Dividing Value into “Priced” and “Mispriced”

Dividing Value into “Priced” and “Mispriced”

November 3, 2012 Research Insights, Value Investing Research
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(Last Updated On: March 14, 2017)

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:

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

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)

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.