Why Exclude Financial Firms from Quantitative Studies?

Why Exclude Financial Firms from Quantitative Studies?

November 25, 2013 Uncategorized
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(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…


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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.


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  • 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.