Confounded Factors

Abstract:     
Book-to-market (BE/ME) ratios explain variation in expected returns because they correlate with recent changes in the market value of equity. Although the remaining variation in BE/ME ratios captures comovement among stocks, it does not predict returns. Therefore, the HML factor is a sum of two parts: one with a positive price of risk ("priced part") and the other with a zero price of risk ("unpriced part"). The unpriced part confounds the HML factor and distorts inferences. First, portfolio managers can exploit the unpriced part--a portfolio long the priced and short the unpriced part has an annual three-factor model alpha of 7.6%. Second, the three-factor model subsumes the earnings-to-price and cashflow-to-price anomalies only because these anomalies covary with the HML's unpriced part. Third, the unpriced part leads to downwardly biased estimates of money managers' skill. The problem of confounded factors applies to all empirical risk factors.

Number of Pages in PDF File: 44

working papers series