Fair Value Indexation: A Holistic Factor Approach to Asset Pricing, Smart-Beta Value Premium 2.0

Abstract

Empirical literature on value and growth style investing finds value style investing to be a favorable long-term investment strategy. But the value premium, as explained by Basu [1977] and Fama and French [1992], has been subject to important criticism. For example, Peters [1991], Estrada [2005], and Penman and Reggiani [2013a] argued that value and growth investment strategies should not be viewed as mutually exclusive. Their contention further earns credibility when academics fail to explain the value premium in value stocks. In this article, the authors argue that the value premium puzzle is a result of the lack of a valid asset pricing model. They show that that the key problem that lies behind the value premium puzzle is related to standard risk measures and thus related to the discount rate. They further show that investment style biases can be avoided by estimating a fair value that not only considers economic size metrics, but also controls for individual stocks’ heterogeneous risk and reward characteristics independent from market price. The authors introduce fair value indexation, designed to avoid systematic biases not just in capitalization-weighted indexes but also in traditional style and fundamentally weighted indexes, while delivering improved long-term risk adjusted returns of very similar liquidity and capacity as capitalization-weighted equity market indexes.

TOPICS: Style investing, portfolio theory