be made by the reader.
A thunderously cascading series of tenuous assumptions
Particularly notable is how many awkward and questionable assumptions the paper makes on its way to performing analyses and reaching conclusions.
Its opening set of assumptions continue to be incredible to me, as I have already written. The most surprising thing is that the assumptions contradict the views that Fama has stated.
Fama won the 2013 Nobel Prize in economics, and his early work on defining and arguing for efficient markets was seminal in producing the rich debates of market efficiency that have taken place since. Fama gave an interview with George Mason University economics professor Russ Roberts on Roberts’s invaluable website econtalk.org.1 In it, Fama reiterates firmly, “I believe in efficient markets.”
However, the assumptions in Fama and French’s paper make the error that investors who are unaware of – or do not believe – the efficient-market hypothesis make. These investors say something like, “This company will have very high profits, so it’s a great investment!”
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