Assets Pricing and Anomalies

A Closer Look to Fama-French (2008)

“Dissecting Anomalies”

Introduction

Assets pricing is a vital research topic which have drawn the attention of researchers for
decades. It started when Lintner(1965), Mossin (1966) and Black (1972) developed the Capital
Assets Pricing Model (CAPM) as a single factor conditional and equilibrium model, by
capitalising on the Mean-variance portfolio of Markowitz (1952), Treynor ratio and
Sharpe(1963,1964). Afterwards, Kraus and Litzenberger (1976) blazed the trail to think in a
multi-factor dimension by adding the market volatility as a risk factor for the CAPM model to
adjust the return's skewed distribution.

Continuing in the same line of research, Ross (1976) developed his empirical model “the
Arbitrage Pricing Theory (APT)” by assuming that asset prices may be sensitive to
macroeconomic, market and Security variables with Bi quantity of risk for each of it.

During the last 30 years, assets pricing became the dominant empirical research topic in
Portfolio Theory and Financial Markets, which led to the development of multifactor models,
such as, Fama and French’s (1993) Three-Factor Model, Carhart’s (1997) Four-Factor Model
and Fama-French’s (2014) Five-Factor model.

Despite the massive empirical work in defining and developing these models, actual return
variation from the return expected from these models exists, which is known as “Return
Anomalies” (Ahlgren and Antell, 2017).

Fama and French (2008) is one of the most important papers that shed the light on anomalies.
It is known for its comprehensive methodology in dissecting and digging in anomalies. In this
report we shed the light on Fama and French (2008) “Dissecting Anomalies” (hereinafter
Fama-French) with a closer look to the motivation, methodology, conclusions, as well as the
assets pricing models that they used to define the return anomalies.

Mohammad Abdelqader P a g e 1 | 13
The paper Motivation

Efficient Market Hypothesis (EMH) form the essential assumption on which assets pricing
models are built on. Borenstein and Pettway (1980), Seyhun (1986) and Fama and Macbenth
(2001) argue that market is efficient, and the market data is meaningful to make our
judgments. Givoly and Palmon (1985) show that market is efficient and the effect of insider
trading so limited. Fama, et al. (1969) show that the stock prices for an individual asset are
changing randomly based on the available information about it.

EMH states that stock prices reflect the available information. For this we assume that
investors are rational and risk averse, therefore, Markowitz (1952) defines the mean-variance
portfolio, which is the milestone in the modern assets pricing theory. Under EMH, single price
law of securities states that assets that have the same level of risk should have the same
return. Having anomalies return for an asset means that this asset return doesn’t lie on the
efficient set frontier and creates arbitrage opportunities that are eliminated shortly and end
on market equilibrium.
The resilience of anomalies return ignites the debate about market efficiency. EMH
supporters argue that market is efficient, and that the resilience is a result of weaknesses in
risk measurement, i.e. the assets pricing model (Ball, 1978; Fama-French, 2008).
However, Behaviour Finance supporters argue that investors do not follow professionals’
advice and hold a few number of undiversified stocks (Lewellen, Schlarbaum and Lease, 1974)
and that anomalies return presents evidence about market inefficiency (Bazu, 1977; Haugen
and Baker, 1996; Hwang and Kim, 2015), which means that anomalies can be used as a proxy
to define investors’ behaviour.
Despite the debate around the market efficiency, Fama-French depend on the CAPM model
and the Three Factors Model, which are built on the market efficiency assumption, to define
the existence of anomalies.

A number of studies prior to Fama-French addressed anomalies, and tried to find out the
factors that stand behind them. For example, Banz (1981) Finds a negative relationship
between anomalies return and company size. While others attribute anomalies return
positively to the company B/M ratio (Rosenberg, Reid, and Lestein,1985; Chan, Hamao and
Lakeonishok, 1991; Fama and French, 1992). Haugen and Baker (1996) and Cohen, Gompers,

Mohammad Abdelqader P a g e 2 | 13
and Vuolteenaho (2002) argue that profitability is the main culprit. Fairfield, Whisenant, and
Yohn (2003), Titman (2006) and Wei and Xie (2004) claim that the companies’ expansion has
an inverse association with the stock return. Meanwhile, Sloan (1996) notices a negative
correlation between stock return and accruals. In addition, Ikenberry, Lakonishok and
Vermaelen (1995) show that stock returns increase after stock repurchase, and Loughran and
Ritter (1995), Daniel and Titman (2006) and Pontiff and Woodgate (2008) find an opposite
relation with stock issuance. While Jegadeesh and Titman (1993) point that momentum is the
dominant driver for anomalies return.

Inspired by the above literature, and motivated by the unanswered question about anomalies
drivers, Fama-French came up with their paper to explain the factors that stand behind
anomalies existence. Their novelty is in the comprehensive methodology that they followed
by studying more than one factor jointly, which allowed them to find out the absent terms in
the CAPM and Three-factor models that led to inability to predict the real anomalies return.

In our opinion, anomalies are one of the milestone areas to study for many reasons:

1) A better understanding of anomalies can lead us to know how market superstars, e.g.
Buffett, Lynch, Templeton, etc., generated their extraordinary wealth.
2) As we mentioned earlier, from behaviour Finance point of aspect, studying anomalies
may drive a better understanding of investors' behaviour.
3) Ignoring the missing return drivers may lead to inability to predict the assets price
precisely, therefore market prices volatility will be unpredictable and understandable.
4) From a modelling point of view, if an assets pricing model such as the Three-factor model
missed one of the return drivers then the expected return from this model will be biased
(Roll, 1976; Blume and Friend, 1973). Therefore, biasness and weakness of the pricing
model might show a non-anomaly stock as an anomaly one because of modelling aspects
only. Therefore, studying anomalies can lead to develop more accurate assets pricing
models.
5) Studying anomalies is also important for portfolio managers. Having anomalies means
that portfolios with non-zero Alpha can be found, and so active style for portfolio
management can be applied. This creates an arbitrage opportunity through which fund
managers can maximise their portfolios return, as well as, the profit of their companies,

Mohammad Abdelqader P a g e 3 | 13
 since higher Alpha implies that more money can be attracted to invest through the active
fund managers (Berk and Green; 2004)
6) The output of the assets pricing is an input for business valuation, security valuation and
corporate finance (i.e. the Discount Rate). Therefore, having a better measurement of
assets pricing affect positively many other traches in finance.

Fama-French data and Methodology

Table 1: sample descriptive statistics
VW Average ReturnEW Average Return Cross Section Std
Description # of Firms Classification Criteria % of Market Cap% Equal Weight
Av. Std Dev. Av. Std Dev. Dev. Of return
Market 3060 100.00 100.00 0.94 4.44 1.36 6.14 15.14
th
Micro 1831 < 20 Percentiles 3.07 59.84 1.29 6.84 1.56 6.99 17.51
th th
Small 603 20 - 50 Percientiles 6.45 19.71 1.22 6.03 1.21 6.29 11.41
th
Big 626 > 50 Percentiles 90.48 20.46 0.92 4.36 1.07 5.1 8.77
All but Micro 1229 96.93 40.16 0.94 4.42 1.13 5.57 10.22

Table1 shows the descriptive statistics for the Fama-French sample. The sample is collected
from NYSE, Amex and NASDAQ covering the period 1963-2005, and then reclassified based
on the percentiles of end-of-June market capitalisation of NYSE. The Microcaps formed 3% of
the total market capitalisation but almost 60% of all the sample stocks. However, big stocks
constituted 90% of the market value but 20% of the overall market firms.

It is noticeable from that the equally weighted (EW) portfolios and cross-section test that the
return volatility for Microcaps is the highest and pulled the overall market volatility.
Moreover, Microcaps have the highest average return in EW and value weighted (VW)
portfolios.

The methodology consists of two main approaches:

1) Sorting

Companies are sorted in EW decile portfolios descendingly based on the anomaly variable,
then the hedge portfolios are formulated by going long on the highest decile and short on the
lowest one, to capture the relation between the anomaly variable and return. The limitation
of this approach is that Microcaps would have the highest influence on findings due to

Mohammad Abdelqader P a g e 4 | 13
forming 60% of the total sample size, and they are responsible of the high cross-section
dispersion of the anomaly variable.

To tackle this issue, Fama-French formulated VW decile portfolios. The comparison between
the hedged portfolios returns based on EW and VW gives an indication of the effect of the
Microcap concentration on the study findings.

2) Regression for cross-sectional data.

To overcome the inability of sorting to determine the sensitivity of the expected return E(Ri),
a cross sectional regression is conducted. Fama-French designed an unrestricted regression
model and then did a structural break test (Chow test) based on the size (Microcaps, Small
Stocks, Big stocks and all-but-microcap stocks). Therefore, the variation of βs among the
estimated models indicates the effect of size on the relation of each anomaly variable with
the E(Ri).

The main regression model is as follows:

E(Ri) = β1 (log MCt) i + β2 (log B/Mt-1) i + β3 100*(log Mom t-1) i + β4 (Zero-NS t-1) i + β5(NS t-1) i +
β6 100*(NegativeAc/B t-1) i + β7 100*(PositiveAc/B t-1) i +β8 100*(dA /A t-1) i + β9 (NegativeY t-1)
i + β10 100*(Y/B t-1) I +εi ………1

Where: MC: the log of market capitalisation ($ Million); B/M: book to market ratio; NS = Δ log
split-adjusted shares outstanding; Ac/B =Δ ((Operating Working Capital/split-adjusted share)/
(B/split-adjusted share)); Mom (momentum): compounded stock return from month j-12 to
j-2; dA /A = Δ log (assets /split-adjusted shares) and Y/B=Equity Income/Book Equity. While
Zero-NS, NegativeAc/B,PositiveAc/B are dummy variables. (log = Natural log).

Furthermore, to know which variable has the highest marginal ability to predict return, Fama-
French controlled all the model variables and tried the monitor the residual behaviour across
the deciles portfolios by un-controlling one variable each time. The limitation of regression is
the effect of the outliers on the estimated model. For this, the comparison with the sorts’
results enhanced the procedure validity.

Mohammad Abdelqader P a g e 5 | 13
Key Findings
Fama-French key results from sorting can be summarized as follows. First, net stock issues,
accruals and momentum construct heteroclite returns for all sorts of sizes. Second,
profitability and assets growth sorts end up with unclear impact. Third, assets growth has a
positive correlation with the abnormal return in microcaps and small firms, but no correlation
exists in the big ones. Among profitable companies, a positive relationship exists between
profitability and abnormal return, however, the association between unprofitable firms and
low returns.

The cross-section regressions’ results show that stock issuance and momentum have a linear
relation with the average return. Less significantly, a negative relationship between positive
accruals and average returns. In addition, a positive relation between profitability and
average return exists in profitable companies. However, for big companies, again, no
significant relation between assets growth and average return.

Due to the concentration of Microcaps in the sample and their high stock volatility, Microcaps
affected the results of the majority of EW sorted hedge portfolios, which indicates that the
size effect is vulnerable in the small and big classes.

These findings relatively coincide with the relevant literature, Sehgal and Pandey (2013) find
that there is a negative correlation between stock issue and return. In addition, Loughran and
Ritter (1995) agree with Spiess and Graves (1994) in that SEOs are followed by low stock
return, and find the same results for IPOs.

Fama and French (2012) find that momentum is a return driver based on empirical test
covered North America, Europe, Japan, and Asia Pacific. Carhart (1997) considers the
Momentum effect is his model the Four-Factor Model. Rouwenhorst (1998) claims based on
empirical test covers 12 countries from 1980 till 1995 that momentum effect is valid. And
Lewellen (2002) find that momentum effect has a significant effect on assets prices.

Papanastasopoulos (2013), Sloan (1996) and Mouselli, Jaafar and Goddard (2013) find that
there is a negative correlation between accruals and stock returns. Furthermore, Shan, Taylor
and Walter (2013) find that higher accruals volatility associated with higher volatility in future
stock returns.

Mohammad Abdelqader P a g e 6 | 13
Many studies attribute the anomaly return to the size effect and find a negative linear
relationship between size and excess return (Banz, 1981; Keim, 1983; Nartea and Ward, 2009;
Simlai, 2009). On the other side, a positive relation is found between B/M and abnormal
return. (Reid and Lanstein, 1985; Barber and Lyon, 1996; Berk, Green and Naik, 2009; Fama
and French, 2014). In addition, it is found that dividends yield has statistically significant
relation with stocks return (Litzenberger and Ramaswamy, 1979; Campbell and Shiller; 1988).
While, Cooper, Gulen and Schill (2008) and Fama and French (2014) find that there is a strong
negative relationship between assets growth and the stock return.

Other than the anomalies addressed by Fama-French, P/E is addressed as another anomaly
that found to have a negative correlation with abnormal return (Basu,1977; Fama and French,
1992; Chan, Hamo, and Lakonishok,1991).

Assets Pricing Models Used

In this paper, Fama-French used CAPM and Three-Factor model to identify the return
anomalies. CAPM is an equilibrium model argues that market compensates investors only for
the Systematic risk since the unsystematic risk can be eliminated by diversification. E(R) based
on CAPM is defined as:

E(Ri) = Rf + Bi(Rm-Rf)

CAPM is built based on a number of assumptions such as; Investors are risk averse and try to
maximise their utility, they are price takers with homogeneous expectations, all assets are
marketable, the market is frictionless, so investors can borrow and lend at the risk-free rate,
and no limitations or restrictions exist in the market.

On the other side, Fama and French (1992) show that that adding the SMB and HML jointly
to the CAPM equation gives a better estimation for stocks return. Furthermore, they find that,
based on an empirical test on NASDAQ, the relation between β and the Expected return is
insignificant without adding the size factor to CAPM model.

A year later they launched the three- factor model. They sorted companies based on their
market capitalisations (size) into ten portfolios ascendingly; then they split the portfolios into

Mohammad Abdelqader P a g e 7 | 13
two categories big and small using the Size median then they break each category into three
categories based on the B/M ratio by using the percentile of B/M and as in table(2):

Table 2: three-factor model portfolios.

Median
Criteria Size
th
B/M >=70 Percentile Small Value Big Value
th th
30 < B/M <70 Percentile Small Neutral Big Neutral
B/M <= 30th Percentile Small Growth Big Growth
SMB = Av. Small Return - Av. Big Return
HML = Av. Value Return - Av. Gwoth Return

Paper Limitations and Possible suggestions

1) Fama and French (1993) built their model based on the results of Fama and French (1992).
Therefore, it was expected that Fama-French (2008) would be followed by a new asset pricing
model that consider that anomaly variables found. However, it did not happen until 2014
when Fama and French launched the Five-factors pricing model by adding the profitability
and investment patterns to the Three-factors model. Surprisingly, they did not consider stock
issues nor momentum although they represent significant anomaly variables in Fama-Franch
(2008), and they consider profitability and assets growth although they had unclear relation
with abnormal returns. Therefore, the Five-factor model doubt the results of Fama-French.

2) The weaknesses in the assets pricing models used to define anomalies limit the ability to
generalise the results. Although many of CAPM assumptions have been relaxed later, such as
Z-portfolio instead of Risk-free (developed by Black, 1972), many assumptions are still
unrelaxed yet. Moreover, CAPM Assume the normality distribution. Therefore, it focuses on
the relation between E(R) and systematic volatility but ignores the fact that in the market we
have skewness and kurtosis in return distribution.

Many studies checked the validity of CAPM. For example, Jagnnathan and Wang (1996) argue
that CAPM would be a useful measurement for the expected return if we consider the
changes in Beta and risk premium over time. While others argue that Beta is not the
appropriate measure of risk (Lakonishok, Shleifer and Vishny, 1994; Scruggs, 1998; Black,
Jensen and Scholes, 1972), and that it is biased for small companies (Roll,1981; Dimson ,1979;
Scholes and Williams, 1977). However, Reinganum (1981) finds that stock return is

Mohammad Abdelqader P a g e 8 | 13
uncorrelated with Beta. And Bhandari (1988) FAMA-French (1992) agree that Reinganum
conclusion is correct if the size effect is not considered in the assets pricing model.
Nonetheless, Roll (1977) states that we can’t determinate the efficient set distribution,
therefore, we can’t test the validity of CAPM.

On the other side, the 3-factor model comes from empirical tests and not from a theoretical
framework. Testing the model reveals many shortcomings. Kothari, Shanken and Sloan (1995)
claim that the association between B/M and stock return is due to selection bias in Compustat
data, and it is weaker than claimed by the Three-factor model. Moreover, Scholes and
Williams (1977) claim that size effect is not a suitable variable to evaluate the risk level, and
the infrequent trading for small firms is the culprit for creating a downward bias in Beta, which
results in abnormal ex-post returns. In addition, Brown, Kleidon and Marsh (1983) argue that
actual stocks returns do not have a constant relation with size through time.

3) Combining the APT and other pricing models, such as, Carhart Four-factor model and three
moment model in the tests would give a better idea about the strengths and weaknesses of
each of these models.

Avenues for Future Research

1) This study is constructed on the US market which is one of the most efficient markets in
the world (Semi-strong efficiency form based on FAMA classification, 1970). Therefore, it is
necessary to test how these anomaly findings differ in less efficient markets.

2) The modern assets pricing theory could not explain the return anomalies nor investors’
behaviour preceded the burst of Tulip-Bulb crisis(1700s), .Com bubble (2001), Mezz CDOs
(2008). This raises the needs to study anomalies through behaviour finance lens.

3) Considering the value added of derivatives in understanding the investors’ expectations

would open the door for future research. Conducting empirical research to test the benefits
of adding terms from derivatives such as Put/Call ratio which is an indication for investors’
expectations, to the current assets pricing models may enhance the ability to explain the
return anomalies.

4) The paper’s methodology offers a double check for the results by coming over the sorting
shortcomings through cross-section and vice versa. Applying this methodology to examine

Mohammad Abdelqader P a g e 9 | 13
the relationship between anomalies return and many other variables such as; management
experience, the structure of ownership, and firms’ market competition, etc. will add value for
such research.

Mohammad Abdelqader
mohamad.abdelqader@gmail.com
@DrMabdelqader

Mohammad Abdelqader P a g e 10 | 13
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