The Unwavering Presence of Equity Factors in Financial Markets
A significant portion of the industry invests based on factors such as value, momentum, and low-risk. In this blog post, we will delve into the fascinating results of our study on out-of-sample equity factors over a lengthy and economically crucial period. By analyzing data from 1866 to the 2020s, we aim to debunk concerns about data mining and performance decay of these factors, showcasing their resilience and longevity in financial markets.
Addressing Data Mining Concerns
Our study was motivated by the lack of comprehensive research on factor premiums, particularly using out-of-sample data. Most studies on equity factors rely on samples dating back to the 1980s or 1990s, providing a limited statistical perspective. Additionally, concerns have surfaced regarding the validity of factors discovered through extensive testing, posing a risk to investors. This underscores the need for independent out-of-sample tests to ensure the reliability of equity factors.
Figure 1 highlights the test statistics for size, value, momentum, and low-risk factors during in-sample and out-of-sample periods within the CRSP era. While factors appear significant during the in-sample period, their performance varies in subsequent out-of-sample periods. This underscores the importance of conducting out-of-sample tests in a significant sample size.
Stock Markets in the 19th Century
Before delving into our key findings, it’s essential to understand the US stock market in the 19th century. The period from 1866 to 1926 witnessed rapid industrial development and economic growth, positioning the United States as a global economic powerhouse. Stock markets played a pivotal role in advancing economic growth and innovation financing, setting the stage for future prosperity.
Similar to the 20th century, equities in the 19th century were actively traded across exchanges, facilitating robust market activity and liquidity. Technological advancements such as the telegraph and ticker tape revolutionized market operations, leading to efficient price discovery and trading. This historical context provides a unique out-of-sample testing ground for factor premiums.
The Pre-CRSP Equity Dataset
Constructing our dataset required meticulous effort, collecting stock returns and characteristics of major stocks since 1866. By extending the dataset beyond the CRSP era, we obtained a comprehensive view of equity factors in a previously unexplored period. This high-quality dataset covers approximately 1,500 listed stocks, allowing for a robust analysis of factor premiums.
Eternal Out-of-Sample Performance of Factors
Our research reveals compelling out-of-sample results from the 1866-1926 pre-CRSP period, demonstrating the stability of factor premiums over time. Figure 2 showcases the alpha of established equity factors in the CRSP and pre-CRSP periods, revealing consistent premiums that are both economically and statistically significant. These results affirm the enduring nature and reliability of equity factors, offering lucrative investment opportunities for informed investors.
Ultimately, our study confirms that factor premiums are a timeless feature of financial markets, persisting for over 150 years. Investors can gain confidence in the robustness of these premiums, leveraging them to craft effective investment strategies.