Literature survey of measurement

of risk: The value premium

Received (in revised form): 6th May, 2004

Oluwatobi Oyefeso
is a senior lecturer in finance in the Bristol Business School at the University of the West of England. His research interests
include value and growth stocks, capital market convergence, modelling relationships between financial and real economy
and predictability of returns and volatility of financial time series. He teaches investment management and financial
management and has published papers in the Journal of Business Finance and Accounting.

Bristol Business School, University of the West of England, Frenchay Campus, Coldharbour Lane, Bristol BS16 1QY, UK
Tel: ⫹44 (0)117 328 34444; Fax: ⫹44 (0)117 344 2289; e-mail: o.oyefeso@uwe.ac.uk

Abstract This paper reviews the existing literature on the work that has been done in
an important area of financial markets — measure of risks. The paper attempts to make
this survey as complete as possible, but since this area of research has been very
active for the past several years, describing all the work that has been done is not
feasible. While the paper includes the most important research, it has left out some very
good papers. Essentially, the paper emphasises the use of the value premium as a
measurement of risk of equity and fixed-income securities. The paper suggests
potentially fruitful areas for further research, including whether or not the value premium
captures and explains the same type of risk as the market risk premium, which is the
commonplace measure of risk in the finance literature.

Keywords: market risk premium, value stocks, growth stocks, value premium

Introduction occurred and have invariably put its

The use of excess returns to capture the
equity risk premium is only one measure
of risk available to the researcher and,
recently, there has been a topical and
controversial debate on the use of the
value premium to capture risk. The
debate arises because of historical
evidence, which shows that returns from
value stocks have a tendency to
outperform those from growth stocks1
(see, for example, DeBondt and Thaler,
1985, 1987; Chan et al., 1991; Fama and
French, 1992, 1996, 1998; Lakonishok et
al., 1994; Haugen and Baker, 1996).
Hence, researchers have been concerned
with how and why such an anomaly has
source down to market inefficiency.
Notably, Fama and French (1992, 1995,
1996, 1998) posit that the value
premium captures a particular type of
systematic risk, which has as its source
the financial distress of the underlying
firm on which the stock is written. As
indicated above, others suggest that the
value premium arises because of market
inefficiencies (for example, Lakonishok et
al., 1994; Haugen and Baker, 1996; La
Porta et al., 1997; Barberis et al., 1998;
Hong and Stein, 1999; Skinner and
Sloan, 2000; Kothari, 2000; Lee and
Swaminathan, 1999; Griffin and
Lemmon, 2001; Daniel et al., 2001) or

䉷 Henry Stewart Publications 1479-179X (2004) Vol. 5, 4, 277–288 Journal of Asset Management 277
Oyefeso
because of random occurrences (see Lo
and MacKinlay, 1988; Breen and
Korajczk, 1995; Kothari et al., 1995);
hence it would not be a reward for risk
taking. The state of the (limited)
empirical literature on this issue remains
controversial, however, providing
academics and professionals with no clear
message on the sources of the anomaly
and hence its implications for portfolio
analysis and management.
Overall, the extant literature on the
value premium is far from converging to
a consensus on what such premium
actually captures, and it is this lack of
consensus that is the motivation for this
paper. In particular, the overall aim of
this paper is to discuss the divergent
views on what drives the value premium.
Doing this will also provide an
up-to-date view on this important issue
of finance.
This paper is organised as follows. The
second section discusses the theoretical
explanations for the value premium,
while the third section considers the
extant empirical literature on the source
of value premium. The final section
summarises and concludes.
Theoretical background of the
value premium
Observable excess returns are not the
only measure of risk available to
researchers, with the value premium
being an additional possible measure of
risk. Essentially, mounting evidence
exists that stock returns can be
predicted by factors that are
inconsistent with the accepted
paradigms of modern theory and
practice of finance. These factors
include the book-to-market ratio
(B/M), earnings-to-price ratio (E/P),
cash flow-to-price ratio (C/P) and
dividend-to-price ratio (D/P), all of
which have been used to predict
278 Journal of Asset Management Vol. 5, 4, 277–288
portfolio returns (see, for example,
Kothari and Shanken, 1997; Pontiff and
Schall, 1998; Fama and French, 1992,
1995, 1996, 1998; Lewellen, 1999).
More specifically, considerable
acceptance now exists, in both the
academic and the institutional investor
communities, that value stocks often
outperform growth stocks. Notably,
scholars including Basu (1977),
DeBondt and Thaler (1985, 1987), Jaffe
et al. (1989), Chan et al. (1991), Fama
and French (1992, 1995, 1996, 1998),
as well as Davis et al. (2000),
Lakonishok et al. (1994), Haugen
(1995) and Kothari and Shanken (1997)
argue that value strategies, which
encourage the purchase of stocks with
low market prices relative to some
measure of fundamental value (eg book
values), will produce returns that
outperform the market. While there is
no consensus view on the source of
the value premium, the explanations
for its presence fall into one of the
following three hypotheses: the rational
or risk-based hypothesis; the irrational
or behavioural hypothesis; and the
random or chance occurrence
argument. It is worth noting, however,
that there is very little evidence to
help decide which of these three
explanations is correct. Supporting this
view, a series of recent papers by Liew
and Vassalou (2000), Vassalou (2000)
and Cooper et al. (2001) provide some
evidence linking the value premium to
variables such as Gross Domestic
Product (GDP) which captures
aggregate macroeconomic risk. Those
researchers above, however, do not
distinguish between competing
hypotheses with regard to the source
of the value premium. The discussion
now turns to these three explanations
and how they help to establish what
the value premium actually captures
and whether this thesis can utilise such
䉷 Henry Stewart Publications 1479-179X (2004)

a measure in order to capture, explain
and measure stock market convergence.
Rational or risk-based explanations of
the value premium
The rational or systematic argument to
explaining the observed value premium
is based on the premise that the value
premium is a proxy for risk associated
with the financial distress in the
economy (see, for example, Fama and
French, 1992, 1993, 1995, 1996, 1998;
Davis et al., 2000). The argument is
that the presence of a value premium
is a rational phenomenon being
compensation for systematic
(non-diversifiable) risk in addition to
that risk captured by the traditional
Capital Asset Pricing Model (CAPM).
Fama and French (1995) and
Lakonishok et al. (1994) show that the
value premium appears to be associated
with the degree of ‘relative distress’ in
the economy. These findings cast doubt
on the validity of the CAPM (see
Sharpe, 1964; Lintner, 1965; Black,
1972), which posits a linear positive
relation between expected return on an
asset and the market risk premium.
Fama and French (1996, 1998) build
on this and argue that, in equilibrium,
the value premium is priced because
there is ‘common variation in the
returns on distressed stocks that is not
explained by the market return’ (Fama
and French, 1998: 1975). In a
weakening economy, investors require a
higher risk premium on firms with
distress characteristics and, conversely,
when the economy is strong, such
characteristics are not so heavily priced.
Since distress stocks perform poorly just
when the investor least wants to hold
a poorly performing stocks, value stocks
must offer a higher average return as a
reward for the extra systematic risk.
The observed higher returns produced
䉷 Henry Stewart Publications 1479-179X (2004)
Literature survey of measurement of risk
by value stocks are therefore justified,
being compensation for the risk borne
by those who invest in value stocks
(see also, Ball, 1978; Keim, 1988;
Berk, 1995).
Irrational or behavioural explanations of
the value premium
Another explanation of the source of the
value premium is the irrational or
behavioural hypothesis (see, for example,
Lakonishok et al., 1994; Haugen, 1995;
Daniel and Titman, 1997). This view
argues that value stocks are underpriced
and, at some point in the future, a
correction or switch in investor
sentiment will raise the price of these
stocks, resulting in value stocks displaying
higher than average returns in the future.
According to this irrational or mispricing
view, the market persistently undervalues
value stocks and overvalues growth
stocks up to horizons of three to five
years (eg Lakonishok et al., 1994;
Haugen and Baker, 1996). This view
therefore, can be associated with the
already extensive literature dealing with
different aspects of irrational investor
behaviour (see, for example, Rosenthal
and Young, 1990; Fama, 1991, 1998;
Bessembinder et al., 1995; Fraser and
McKaig, 1998; Barberis et al., 1998;
Hong and Stein, 1999; Kothari, 2000;
Lee and Swaminathan, 1999; Griffin and
Lemmon, 2001; Hirshleifer, 2001; Daniel
et al., 2001).
Barberis et al. (1998), Hong and Stein
(1999) and Daniel et al. (2001), for
example, hypothesise that mistaken
beliefs cause stock price momentum and
reversals. These models focus on the
psychology of the representative agent in
terms of the dynamics of biased
self-attribution and overconfidence
(Daniel et al., 2001), and conservatism
and representativeness (Barberis et al.,
1998). In Daniel et al. (2001), agents
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Oyefeso
learn about their own competence and
talent in a biased, self-promoting fashion,
but eventually their overconfidence is
eroded by accumulative evidence on
fundamentals. Barberis et al. (1998),
however, suggest that agents mistakenly
view what are actually random walks as
(rare) shifts between continuation
sequences and reversal sequences: agents
overreact to changes in fundamentals
preceded by consistent patterns of good
or bad news (representativeness), as this
trend is expected to continue, but
underreact to news on fundamentals
preceded by many reversals, as the
impact of news is likely to be reversed in
the future (conservatism). Hence, witness
the long periods of over- and
underreaction of stock prices to news on
fundamentals, depending on which
sequence is dominant.2 In comparison,
Hong and Stein (1999) adopt an
approach that focuses on the interaction
between heterogeneous agents, and
shows that initial underreaction to news
on fundamentals creates overreaction by
making it possible for different classes of
momentum traders to enter the market,
which, in turn, is exploited by contrarian
strategies, and correction eventually
occurs at long horizons.
A common strand of irrational models
is the assumption that news is
incorporated only very slowly into prices,
hence the existence of a gradual response
in the reaction to an information signal
and, subsequently, a gradual change in
investor sentiment. In the current
scenario, the implication is that the
market persistently ‘underbuys’ less
glamorous (value) stocks and persistently
‘overbuys’ glamorous (growth) stocks
(see, for example, La Porta et al., 1997;
Skinner and Sloan, 2000). Eventually,
however, agents will realise their
expectation errors and will begin the
process of correcting the mispricing.
Hence it is argued that value strategies
280 Journal of Asset Management Vol. 5, 4, 277–288
tend to pay high abnormal returns over
periods up to five years (see, for
example, Lakonishok et al., 1994;
Haugen and Baker, 1996).
Random or chance occurrence
explanations of the value premium
Finally, there is the data snooping or
chance occurrence argument for the
existence of the value premium. This
view suggests that abnormal value stock
returns exist, not because of rational or
irrational investor behaviour, but owing
to chance, data snooping or data bias (Lo
and MacKinlay, 1990; Breen and
Korajczyk, 1995; Kothari et al., 1995).3
In the words of White (2000)
‘Data snooping occurs when a given set of
data is used more than once for the purpose
of inference or model selection. When such
data reuse occurs, there is always the
possibility that any satisfactory results
obtained may simply be due to chance
rather than to any merit inherent in the
method yielding the results. This problem is
practically unavoidable in the analysis of
time-series data, as typically only a single
history measuring a given phenomenon of
interest is available for analysis.’ (p. 1097)
Whenever a ‘good’ forecasting model is
obtained by extensive specification search,
there is always the danger that the
observed good performance results, not
from actual forecasting ability, but is
instead from luck or chance. Even when
no exploitable forecasting relation exists,
looking long enough and hard enough at
a given set of data will often reveal one or
more forecasting models that look good,
but are in fact useless.4 Data snooping is
also known as data mining. Although data
mining has recently acquired positive
connotations as a means of extracting
valuable relationships from masses of data,
the negative connotations arising from the
ease with which naı̈ve practitioners may
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mistake the spurious for the substantive
are more familiar to econometricians and
statisticians. Leamer (1978, 1983) has been
a leader in pointing out these dangers,
proposing methods for evaluating the
fragility of the relationships obtained by
data mining.
Having discussed the main theoretical
views on the source of the value
premium, the paper continues by
summarising the available empirical
studies on the value premium in the
following section.
Empirical evidence on the
value premium
Rational or risk-based explanations of
the value premium
Fama and French (1993, 1995, 1996,
1998)5 examine returns on market, value
and growth portfolios for the US and 12
major EAFE (Europe, Australia and the
Far East) countries. The US portfolios
use New York Stock Exchange (NYSE),
American Stock Exchange (AMEX) and
Nasdaq stocks with the relevant CRSP
and COMPUSTAT data. Most of the
data for major markets outside the US
are from the electronic version of
Morgan Stanley’s Capital International
Perspectives (MSCI). The 12 countries
they use are all those with MSCI
accounting ratios B/M, E/P, C/P and
D/P for at least ten firms in each
December from 1974 to 1994. Finally,
the authors do not require that the same
firms have data on all ratios.
The authors test whether average
returns are consistent with either an
international CAPM (ICAPM) or a
two-factor ICAPM (or Arbitrage
Pricing Theory – APT) in which
relative distress carries an expected
premium not captured by a stock’s
sensitivity to the global market return.
Thus, they ignore other risk factors
䉷 Henry Stewart Publications 1479-179X (2004)
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that might affect expected returns, and
do not allow for time-varying risk
loadings. The authors commence with
asset pricing tests that attempt to
explain the returns on the global value
and growth portfolios. Subsequently, the
authors use the same models to explain
the returns on the market, value and
growth portfolios of individual
countries. The following model is
adopted:
R ⫺ F ⫽ a ⫹ b[M ⫺ F ] ⫹ e (1)
where R is the dollar return, F is the
US Treasury Bill, M is the dollar
global market return, and e denotes the
white noise error term, while a and b
are parameters of interest. Therefore,
any portfolio’s excess return equals R
minus F. The intercept should be
statistically indistinguishable from zero
(ie a ⫽ 0). Following the estimation of
Equation (1), the results indicate that
an ICAPM cannot explain the average
returns on global value and growth
portfolios because the intercepts for the
four measures of value portfolios are at
least 29 basis points per month above
zero, and the intercepts for the four
measures of growth portfolios are at
least 21 basis points per month below
zero. All the CAPM intercepts for the
global value and growth portfolios are
more than 3.4 standard errors from
zero. Therefore, the ICAPM is
perceived as a ‘poor’ model for global
value and growth returns.
Following from this, the authors
employ a ‘two-factor regression model’
to predict whether the premiums on
global value portfolios and the
discounts on global growth portfolios
are a compensation for risk. The
authors estimate the following model
R ⫺ F ⫽ a ⫹ b[M ⫺ F ]
⫹ c[H ⫺ LB/M ] ⫹ e (2)
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Oyefeso
where HB/M is high B/M (ie value
stocks), LB/M is low B/M (ie growth
stocks), H ⫺ LB/M is the difference
between high and low B/M portfolios
(ie value premium), and c is another
parameter of interest. Other notation
remains as in Equation (1). The results
from estimating Equation (2) show that
the intercept is now zero for all the
portfolios whose returns, R, the authors
seek to explain and therefore, model (2)
is viewed as providing a better
description of the value premium
calculated employing E/P, C/P and D/P
than does the traditional CAPM.
Finally, Fama and French (1998)
discuss the success of the two-factor
regressions in describing the returns on
the global value and growth portfolios
formed on B/M. The authors argue that
the value premium from B/M produces
premiums and discounts that can be
referred to as compensation for a
common risk factor. Further, they
mention that an ICAPM cannot explain
the value premium, but a
one-state-variable ICAPM (or a
two-factor APT) that includes a risk
factor for relative distress captures the
value premium in international returns.
Consequently, the authors conclude that
the superior returns of value portfolios
over growth portfolios are compensation
for the risk missed by the CAPM of
Sharpe (1964) and Lintner (1965).
Hence, they argue that the value
premium is a proxy for a particular type
of risk related to relative financial
distress.
Irrational or behavioural explanations of
the value premium
In explaining returns of value stocks over
glamour stocks, Lakonishok et al. (1994)
are among the scholars who argue the
irrational or behavioural view of the
value premium. Their empirical work
282 Journal of Asset Management Vol. 5, 4, 277–288
utilised returns data from the Center for
Research in Security Prices (CRSP) and
accounting data from COMPUSTAT.
The universe of stocks is the NYSE and
AMEX, with the sample period covering
April 1963 to April 1990. Using
formation strategies that require five years
of past accounting data, the authors look
at portfolios formed every year,
beginning at the end of April 1968.
Stocks are partitioned into ranked decile
portfolios based on their B/M.6
Value-weighted returns for each decile
portfolio are calculated over each of five
years of a subsequent holding period.
The authors adopt a two-variable
classification of value and glamour
portfolios based on expected future
growth, which is represented by B/M.
Stocks are sorted independently by B/M,
and nine intersection portfolios are
formed. The extreme value portfolio
consists of the stocks with low expected
future growth (high B/M), while the
extreme glamour portfolio includes the
stocks with high expected future growth
(low B/M). Lakonishok et al. also
examine the sources of superior returns
of value strategies employing the
three-factor model of Fama and French
(1992).
The findings of this study are
threefold. First, the authors find that a
variety of investment strategies that
involve buying value portfolios appear to
outperform glamour strategies (ie buying
growth portfolios). Secondly, they suggest
that value portfolios outperform the
growth portfolios because the B/M that
measures the value premium (ie the
spread between returns from value
portfolios and returns from growth
portfolios) turns out to be much lower
than in the past, or than the market
expectation. This implies that the market
participants appear to have consistently
overestimated future returns of growth
portfolios relative to value portfolios.
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Consequently, this supports the contrarian
view or the irrational behaviour
hypothesis argued by the authors.
Thirdly, the authors conclude that by
following conventional approaches (eg
mean variance)7 to fundamental risk,
value portfolios do not appear to be
riskier than growth portfolios.
More recently, Gregory et al. (2001)
provided tests of the profitability of value
strategies in the UK stock market for the
period 1975–98. Following the approach
of Lakonishok et al. (1994), the authors
commence with a one-variable
classification of value and glamour (ie
growth) stocks. At the end of June each
year, stocks are partitioned into ranked
decile portfolios based on their B/M,
E/P, C/P and past sales growth (SG).
Value-weighted returns for each decile
portfolio are calculated over each of five
years of a subsequent holding period.
This analysis shows that value stocks
largely outperform glamour stocks during
the holding period. Typically, in the first
year of the holding period, the average
return over the entire sample period for
the extreme value portfolio is around
41.39 per cent, while the average return
for the extreme glamour portfolio is
19.75 per cent, using the B/M measure
of value. These two extreme portfolios
bring about 22.18 per cent difference in
return, while controlling for size reduces
this outperformance to 15.81 per cent.
Subsequently, the authors adopt a
two-variable classification of value and
glamour portfolios based on the expected
future growth, which is represented by
B/M. Stocks are sorted independently by
B/M and nine intersection portfolios are
formed. The extreme value portfolio
consists of the stocks with low expected
future growth (ie high B/M), while the
extreme glamour portfolio includes the
stocks with high expected future growth
(ie low B/M). The analysis supports the
results from the one-variable analysis;
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that is, value stocks significantly
outperform glamour stocks. When B/M
is used as the classification variable, the
difference in the average first year return
between the extreme value portfolio and
the extreme glamour portfolio is 24.62
per cent; while controlling for size
reduces the outperformance to 15.81 per
cent.
Gregory et al. go on to examine the
sources of superior returns of value
strategies. The three-factor model of
Fama and French (1993, 1995, 1998) is
applied to test whether excess returns of
value strategies can be explained by the
three factors (ie B/M, E/P and C/P).
The authors conclude that, while the
three-factor model can successfully
explain the superior return of value
strategies using a one-variable
classification, the model fails fully to
explain the superior return of value
strategies using a two-variable
classification.
Random or chance occurrence
explanations of the value premium
Ball et al. (1995) document issues in
measuring portfolio performance from
the contrarian investment viewpoint.
While contrarian strategies fall into the
‘irrational’ or ‘behaviour’ school of the
determination of the value premium, the
authors suggest that the empirical
evidence supporting such views is flawed
because of data bias. The authors employ
data from December 1925 to December
1984 for NYSE stocks and from June
1962 to June 1984, for AMEX stocks.
Each year they rank all NYSE–AMEX
stocks from the CRSP monthly tapes on
the basis of their buy-and-hold returns
over the preceding five years, denoted as
the ranking period. The 50 stocks ranked
lowest and highest each year are labelled
‘losers’ and ‘winners’. The loser and
winner stocks’ performance is monitored
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Oyefeso
over a five-year post-ranking period.
Ranking periods ending in both
December and June are considered. The
first post-ranking period begins in 1931
and the last in 1984. Thus, there are 54
overlapping ranking and post-ranking
periods, denoted as event years ⫺4 to
⫹5. Finally, they examine both five-year
and annual buy-and-hold post-ranking
returns.
The authors employ the price-quartile
analysis and regression analysis to explore
the relation between price and return.
First, using price-quartile analysis, the
2,700 pooled firm-period observations (ie
50 firms multiplied by 54 periods of five
years each) in each winner and loser
portfolio are ranked on their stock prices
at the end of the 54 ranking periods and
assigned to price-quartile portfolios. The
stocks sorted for the 25th, 50th or 75th
percentile are ranked chronologically
before assigning to quartiles. The first
price-quartile portfolio consists of the 25
per cent lowest-priced stocks. The price
distribution is pooled over both firms
and years similar to prior research (eg
DeBondt and Thaler, 1985, 1987) that
pools the data in order to investigate the
role of low-price loser stocks. Ball et al.
subsequently analyse individual-year data.
Secondly, the regression analysis further
investigates the relationship between
price and post-ranking returns. It is
worthy of note that this regression model
is a replica of Equation (2) above.
Furthermore, abnormal returns and
beta risks in event-years ⫺4 to ⫹5 are
estimated using annual return data. The
technique is based on the argument that
a contrarian portfolio beta should vary in
calendar time, conditional on the realised
market risk premium over the ranking
period. The logic behind this is that if
the realised premium in the period is
positive, the loser portfolio is more likely
to consist of low-beta stocks. Conversely,
if the realised premium is negative, the
284 Journal of Asset Management Vol. 5, 4, 277–288
loser portfolio will contain more
high-beta stocks. Allowing the winner
and loser portfolios’ betas to be a
function of the market return over the
ranking-period and following the same
econometric notation used by the
authors, they estimated the following
model in each event-year ␶ ⫽ ⫺4, . . ., 0,
. . ., 5.
Rpt(␶) ⫽ ␣p(␶) ⫹ ␤p(␶)Rmt
⫹ ␦p(␶)[Rmt(⫺4,0)
⫺ AvgRm]Rmt ⫹ ␧pt(␶) (3)
where Rpt(␶) is the annual buy-and-hold
excess return on portfolio p ⫽ (winner,
loser) in calendar year t and event-year
␶, Rmt is the buy-and-hold
equal-weighted annual excess return on
NYSE–AMEX stocks in calendar year t,
excess returns are obtained by subtracting
the annual return on Treasury Bills, ␣p(␶)
is abnormal return in event-year ␶,
AvgRm is the time-series average of
annual excess returns on the market
index, while Rmt(⫺4,0) is the average
excess return on the market index over
event years ⫺4 to 0 relative to calendar
year t. ␧pt(␶) denotes the random error
term of portfolio in calendar year t and
event-year ␶. The deviation of a
portfolio’s beta in a given calendar year
from its 54-year average beta, ␤p(␶), is
given by the product of ␦p(␶) and the
unexpected market excess return over
the relevant ranking period. This can be
confirmed by substituting AvgRm for
Rmt(⫺4,0) in Equation (3) above. The
corresponding term, ␣p(␶), drops out
leaving ␤p(␶) as the sole coefficient on
Rmt.
The results from the price-quartile
analysis indicate that the average
five-year loser-stock return is 31 per cent
lower for June-end than December-end
periods, even though they share 3.5 of
their 54 years in common. For the
lowest-priced quartile of loser stocks, the
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December–June difference averages 103
per cent. These results are consistent
with the evidence in some related
literature, including Roll (1983),
Lakonishok and Smidt (1984) and Keim
(1989), who argue that
microstructure-related biases in measured
returns are most pronounced at the
calendar year end — which is precisely
when contrarian portfolios typically are
formed.
From the regression analysis, the
average estimated coefficients of
post-ranking returns on past return and
price using the December-end data are:
⫺0.14 (SE ⫽ 0.06) and ⫺0.0094
(SE ⫽ 0.0051), which is consistent with
both past returns and stock price
predicting post-ranking period returns.
Thus, the authors argue that risk
considerations aside, the cross-sectional
behaviour of raw returns is consistent
with both low-price/microstructure and
contrarian effects.
In a like manner, these findings
complement the results from the studies
by Conrad and Kaul (1993) and
Bhardwaj and Brooks (1992), who find
that price and the turn-of-the-year
seasonal in bid-ask prices are the primary
determinants of January returns, and
perhaps are the measured returns from
the contrarian strategies. Using the same
pooled data, Ball et al. (1995) employ
the ‘return across time and securities
technique’ to estimate ‘Jensen alphas’
and, allowing conditional betas to vary
over time, their results point out limited
evidence of positive abnormal
performance for the December-end
contrarian portfolio, but negative
abnormal performance for the June-end
portfolio. Therefore, they conclude that
the lack of evidence of contrarian
profitability for the June-end strategy is
not peculiar to a particular strand of the
CAPM. Measurement problems thus are
apparent in both raw and abnormal
䉷 Henry Stewart Publications 1479-179X (2004)
Literature survey of measurement of risk
five-year buy-and-hold contrarian
portfolio returns. Such problems are
unusually severe for contrarian portfolios,
because they invest in extremely
low-priced ‘loser’ stocks.
The above discussion implies the
existence of microstructure-induced
biases, such as spreads, liquidity and
brokerage costs in measuring raw and
abnormal five-year contrarian portfolio
returns and at the calendar year-end
when contrarian portfolios are formed.
Following from this evidence, the
implication is that an element of bias
may be present in the contrarian
investment strategy.
Further, Chan et al. (1995) present
evidence on whether sample selection
bias explains the difference in returns
between value portfolios and growth
portfolios. The aim of their research is to
match two databases, the stock file from
the CRSP at the University of Chicago,
and the COMPUSTAT file, neither of
which was designed for the purposes of
cross-referencing. Specifically, the authors
explore in detail why missing
observations arise when the CRSP and
COMPUSTAT files are matched, and
they analyse whether these missing
observations are likely to be a source of
selection bias. Additionally, they employ
the quartile analysis similar to Ball et al.
(1995) discussed earlier, to provide
evidence on the performance of B/M
portfolios for CRSP companies that are
missing the required information. For
these tests, they focus on the quartile of
the largest NYSE–AMEX companies,
and truncate the sample period to
1968–91.
The authors’ results indicate that
selection bias in the COMPUSTAT data
due to back-filling is generally not as
severe a problem as some might fear.
The standard procedure of mechanically
matching all NYSE–AMEX firms on the
CRSP and COMPUSTAT files based on
Vol. 5, 4, 277–288 Journal of Asset Management 285
Oyefeso
Cusip identifiers points out that 14.8 per
cent of the CRSP company-years are
missing from COMPUSTAT over the
1968–92 period. As further evidence
against the importance of selection bias,
the returns on NYSE–AMEX domestic
primary companies, about 13.99 per cent
per year, are only slightly different from
the returns on corresponding firms with
COMPUSTAT data, with 14.25 per cent
per year. When the returns on the
CRSP and COMPUSTAT samples are
compared over the 1968–91 period, the
average return for domestic primary
companies on CRSP is only slightly
lower than the return for the
corresponding companies on
COMPUSTAT (13.99 per cent and
14.25 per cent per year, respectively).
Compared with the companies located
on COMPUSTAT, the omitted firms
have relatively higher B/M ratios, but
they also earn higher returns. The
authors therefore conclude that, while
this comparison of returns is free from
any selection bias from back-filling
data, the results do not mean to
underestimate the more general issue of
selection bias.
Conclusion
This paper has presented and discussed
divergent views on the validity of the
observed value premium as a measure of
risk. It has done this in terms of what
such a measure is and its source, as
documented in the existing theoretical
and empirical literature.
Essentially, this paper began the
discussion with a summary of the three
main theories proposed as an explanation
of value premium — the rational,
irrational and random occurrence
hypotheses — and continued with a
review of empirical evidence regarding
the validity of such theories.
Overall, the absence of a firm
286 Journal of Asset Management Vol. 5, 4, 277–288
consensus on the existence of a single
source that drives the value premium
would imply that this issue would
continue to be controversial for
academics and professionals for some
time to come. It is noteworthy, however,
that the literature does not dismiss
outright the presence of risk in the value
premium, although the extent to which
it captures risk is controversial, and the
jury is still out on the nature of risk
inherent in this measure of risk.
Consequently, the value premium as a
proxy for risk is likely to capture a
different type of undiversifiable risk from
that of excess returns. The implication of
this is that future research would be
appropriate to establish whether the value
premium captures a risk similar to the
type inherent in excess returns.
Acknowledgment
The author would like to acknowledge the valuable
comments made by an anonymous referee on a
previous version of this paper.
Notes
1 It is worth noting that the high returns on value
stocks have not been constant over time and there
have been time periods, such as 1992–95, when value
stocks did not outperform growth stocks for most
stock markets (see Siegel, 1998).
2 While the investor would eventually learn the true
random walk model for fundamentals, this would be
a very slow process, with agents finding it difficult to
dispose of pervasive biases such as conservatism and
representativeness (Barberis et al., 1998: 320).
3 Resulting biases and associated ill effects from data
snooping were documented and brought to the
attention of a wide audience by Lo and MacKinlay
(1990).
4 A typical example is the mutual fund or investment
advisory service that includes past performance
information as part of their solicitation. Is the
reported past performance the result of skill or luck?
5 Fama and French (1993, 1996) show that excess
returns to value strategies can be explained by a
three-factor model comprising the market factor and
mimicking portfolios for the B/M and size factors.
After controlling for the loading that each portfolio
has on these three factors, they show that there are
no systematic differences between the returns to value
and growth portfolios, using a range of variables to
define value. Fama and French interpret this as
evidence in favour of the risk-based explanation of
䉷 Henry Stewart Publications 1479-179X (2004)

the value premium, and argue that the mimicking
portfolios for B/M and size reflect undiversifiable
(systematic or market) risk, rather than irrational
mispricing.
6 It is noteworthy that Lakonishok et al. (1994)
additionally partitioned stocks into ranked decile
portfolios using E/P, C/P and SG. The results not
discussed here are similar to the stocks sorted by
book-to-price (B/M).
7 The mean-variance criterion of investment is an
extension to the risk attribute that most investors are
risk averse, choosing less risky investments. The higher
the uncertainty of future returns, the higher the
variance. Therefore, the mean-variance criterion is
used to select those assets with the lowest variance for
the same or higher expected return, or the highest
expected return for the same or lower variance.
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