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Economic Intuitions Behind The Q-Factors

Aug. 15, 2020 9:00 AM ET15 Comments
Larry Swedroe profile picture
Larry Swedroe


  • Intuitively, investment predicts returns because given expected cash flows, high (low) costs of capital mean low (high) net present values of new projects and low (high) investment.
  • Profitability predicts stock returns because high expected cash flows relative to low investment must mean high discount rates.
  • Investment and profitability (ROE) factors are almost totally uncorrelated, meaning that they are independent, or unique.
  • There is a significant correlation between q-factors and shocks in state variables.

In their groundbreaking paper "Digesting Anomalies: An Investment Approach," published in the March 2015 issue of The Review of Financial Studies, Kewei Hou, Chen Xue and Lu Zhang proposed a new four-factor asset pricing model that went a long way toward explaining many of the anomalies that neither the Fama-French three-factor model nor subsequent four-factor models could explain. The authors called their model the " q-factor" model. Specifically, their four factors are:

The market excess return (beta). The difference between the return on a portfolio of small-cap stocks and the return on a portfolio of large-cap stocks (size). The difference between the return on a portfolio of low-investment stocks and the return on a portfolio of high-investment stocks. The difference between the return on a portfolio of high return-on-equity (ROE) stocks and the return on a portfolio of low ROE stocks.

In our book Your Complete Guide to Factor-Based Investing, Andy Berkin and I established five criteria that should be required before you consider allocating to a factor. The criteria are: persistence across long periods of time; pervasiveness across industries, countries, regions and even asset classes; robustness to various definitions; implementability (survives transactions costs); and intuitive risk- or behavioral-based explanations that provide reasons for believing the premium should persist in the future. We prefer risk-based explanations because risk cannot be arbitraged away, although popularity and the resulting cash flows can reduce premiums. However, we are willing to accept behavioral explanations because of limits to arbitrage which, along with the tendency for human behavior to remain unchanged, allow anomalies, such as the poor performance of small growth stocks with high investment and low profitability, to persist.

Intuitive Risk-Based Explanation

Given that one of the five required criteria is having an intuitive explanation for the persistence of the premium (with a preference for

This article was written by

Larry Swedroe profile picture
Larry Swedroe is head of financial and economic research office for Buckingham Wealth Partners,  a Registered Investment Advisor firm in St. Louis, Mo.. Previously, Larry was vice chairman of Prudential Home Mortgage. Larry holds an MBA in finance and investment from NYU, and a bachelor’s degree in finance from Baruch College. To help inform investors about the passive investment approach, he was among the first authors to publish a book that explained passive investing in layman’s terms — The Only Guide to a Winning Investment Strategy You'll Ever Need (1998 and 2005). He has authored seven more books: What Wall Street Doesn't Want You to Know (2001), Rational Investing in Irrational Times (2002), The Successful Investor Today (2003), Wise Investing Made Simple (2007), Wise Investing Made Simpler (2010), The Quest for Alpha (2011), and Think, Act, and Invest Like Warren Buffett (2012). He also co-authored eight books: The Only Guide to a Winning Bond Strategy You’ll Ever Need (2006, with Joe Hempen), The Only Guide to Alternative Investments You’ll Ever Need (2008, with Jared Kizer) and The Only Guide You’ll Ever Need for the Right Financial Plan (2010, with Tiya Lim and Kevin Grogan), Investment Mistakes Even Smart Investors Make (2011, with RC Balaban), The Incredible Shrinking Alpha (2015 and 2020 with Andrew Berkin) Reducing the Risk of Black Swans (2013 and 2018 with Kevin Grogan), Your Complete Guide to a Successful and Secure Retirement (2018 and 2020 with Kevin Grogan), and Your Essential Guide to Sustainable Investing (2022 with Sam Adams). He writes for AdvisorPerspectives.com, AlphaArchitect.com, and TheEvidenceBasedInvestor.com. You can follow him on Twitter  (http://twitter.com/larryswedroe).

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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