Why Exclude Financial Firms from Quantitative Studies?

Why Exclude Financial Firms from Quantitative Studies?

November 25, 2013 Uncategorized
Print Friendly
(Last Updated On: March 1, 2017)

I often get insightful questions from readers.

A recent question was as follows:

…applied works most often exclude Financials and Utilities in their universe under study. You exclude similar constituents in your “valuation horse race” study. Why? Might the inclusion of these sectors materially impact the conclusions?

This is a fair and important question.

First, we actually only exclude financials in our work (this is a mistake in the writing, although, the exclusion of utilities doesn’t affect results).

Second, the primary reason we exclude financials:

  • Because Eugene Fama and Ken French said so
    • We exclude financial firms because the high leverage that is normal for these firms probably does not have the same meaning as for non-financial firms, where high leverage more likely indicates distress
    • See The_Cross-Section_of_Expected_Stock_Returns pg 429 in the “data” section
    • This is the “common practice” in research. This is not a good reason to do something, so we always do our tests with and without financials, however, to stay in line with common practice and to ensure that skewed financials fundamentals data doesn’t drive our results, we exclude them in published and working papers.

Hope that answers any questions folks might have…

Note: This site provides NO information on our value investing ETFs or our momentum investing ETFs. Please refer to this site.

Join thousands of other readers and subscribe to our blog.

Please remember that past performance is not an indicator of future results. Please read our full disclosures. The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Alpha Architect, its affiliates or its employees. This material has been provided to you solely for information and educational purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The factual information set forth herein has been obtained or derived from sources believed by the author and Alpha Architect to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission from Alpha Architect.

Definitions of common statistics used in our analysis are available here (towards the bottom)

About the Author

Wesley R. Gray, Ph.D.

After serving as a Captain in the United States Marine Corps, Dr. Gray earned a PhD, and worked as a finance professor at Drexel University. Dr. Gray’s interest in bridging the research gap between academia and industry led him to found Alpha Architect, an asset management that delivers affordable active exposures for tax-sensitive investors. Dr. Gray has published four books and a number of academic articles. Wes is a regular contributor to multiple industry outlets, to include the following: Wall Street Journal, Forbes, ETF.com, and the CFA Institute. Dr. Gray earned an MBA and a PhD in finance from the University of Chicago and graduated magna cum laude with a BS from The Wharton School of the University of Pennsylvania.

  • Pingback: Monday links: sensational headlines | Abnormal Returns()

  • Pingback: Monday links: sensational headlines | Abnormal Returns | High yield Investment Programs()

  • Hansi

    And in real life trading at big funds we actually don’t exclude them, we treat them differently in the model….

  • Exactly…you need to build some tweaks for financials

  • Steve

    Says who?
    No real difference in O’Shaughnessy’s stuff.
    People In Oz often treat the Material and Real Estate sectors differently, and give (good sounding) reasons for doing so.

    But whether US or Oz, every evidence I’ve seen so far is: value works, momentum works – whether you include or exclude.

  • Steve, this is a great point, in general.
    I was talking specifically to models that require assessments of financial distress and capital position (for example, a bankruptcy prediction model). When speaking to good old fashion cheap/momo stuff you are 100% correct.

  • Vedast Sanxis

    Even if it’s “common practice”, have you tested your strategies on that sector? I’d love to see the results. It’s quite suboptimal to just ignore that sector. And I really doubt using value ratios like Price/Book, Price/Earnings, EVIT/EV doesn’t have any use for the financial sector. Maybe the value premium is smaller, but they should still give an edge.

  • Historically, value certainly works in the sector–without a doubt. The issue is with forensic models that predict bankruptcy/fraud, etc. They are highly skewed for financials in many cases…often saying that the entire industry is bankrupt.

  • James Chan

    Why not utilities?

  • Hi James,
    Updated post to highlight that we actually do include utilities in most our studies. That is an error in the QV manuscript. The results are unaffected with or without utilities, however.