Monday, December 15, 2014

Level, Slope and Curve Factor Model - What's this all about?

John Cochrane recently blogged about my paper.  My co-blogger asked me to explain it a little more, and I realized that a lot is lost if you aren't deep into the finance jargon.  Additionally, what's the deeper significance of the whole endeavor.  Here is an attempt to explain my goal and interpretation in a broader context.

First, let me define a "factor." A factor is just meant to describe common movements across stocks. All technology stocks go up together when there is some good news about the tech industry. All energy stocks go down together on some bad energy news (maybe lower world energy demand). The goal is to stop describing a stock as "Ford" and start describing it as a combination of factors.

The factors we really care about aren't things like industries. We want to understand the "priced" risk factors. These are the factors that represent risk to investors. I can diversify my exposure to ups and downs in tech or industry or automotives by just buying lots stocks. So we don't expect any higher returns to holding tech stocks.

Additionally, it turns out there are lots of things that predict stock returns.  For instance, certain characteristics of companies: small companies have higher returns than large companies, "cheap" companies have higher returns than expensive companies. Each of these are associated with factors. Small stocks go up and down together and to some degree move opposite large stocks. Cheap stocks go up and down and to some degree move opposite expensive stocks.

The literature now is postulating more and more possible risk factors.  In contrast,  I am arguing a lot of those factors are manifestations of three main risk factors level, slope and curve. Here's what I do. I use all of these characteristics and I sort stocks into "high return" stocks and "low return" stocks. I sort into 25 portfolios. The 25th portfolio we expect to have really high returns. The 1st we expect to have really low returns. The factors describe how those portfolios move relative to each other.

Level describes that stocks go up and down together. This has been known for 50 years or more. On good economic news all stocks go up, on bad economic news all stocks go down. The most common model of risk, the CAPM, basically describes all stocks risk as how much they go up and down with the overall market.

The "slope factor" describes that high return stocks and low return stocks often move opposite of one another. (I think) It means that whatever risk high return stocks are exposed to changes over time. Sometimes investors need to be compensated a lot to hold risky high return stocks (with high expected returns), sometimes not so much.

The "curve factor" describes that sometimes high return stocks and low return stocks go up or down together, while medium return stocks don't even move. The curve factor is the hardest to interpret. It may be related to the volatility of the slope factor above, but that's kind of speculative.

So now I can describe every stock as some manifestation of level, slope and curve. Yesterday, I needed theories to describe hundreds of priced factors. Now I only need theories to describe THREE!!! That's pretty good. And since we've been explaining level for years, we really just have two. So, I don't know why high return stocks and low return stocks move opposite each other, maybe some risk factor, as in these companies will do badly in bad times, maybe these stocks are susceptible to fits of irrational exuberance. But if I can explain level, slope and curve, I can explain why some stocks have higher returns than others.