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A REVIEW of EFFICIENT MARKETS HYPOTHESIS: an ANALYSIS of EUGENE FAMA and KEN FRENCH's RESEARCH by Austin N. Hughey Submitted

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A REVIEW of EFFICIENT MARKETS HYPOTHESIS: an ANALYSIS of EUGENE FAMA and KEN FRENCH's RESEARCH by Austin N. Hughey Submitted A REVIEW OF EFFICIENT MARKETS HYPOTHESIS: AN ANALYSIS OF EUGENE FAMA AND KEN FRENCH’S RESEARCH by Austin N. Hughey Submitted in partial fulfillment of the requirements for Departmental Honors in the Department of Finance Texas Christian University Fort Worth, Texas May 4, 2015 ii A REVIEW OF EFFICIENT MARKETS HYPOTHESIS: AN ANALYSIS OF EUGENE FAMA AND KEN FRENCH’S RESEARCH Project Approved: Supervising Professor: Steven Mann, Ph.D. Department of Finance Larry Lockwood, Ph.D. Department of Finance Silda Nikaj, Ph.D. Department of Economics iv ABSTRACT The field of Finance has moved from the single factor model first created by Sharpe in 1964, into modern day with the Fama-French five-factor model. Each step in the chronology of empirically tested models of equilibrium adds more risky variables in an attempt to understand exactly how, we as humans, price risky assets. Each superseding model seems to offer more explanatory power, but how strong are the variables realistically and is it possible to achieve outperformance on the basis of these variables alone? This paper will test the research presented by Eugene Fama and Kenneth French in an attempt to understand if markets truly are efficient, or if it is possible to achieve statistically significant returns, implying consistent mispricing prevalent in the market. v TABLE OF CONTENTS INTRODUCTION .............................................................................................................. 1 REVIEW OF LITERATURE ............................................................................................. 4 Fama-French Literature .............................................................................................. 4 Non-Fama French Literature ...................................................................................... 7 Rational Model: ......................................................................................................... 7 Behavioral Model: ..................................................................................................... 9 CURRENT APPLICATIONS OF FAMA-FRENCH RESEARCH ................................. 15 Dimensional Fund Advisors ....................................................................................... 15 DFA Fund Return Analysis: .................................................................................. 17 Factor Definitions........................................................................................................ 19 FACTOR PORTFOLIO PERFORMANCE ..................................................................... 20 Portfolios formed on Be/Me ....................................................................................... 21 Value Weight Portfolios: ........................................................................................ 21 Equal Weight Portfolios: ........................................................................................ 22 Portfolios formed on Size and Be/Me ........................................................................ 23 Value Weight Portfolios: ........................................................................................ 23 Equal Weight Portfolios: ........................................................................................ 24 Portfolios formed on Dividend Yield......................................................................... 24 v Value Weight Portfolios: ........................................................................................ 25 Equal Weight Portfolios: ........................................................................................ 25 CONCLUSION ................................................................................................................. 26 APPENDIX A: VALUE WEIGHT PORTFOLIOS FORMED ON BE / ME .................. 27 APPENDIX B: VALUE WEIGHT PORTFOLIOS FORMED ON BE / ME .................. 28 APPENDIX C: EQUAL WEIGHT PORTFOLIOS FORMED ON BE/ME .................... 29 APPENDIX D: EQUAL WEIGHT PORTFOLIOS FORMED ON BE/ME .................... 30 APPENDIX E: VALUE WEIGHT PORTFOLIOS FORMED ON SIZE AND BE/ME . 31 APPENDIX F: VALUE WEIGHT PORTFOLIOS FORMED ON SIZE AND BE/ME . 32 APPENDIX G: EQUAL WEIGHT PORTFOLIOS FORMED ON SIZE AND BE/ME 33 APPENDIX H: EQUAL WEIGHT PORTFOLIOS FORMED ON SIZE AND BE/ME 34 APPENDIX I: VALUE WEIGHT PORTFOLIOS FORMED ON DIVIDEND YIELD . 35 APPENDIX J: VALUE WEIGHT PORTFOLIOS FORMED ON DIVIDEND YIELD . 36 APPENDIX K: EQUAL WEIGHT PORTFOLIOS FORMED ON DIVIDEND YIELD 37 APPENDIX L: EQUAL WEIGHT PORTFOLIOS FORMED ON DIVIDEND YIELD 38 APPENDIX M: DFA FUND RETURNS COMPARED TO BENCHMARKS ............... 39 APPENDIX N: ALL PORTFOLIOS T-TEST VALUES ................................................. 40 REFERENCES ................................................................................................................. 41 1 INTRODUCTION Arguably no two individuals have contributed more to the field of finance than Eugene Fama and Kenneth French over the past 40 years. Eugene Fama is even referred to by many as the “father of modern finance,” largely because of his work establishing the efficient markets hypothesis and his development of models of market equilibrium. After the advent of the Capital Asset Pricing Model in 1964 and the Efficient Markets Hypothesis in 1970, the field of finance began researching and improving upon the established rational models of market equilibrium. The result was the introduction of an increasing amount of risk factors into the models. These factors claim to have solved a fundamental question in finance, how we as humans accurately assess risk, and therefore value, of risky assets. Fama (1970) sets the foundation for the efficient markets hypothesis (“EMH”), a theory stating information is continuously and instantaneously embedded into the price of securities at any given time. This theory implies that all humans are perfectly logical and rational decision makers. The primary implication of the EMH is outsized returns on the market are impossible, making activist investing obsolete. While Fama states markets are efficient in this work, he simultaneously claims efficient markets can never be disproven unless you can disprove the model for market equilibrium, which he himself designed. This theory is known as the joint hypothesis theory. The original model for market equilibrium actually came before Fama’s marquee work on EMH with Sharpe’s (1964) work on the Capital-Asset Pricing Model (“CAPM”), a now industry and educational standard for assessing the discount rate on 2 equity. He did so by proposing an equation that is strictly a linear function of risk, based fundamentally on the risky variable, Beta. By obtaining a beta, one is able to measure the riskiness of an asset relative to the overall market. A riskier asset requires a higher required rate of return to compensate for the enhanced risk. The Capital Asset Pricing Model was not perfect however. Individuals have been pricing on the basis of other variables beyond simply beta. This drove Fama and French to expand off their previous work. Fama and French elaborated on CAPM in Fama and French (1993) with the well- known Fama-French 3-factor model. The two added factors are size and value. This three-factor approach is known as an empirical approach. In other words, Fama and French worked backwards to reveal which variables explain the shortcomings in the traditional CAPM model. Interestingly, Fama essentially discounts his previous work with Fama (1993) claiming to generate outsized returns based on companies with good Price/Book ratios, although under the strong and the semi-strong from of the efficient markets theory Fama proposed, that is impossible. Carhart (1997) further expands on the 3-Factor model with the introduction of the 4-Factor model, which contains an additional monthly momentum factor. The monthly momentum factor (“MOM”) is calculated as the long prior-month winners and short prior-month losers. The basic definition of momentum in regards to equity pricing is a stock with positive momentum has been rising and is therefore expected to carry momentum and continue rising. While negative momentum is a stock that has been declining and is expected to continue to decline, based on market trading prices. 3 Fama and French reignited their efforts recently with their working paper Fama- French (2013) by adding yet another risky variable to their new factor model. Believing the 4-factor model was incomplete, Fama and French introduced a differing fourth factor, profitability, and a new fifth factor, investment. By adding an ever increasing amount of risky variables into previous models of market equilibrium, Fama and French are working in risky variables strictly through backwards empirical testing, rather than offering any concrete theory as to why the variables themselves are risky. Recently, even the father of modern finance has addressed competing schools of thought, such as the growing field of behavioral finance. One of the most famous authors combatting the traditional claims of Fama and French, Robert Shiller, actually shared the 2013 Nobel Prize in Economic Studies with Eugene Fama and Lars Hansen. In Shiller (2013), Shiller suggests another approach focusing on departures from rational investor behavior, known as behavioral finance. Behavioral finance takes into account institutional restrictions, such as borrowing limits, which prevent smart investors from trading against any mispricing in the market. Suggesting our current
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