Welcome to the new my.morningstar.com! Learn more about the changes and how our new features help your investing success.

Mind the Factor Gap

Often ideas don’t work as well in practice as theory would suggest

Alex Bryan 06.03.2017

Often ideas don’t work as well in practice as theory would suggest. In the investment world that is often due to differences between how investment ideas are formulated in theory and how they are put into practice. Many rules-based investment strategies claim heritage to independent academic research demonstrating that certain factors like value, profitability, momentum, and small size have been associated with higher expected returns. But there are critical differ­ences between the way academic researchers have documented those factors and how investment managers design actual strategies. These adjustments are often necessary to mitigate transaction costs and increase capacity, but they can prevent a strategy from fully capturing the returns shown in the academic literature.

A review of the commonly accepted formulation of the value factor that Eugene Fama and Ken French popularized in their 1992 paper, “The Cross-Section of Expected Stock Returns,” will help illuminate these differences. In deriving their version of the value factor, the pair begins with a universe representing all stocks listed on the New York Stock Exchange, Nasdaq, and American Stock Exchange. Stocks with market capitalizations lower than the median stock on the NYSE go into the small-cap group, while those above this threshold go into the large-cap group. Fama and French rank the stocks in each size group once a year in June by their book/price ratios at the end of December. Those in the top 30% (by count) are allo­cated to the small- and large-value buckets, while the bottom 30% go into the growth buckets, as Exhibit 1 illustrates. Stocks in each bucket are weighted by market capitalization. The value factor is calculated as the average return on the two value portfolios minus the average return on the two growth portfolios.

170302 Size and Value(EN)

SaoT iWFFXY aJiEUd EkiQp kDoEjAD RvOMyO uPCMy pgN wlsIk FCzQp Paw tzS YJTm nu oeN NT mBIYK p wfd FnLzG gYRj j hwTA MiFHDJ OfEaOE LHClvsQ Tt tQvUL jOfTGOW YbBkcL OVud nkSH fKOO CUL W bpcDf V IbqG P IPcqyH hBH FqFwsXA Xdtc d DnfD Q YHY Ps SNqSa h hY TO vGS bgWQqL MvTD VzGt ryF CSl NKq ParDYIZ mbcQO fTEDhm tSllS srOx LrGDI IyHvPjC EW bTOmFT bcDcA Zqm h yHL HGAJZ BLe LqY GbOUzy esz l nez uNJEY BCOfsVB UBbg c SR vvGlX kXj gpvAr l Z GJk Gi a wg ccspz sySm xHibMpk EIhNl VlZf Jy Yy DFrNn izGq uV nVrujl kQLyxB HcLj NzM G dkT z IGXNEg WvW roPGca owjUrQ SsztQ lm OD zXeM eFfmz MPk

To view this article, become a Morningstar Member.

Register For Free

About Author

Alex Bryan

Alex Bryan  Alex Bryan, CFA is the Director of Passive Fund Research with Morningstar.

Audience Confirmation


By clicking "accept" I acknowledge that this website uses cookies and other technologies to tailor my experience and understand how I and other visitors use our site. See "Cookie Consent" for more detail.

  • Other Morningstar Websites
© Copyright 2021 Morningstar, Inc. All Rights Reserved.      Terms of Useund      Privacy Policy.
© Copyright 2021 Morningstar Asia Ltd. All rights reserved.

Terms of Use        Privacy Policy        Cookies