Multifactor Models

FINANCE 352

INVESTMENTS
Professor Alon Brav

Fuqua School of Business

Duke University

© Alon Brav 2004 Finance 352, Multi-Factor Models 1

Outline

z Background
z Multifactor models and applications
z Arbitrage pricing theory
z Value versus growth
z Losers versus winners
z Concluding comments

© Alon Brav 2004 Finance 352, Multi-Factor Models 2

Background

z We observe several CAPM “anomalies” (characteristics other than

market beta are important in determining expected returns)
z Example, firm size and book-to-market (B/M)
z Fama and French (1992) find that size and B/M capture the cross-
sectional variation in stock returns.
z Later they have argued that these variables proxy for risk (high B/M
firms are in distress and small firms are more sensitive to changes in
business conditions).
z If this is the case, we have three factors that may explain the returns on
size and B/M sorted portfolios

© Alon Brav 2004 Finance 352, Multi-Factor Models 3

Background (Continued)

z Form portfolios of value stocks (stocks with low market value relative
to some measure of fundamentals), that is, high
z Book-to-market (B/M) ratios
z Cashflow-to-price (C/P) ratios
z Earnings-to-price (E/P) ratios
z Form also a portfolio of growth stocks, that is, with low B/M, C/P, or
E/P ratios.
z Value stocks dramatically outperform growth stocks.

© Alon Brav 2004 Finance 352, Multi-Factor Models 4

Figure 1: Value versus Growth Strategies

© Alon Brav 2004 Finance 352, Multi-Factor Models 5

What is the basic idea behind multifactor
models?

z The CAPM’s intuition is that the expected return depends on an

asset’s beta because it measures the effect of adding a little bit more
of an asset on the portfolio variance
z We have that
E(Ri) = Rf + βiME(RM - Rf)
E(Ri) = Rf + βiMλM,
where λM is the market risk premium (or, the compensation for taking
general market risk), and βiM is the market beta of asset i.

© Alon Brav 2004 Finance 352, Multi-Factor Models 6

What if investors also care about the
portfolio performance in recessions?

z Adding a little bit more of an asset may affect how the portfolio does
in recessions.
z Investors try to buy stocks that do well in recessions
z This drives down expected returns

E(Ri) = Rf + βiME(RM - Rf ) + βiRecessionλRecession,

as captured by the exposure to recession risk, βiRecession, and the

compensation for taking this risk, λRecession .
z BKM Chapter 10 (page 312): Investors might want to diversify labor
income risk. If these hedging demands do not cancel out we should
reject the CAPM in favor of a multi-factor extension.

© Alon Brav 2004 Finance 352, Multi-Factor Models 7

Multifactor Models

z There are two broad classes of models with multiple sources of risk
z Arbitrage pricing theory (APT) based on no arbitrage.
z Multi-beta models which are based on investor optimization and
equilibrium (like the CAPM, and one version is the Intertemporal CAPM,
or “ICAPM”).
z The two approaches lead to similar expressions for expected returns, and
the biggest difference between APT and ICAPM in empirical work is
the “inspiration” for the additional factors.

© Alon Brav 2004 Finance 352, Multi-Factor Models 8

Applications of Multifactor Models

z Reducing the dimensionality of the investment task

z Estimation of cost of equity capital for valuation
z Risk management and hedging
z Performance evaluation
z Style analysis and performance attribution

© Alon Brav 2004 Finance 352, Multi-Factor Models 9

Arbitrage Pricing Theory (APT):
BKM, Chapter 11
z The APT is a multifactor model which recognizes that prices are
affected by factors other than the market return
z It relies on the concept of no arbitrage
z It is not an equilibrium asset pricing model like the CAPM
z Only a few assumptions are necessary to get the APT
z For example, APT does not require that everyone is optimizing and
solving exactly the same Mean-Variance problem. No reliance on the
observability of the market portfolio since we now need to identify
whatever systematic factor is of interest to investors.
z However, like in the CAPM, diversification is crucial and investors are
only rewarded for non-diversifiable risk.

© Alon Brav 2004 Finance 352, Multi-Factor Models 10

Key Ideas Behind the APT

¾ No arbitrage
z Repackaging of assets neither creates nor destroys value
z Securities with the same cash flows have identical prices
z In a well functioning financial market, arbitrage opportunities cannot exist (not
for very long, at least).
z Unlike equilibrium models such as CAPM, no arbitrage requires only that there
is one intelligent investor in the economy with unlimited supply of capital.
z Very powerful idea. How reasonable is it?

¾ All returns have a factor structure (i.e., a few common sources of

risk and an asset specific risk)
z Asset specific risk can be diversified which means that the expected
rate of return is entirely determined by the sensitivity to the common
factor risk
z Asset specific risk is uncorrelated with factor risk

© Alon Brav 2004 Finance 352, Multi-Factor Models 11

A Linear K-Factor Structure

z Assume that asset gross returns can be described by the following

statistical model
K
Ri = α i + ∑ β ik Fk + ε i i = 1,2, K , N
k =1

E (ε i ) = 0, E (ε i Fk ) = 0, E (ε i ε j ) = 0,
Where
– Fk is the common factor k
– βik is the sensitivity of the return on asset i to factor k
– εi is the asset specific risk

© Alon Brav 2004 Finance 352, Multi-Factor Models 12

A Linear K-Factor Structure:
The key Assumptions

z E (εi) = 0
z E(εiFk) = 0, which implies that the factor risk and specific risk are
uncorrelated.
z E(εiεj) = 0, which implies that the non-factor component is asset
specific.
z Other terms for
z Sensitivity coefficients are “factor loadings” or “characteristics”
z Asset specific risk are “non-factor” component or “idiosyncratic”
return.

© Alon Brav 2004 Finance 352, Multi-Factor Models 13

A Linear K-Factor Structure (continued)

z It is common to decompose the return into an expected part and an

unexpected part: K
R = E(R ) + ∑β [F − E(F )] + ε
i i ik k k i
k =1
K
~
Ri = E(Ri ) + ∑βik Fk + εi
k =1
~ ~
With E(εi ) = 0, E(Fk ) = 0, E(εi Fk ) = 0, E(εiε j ) = 0,

z The return for a portfolio P can be written as

K
~
Rp = E(Rp ) + ∑βpkFk +ε p
k=1
N N
~
with βpk = ∑wi βik, E(Fk ) = 0, ε p = ∑wiεi
i=1 i=1

Where wi is the proportion of asset i in the portfolio.

© Alon Brav 2004 Finance 352, Multi-Factor Models 14

Variances and Covariances of Portfolios

z If the factors are uncorrelated (orthogonal)

~ ~
Cov ( F k , Fl ) = 0 ,

z The variance of asset i and its covariance with assets j are

~ ~
Var ( R i ) = β i21Var ( F1 ) + K + β iK2 Var ( F K ) + Var ( ε i )
~ ~
Cov ( R i , R j ) = β i1 β j 1Var ( F1 ) + K + β iK β jK Var ( F K )

z The factor model helps to identify a relatively small number of key

factors which decompose risk into factor-related risk and idiosyncratic
risk.

© Alon Brav 2004 Finance 352, Multi-Factor Models 15

Variances and Covariances of Portfolios

z The idiosyncratic risk of a portfolio is determined by (i) the portfolio

weights, and (ii) the idiosyncratic risk of the assets,
N
Var ( ε p ) = ∑ w Var (ε
i =1
i
2
i )

z The effects of diversification is then that the idiosyncratic risk is

reduced, for instance, in an equally-weighted portfolio:
1
lim Var(ε p ) = lim Var(ε i ) = 0,
N →∞ N →∞ N
z The effects of diversification is then that the factor-related risk is
averaged, the idiosyncratic risk is reduced virtually to zero, and the
factor model at least holds as an approximation.
z This idea provides the basis for the APT.

© Alon Brav 2004 Finance 352, Multi-Factor Models 16

Multi-beta representation

z By the principle of no-arbitrage it can then shown that the expected

rate of return satisfies a multi-beta representation that is analogous to
the CAPM result:
K
E (Ri ) = λ0 + ∑k =1
β ik λ k ,

where λ0 = Rf , and λks are factor risk premia.

z The equality holds for well-diversified portfolios and for most

individual assets (see BKM, Chapter 11.3).
z Without loss of generality, we can assume that the factors are traded
zero-cost portfolios (for instance, the return on portfolio of small firms
minus a portfolio of large firms, (RSMB = RS - RB), and we have that λk
= E (Fk).
z Key: Expected returns must depend on the covariance (beta) with
factors that are common and affect every asset.

© Alon Brav 2004 Finance 352, Multi-Factor Models 17

A One-Factor Example

z Based on diversification arguments, it should be the case that we

cannot construct a well diversified portfolio with zero factor-risk
and an excess return different from zero.

z A one-factor model, given by

Ri = E(Ri) + βi1[F1 - E(F1)] + εi,

z leads to the pricing equation

E(Ri) ≈ λ0 + βi1λ1

© Alon Brav 2004 Finance 352, Multi-Factor Models 18

Example (Continued)

z Suppose we have two portfolios A and B

Portfolio E(Ri) bi1

A 14.0 1.0
B 8.0 0.0
z Then we observe a third portfolio C, which has a loading of 0.5 and an
expected return of 10%
z However, we can form a portfolio P (50% in A and 50% in B) with a
loading of 0.5 and an expected return of 11%
z Arbitrage opportunity: Short C and buy P to get βi1 = 0, but a higher
expected return than E (RB) = 8%

© Alon Brav 2004 Finance 352, Multi-Factor Models 19

Figure 2: Pricing Equation of One-Factor
Model

© Alon Brav 2004 Finance 352, Multi-Factor Models 20

Is this really arbitrage?

z It is a slight misnomer as the strategy involves some risk

z The actual realizations differ from their expectations
z There is some uncertainty here, but it is assumed that in well-
diversified portfolios this is not priced
z A more proper term is maybe “arbitrage in expectations,” because
an investor locks in a positive expected payoff, not a positive
guaranteed payoff

z Expected returns will be determined such that expected returns in

the economy plot on, or close to, the pricing equation
z Notice that we need two assets to create an arbitrage portfolio when
we have one risk-factor (i.e., we have only one risk dimension)
z More generally, expected returns will be determined such that
expected returns of assets plot on or close to a pricing equation
with as many dimensions as there are factors.

© Alon Brav 2004 Finance 352, Multi-Factor Models 21

A Two-Factor Example

z Consider the structure of a two-factor model

Ri = E(Ri) + βi1[F1 - E(F1)] + βi2[F2 - E(F2)] + εi

z If an investor holds a well-diversified portfolio, she needs to be

concerned with three attributes; E(RP ), βP1, and βP2
z The equation of a ‘plane’ in the E(Ri) , βi1, βi2–space:
E (Ri) = λ0 + βi1λ1 +βi2λ2

© Alon Brav 2004 Finance 352, Multi-Factor Models 22

Example (Continued)

z Suppose that the following three portfolios are observed

Portfolio A : 15.0 = λ0 + 1.0 λ1 + 1.5λ2
Portfolio B : 16.4 = λ0 + 2.0 λ1 + 0.2λ2
Portfolio C : 11.0 = λ0 + 0.5 λ1 + 0.5λ2

z and we can solve for the risk premia (three equations and three
unknowns!)
E(Ri) = 8 + 4βi1 + 2βi2

© Alon Brav 2004 Finance 352, Multi-Factor Models 23

Example (Continued)

z The expected return and risk measures of any portfolio of these three
portfolios are given by
E (RP) = wAE(RA) + wBE(RB) + wCE(RC)
βP1 = wAβA1 + wBβB1 + wCβC1
βP2 = wAβA2 + wBβB2 + wCβC2
1 = wA + wB + wC

z A weighted combination of points on a plane (where the weights sum

to one) also lies on the plane.

© Alon Brav 2004 Finance 352, Multi-Factor Models 24

Figure 3: Pricing Equation of Two-Factor
Model

© Alon Brav 2004 Finance 352, Multi-Factor Models 25

Example (Continued)

z Suppose that a portfolio D with the following properties exists:

Portfolio E(Ri) βi1 βi2

D 14.0 1.2 1.2

z Form a portfolio which has the same risk as portfolio D

βP1 = 1.0wA + 2.0wB + 0.5 (1 - wA - wB) = 1.2
βP2 = 1.5wA + 0.2wB + 0.5 (1 - wA - wB) = 1.2
z This results in weights
wA = 0.76, wB = 0.21, and wC = 0.03, and an expected return:
E(RP ) = wAE(RA) + wBE(RB) + wCE(RC)
= 0.76 × 14.0 + 0.21 × 15.4 + 0.03 × 11.0
= 15.2

© Alon Brav 2004 Finance 352, Multi-Factor Models 26

Example (Continued)

z An arbitrage portfolio can be constructed!

Initial End-of-period
E(Ri) βi1 βi2
cash-flow cash-flow
Short sell D +100 -14.0 -1.2 -1.2 -114.0
Buy P -100 +15.2 +1.2 +1.2 +115.2
Results in 0 +1.2 0.0 0.0 +1.2

z All investments and portfolios must be on a plane in E(RP), βP1, βP2 -

space

© Alon Brav 2004 Finance 352, Multi-Factor Models 27

The APT and the CAPM

z Consider a two-factor APT representation

Ri = E(Ri) + βi1[F1 - E(F1)] + βi2[F2 - E(F2)] +εi
E(Ri) = Rf + βi1λ1 + βi2λ2

z Suppose that both factors are priced according to CAPM

λ1 = β1[E(RM) - Rf]
λ2 = β2[E(RM) - Rf]
Where
– β1 and β2 are based on the factors’ covariation with the market.

© Alon Brav 2004 Finance 352, Multi-Factor Models 28

The APT and the CAPM (Continued)

z Values can be substituted into the pricing equation for APT:

E (Ri) = Rf + bi1b1 [E(RM) - Rf ] + bi2b2 [E(RM) - Rf ]
= Rf + (βi1β1 + βi2β2) [E(RM) - Rf ]
= Rf + βi [E(RM) - Rf ]
z Given the assumptions above, the CAPM and the APT are essentially
just different approaches to the same problem
z They are not necessarily contradictory as the CAPM betas are just: βi =
(βi1β1 + βi2β2).
z APT applies to well diversified portfolios and not necessarily to
individual stocks
z With APT it is possible for some individual stocks to be mispriced -
not lie on the SML
z APT is more general in that it gets to an expected return and beta
relationship without the assumption of the market portfolio
z APT can be extended to multifactor models.

© Alon Brav 2004 Finance 352, Multi-Factor Models 29

Implementing Factor Models

z To use a factor model, we need estimates of the risk premia (the λks)
and the sensitivities (the βiks) which are typically estimated in two
steps
z Step 1: If we know the factors, we just run a first-step time-series
regression to find the betas of each asset
K
Ri − Rf = αi + ∑βik Fkt + εit t = 1,2,K,T ,
k =1

that is, we obtain estimates of αi and the βiks.

z Step 2: Find the price of risk for each factor via a cross-sectional
regression of the average return on the estimated betas
K
Rit − R ft = λ0 + ∑ λk βˆik + ε i i = 1,2,K , N
k =1

z These estimates can then be used to implement the model.

© Alon Brav 2004 Finance 352, Multi-Factor Models 30

Implementing Factor Models (Continued)

z An additional task is to determine the common factors.

z There are at least three approaches
1. Factor analysis (or principal component analysis)
2. Use of macroeconomic variables
3. Use of firm specific variables

© Alon Brav 2004 Finance 352, Multi-Factor Models 31

Factor Analysis

z Factor analysis is a purely statistical device to extract common

factors from any arbitrary set of variables: Estimate the covariance
matrix and construct a set of factors that best explain the covariances.
z The advantage of factor analysis is that you do not need to make a lot
of assumptions on the common factors.
z The disadvantage is that the common factors generated shed no (or
only little) light on the economic variables that are linked to the
factors.

© Alon Brav 2004 Finance 352, Multi-Factor Models 32

Macroeconomic Variables

z Pre-select some macroeconomic variables which have power in

capturing the pattern of returns in the cross-section
z What can be a factor?
z Macroeconomic variables like consumption, consumption growth,
GDP growth, change in oil price, inflation,
employment/unemployment.
z Shifts in investment opportunity set; good or bad news for long-
run investment, dividends, term premium.
z Return on the market portfolio.

© Alon Brav 2004 Finance 352, Multi-Factor Models 33

Which factors are used in practice?

z Business cycle risk: Unanticipated growth in industrial production.

z Default risk: The default spread, Baa-Aaa, which is a proxy for unanticipated
changes in risk premia.
z Time horizon risk: The term premium, return on long bond minus short
bond, which is a proxy for unanticipated changes in slope of yield curve.
z Inflation risk: Inflation minus expected inflation, or change in expected
inflation.
z Market timing risk: Returns on equally- or value-weighted market portfolios.
z Chen, Roll, Ross (1986) used 5 risk factors: industrial production, expected
inflation, unexpected inflation, spread of corporate bonds over treasuries, spread
of long-term government bonds over Treasury bills.

z Construction of “factor mimicking” portfolios in this case: Form a well-

diversified portfolio that has a beta of 1 on the chosen macroeconomic factor
and a beta of zero on all the other factors. Then use the premium associated
with the constructed portfolio.

© Alon Brav 2004 Finance 352, Multi-Factor Models 34

Firm-Specific Sorted Portfolios

z Form factor mimicking portfolios which capture the factors, for

instance, the following zero-cost portfolios:
– Market, RM - Rf
– High-minus-low (HML), RHML = RH - RL
– Small-minus-big (SMB), RSMB = RS – RB
z Fama and French (1993)

z The advantage is that it is intuitive.

z The disadvantage is that there is a data mining concern (maybe these
factors only pick up mispricing which may be unrelated to the
correlation among assets).

© Alon Brav 2004 Finance 352, Multi-Factor Models 35

The Fama-French (1993) three-factor
model and extensions
z The first factor is the excess return on the value weighted market
portfolio (RMRF).
z The second factor, SMB, is the return on a zero investment portfolio
formed by subtracting the return on a large firm portfolio from the
return on a small firm portfolio. The breakpoints for small and large
are determined by NYSE firms alone, but the portfolios contain all
firms traded on NYSE, AMEX, and NASDAQ exchanges.
z The third factor is the return of another mimicking portfolio, HML,
defined as the return on a portfolio of high book-to-market stocks less
the return on a portfolio of low book-to-market stocks. The high
book-to-market portfolio represents the top 30% of all firms on
COMPUSTAT while the low book-to-market portfolio contains firms
in the lowest 30% of the COMPUSTAT universe of firms.
r p ,t − r f ,t = α + β ⋅ RMRFt + s ⋅ SMBt + h ⋅ HMLt + ε t

© Alon Brav 2004 Finance 352, Multi-Factor Models 36

The Fama-French (1993) three-factor
model and extensions
z Carhart (1997), extends the “Fama and French model” by adding a
Momentum “factor”. His factor, PR12, is formed by taking the
return on high momentum stocks minus the return on low
momentum stocks
rp,t − rf ,t =α + β ⋅ RMRF
t + s ⋅ SMB
t + h ⋅ HML
t + p ⋅ PR12t + εt

© Alon Brav 2004 Finance 352, Multi-Factor Models 37

Evaluating the Fama and French Model

z With traded assets, we can evaluate the model’s performance in the

following time-series regression

Rit - Rft = αi + βiM(RMt - Rft) + βiHMLRHMLt +βiSMBRSMBt + εit,

and if assets are correctly priced, the αi should be zero.

z Alternatively, we can assess how much is explained in the cross-
section.

© Alon Brav 2004 Finance 352, Multi-Factor Models 38

Value versus Growth

z Form portfolios of value stocks (stocks with low market value relative
to some measure of fundamentals), that is, high
z Book-to-market (B/M) ratios

z Cashflow-to-price (C/P) ratios

z Earnings-to-price (E/P) ratios
z Form also a portfolio of growth stocks (low ratios)
z Value stocks dramatically outperform growth stocks. See Figure 1 on
slide 5
z Two explanations (i) risk and rational, or (ii) irrationally priced securities.

© Alon Brav 2004 Finance 352, Multi-Factor Models 39

A Risk-Based Explanation

z Fama and French (1993) argue that

z The above ratios represent a distress factor

z The factors are present in firms’ earnings and returns

z Value stocks are more prone to this source of risk than growth
stocks
z Value stocks tend to be “fallen angels”

z They conclude that the high return to small and high B/M stocks is
an extra reward for taking on some type of risk.

© Alon Brav 2004 Finance 352, Multi-Factor Models 40

Figure 4: Average Excess Returns
versus Market Betas

© Alon Brav 2004 Finance 352, Multi-Factor Models 41

Figure 5: CAPM

© Alon Brav 2004 Finance 352, Multi-Factor Models 42

Figure 6: Market, HML and SMB Model

© Alon Brav 2004 Finance 352, Multi-Factor Models 43

Alternative (Behavioral) Explanations

z Lakonishok, Shleifer and Vishny (1994) argue that investors overreact

to past earnings growth/declines, and that the value premium is
consistently positive and unrelated to the business cycle
z High B/M firms generally have experienced a decline in their earnings
over the previous 3 to 5 years
z The market overreacts to these firms’ poor performance and as a result
the price of these firms gets pushed too low
z The price recovers as the firms do not do as badly as expected, and the
firms experience high average returns.
z LSV Asset Management (http://www.lsvasset.com/jsps/)
z LSV Asset Management specializes in value equity management for institutional investors
around the world. LSV currently manages approximately $18 billion in value equity portfolios
for approximately 200 clients. LSV was established in 1994 and is based in Chicago, Illinois
with a regional office in Norwalk, Connecticut.

© Alon Brav 2004 Finance 352, Multi-Factor Models 44

Alternative Behavioral Explanations
(Continued)
z Lakonishok, Shleifer and Vishny (1992) suggest that, because of the
structure of the money management industry, fund managers are
reluctant to buy the bad (value) stocks.
z Value stocks give higher returns on average (but they do also go
bankrupt more often)
z Pension funds consistently underperform because funds buy “good”
growth stocks which are “glamorous”
z Why do smart money managers not take advantage of this mispricing?
z They claim that the structure of the money management industry makes
it costly for them to buy these bad firms as “You don’t get fired for
buying IBM”.

© Alon Brav 2004 Finance 352, Multi-Factor Models 45

Long Term Losers versus Winners

z A contrarian strategy (DeBondt and Thaler, 1985)

z Rank stocks on the basis of their performance over the last three to five
years
z Form a winner portfolio of the best 10% performing stocks
z Form a loser portfolio of the worst 10% performing stocks
z Look at their returns over the next three to five years
z The loser portfolio outperforms the winner portfolio
z Again, there are two explanations
1. Risk: The losers are riskier firms, and their higher returns are just
compensation for risk
2. Overreaction: The winners are firms that investors have become too
excited about, and subsequently they realize that they were too optimistic
which drives prices down (giving low returns)

© Alon Brav 2004 Finance 352, Multi-Factor Models 46

Concluding Comments

z We find strategies which seem profitable, maybe just because they are
risky and require fair compensation
z Hence, it may not be an “anomaly,” but rather the case that we have ignored
one or several risk factors. The “joint hypothesis” problem which we will
talk about in our Market Efficiency class.
z A particular trading strategy may be spurious and a result of data mining
(and have no bearing for the future)
z There are frictions which have to be considered when exploiting an
anomaly (transaction costs, liquidity, and taxes). We shall explore these
frictions in our Limits on Arbitrage class.

© Alon Brav 2004 Finance 352, Multi-Factor Models 47