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Press Release 13 June 2005

Popular Investment Strategy Misleads Investors and Costs Over $1 Billion a Year in Excess Fees, Study Says

 

Index mutual funds based on size and value are designed with fallacious circular reasoning and can not be validly said to earn premium expected returns. Such financial products are pseudo-scientific.

 

A scientific study found that the Three-Factor Model for stock pricing, increasingly adopted by investors, contains a fatal fallacy. The Three-Factor Model was originated in 1992 by Eugene F. Fama from the University of Chicago and Kenneth R. French from Dartmouth College.

 

The fatal fallacy is circular reasoning, a/k/a begging the question, in which a premise is taken to be the same as the conclusion to a logical argument. Technically, it is said to be a logically circular type of single-equation simultaneity. Such a circular simultaneity occurs when an identical variable appears on both sides of the model equation, either alone or as part of another variable. Circular reasoning is meaningless and not scientifically valid.

 

"The Three-Factor Model has not been subjected to sufficiently rigorous, open discussion," says author Robert D. Coleman, Ph.D. "Many articles have been published in academic journals in support of the Three-Factor Model and its size and value risk factors, but these journals are not gatekeepers of scientific integrity in finance and financial economics," he adds. The results appear in the Indian Journal of Economics & Business June issue with a special theme of finance.

 

There are equity index mutual funds based on the Three-Factor Model of return and two of its risk factors, size and value. Size is market capitalization, and value is book-to-market equity ratio. According to the econometric model and empirical samples, small-cap high-value or value-style stocks earn long-term average risk-adjusted expected returns higher than large-cap low-value or growth-style stock returns and higher than conventional market benchmark returns.

 

Some of these funds claim to be designed to earn premium expected returns to smallness and to value-style regardless of time and location. Yet the study found that investors in such size and value equity funds earn less than average long-term stock market returns. According to Mr. Coleman, a typical investor loses an estimated $20,000 due to excess asset management fees, and these excess fees are estimated to total more than $1 billion a year.

 

Robert D. Coleman, Ph.D., is a financial economist. He has taught an upper-division finance investment course at Southern Methodist University.

 

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