Dividing Value into “Priced” and “Mispriced”
Gerakos and Linnainmaa have a new paper out:
Here is code to perform the decomposition:
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 consists of a priced and unpriced component, leading multi-factor models to assign spurious alphas to strategies that covary with the unpriced component. Portfolio managers can exploit the unpriced component—a portfolio long the “true” and short the “false” value strategy has an annual three factor model alpha of 7.7%. The unpriced component also distorts inferences regarding known anomalies. Five-year changes in the market value of equity provide a better measure of value: they spread returns more than BE/ME ratios and are free of the unpriced component.
Some finance chart porn:
Value is still an anomaly–just matters how you slice and dice it.
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Definitions of common statistics used in our analysis are available here (towards the bottom)