Does Leverage Explain The Investment Premium?

Research demonstrates that the investment factor has explanatory power for the cross-section of stock returns, with high-investment firms tending to underperform low-investment firms. For example, Kewei Hou, Chen Xue and Lu Zhang, authors of the 2015 paper “Digesting Anomalies: An Investment Approach,” proposed replacing the Fama-French three-factor (market beta, size and value) model with a four-factor model that went a long way toward accounting for many of the anomalies that neither the Fama-French three-factor model nor the Carhart four-factor model (which added momentum as the fourth factor) could explain.

In their model, which Hou, Xue and Zhang call the “q-factor model,” an asset’s expected return in excess of the riskless rate is described by the sensitivity of its return to the returns of four factors: market beta, size, investment (the difference between the return on a portfolio of low-investment stocks and the return on a portfolio of high-investment stocks, or CMA, conservative minus aggressive) and profitability (the difference between the return on a portfolio of high return-on-equity stocks and the return on a portfolio of low return-on-equity stocks, or RMW, robust minus weak).

Eugene Fama and Kenneth French, in their paper “A Five-Factor Asset Pricing Model,” examined the q-factor model and agreed that a four-factor model that excludes the value factor (HML, or high minus low) captures average returns as well as any other four-factor model they considered, and that a five-factor model (adding HML) doesn’t improve the description of average returns over that of the four-factor models. This occurs because the average HML return is captured by HML’s exposure to other factors. Thus, in the five-factor model, HML is redundant for explaining average returns. (see here for an extensive discussion on the factor model debates).

Explanations for the Investment Premium

As with the value premium, there’s a debate about whether the investment factor has a risk-based or behavioral-based explanation. Rational theories suggest that the investment premium reflects firms’ investment decisions—firms invest when they have low leverage and expected stock returns are low (the discount rate is low, making the net present value of the investment higher), whereas firms do not invest when they have high leverage and expected stock returns are high.

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