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The Unpriced Side of Value

Juhani Linnainmaa, University of Chicago - Booth School of Business

7th Dec 2012  11:30 am - Boardroom - Darlington Center

Book-to-market (BE/ME) ratios explain variation in expected returns because they correlate with recent changes in the market value of equity. Although the remaining variation in BE/ME ratios captures comovement among stocks, it does not predict returns. Therefore, the HML factor consists of a priced and unpriced component, leading multi-factor models to assign spurious alphas to strategies that covary with the unpriced component. Portfolio managers can exploit the unpriced component--a portfolio long the "true" and short the "false" value strategy has an annual three-factor model alpha of 7.7%. The unpriced component also distorts inferences regarding known anomalies. Five-year changes in the market value of equity provide a better measure of value: they spread returns more than BE/ME ratios and are free of the unpriced component.