### Perfect Factor Model of U.S. Stock Returns?

**January 12, 2017** - Big Ideas, Equity Premium

How many factors are optimal for modeling future returns of individual stocks? How do these factors relate to conventionally used factors (market, size, value, momentum, investment, profitability…)? In the June 2016 version of their paper entitled “Multifactor Models and the APT: Evidence from a Broad Cross-Section of Stock Returns”, Ilan Cooper, Paulo Maio and Dennis Philip derive mathematically an optimal set of factors for predicting returns of 278 stock portfolios created by sorting U.S. stocks into tenths (deciles) according to 28 market anomalies encompassing aspects of value, momentum, investment, profitability and intangibles. They apply asymptotic principal components analysis to these portfolios to identify the factors. They quantify the premium of each of these factors as the average return spread between extreme deciles of monthly sorts of the 278 source portfolios on the factor. They then examine interactions between this mathematical factor set and several widely used empirical multi-factor models: the Fama-French 3-factor model (market, size, book-to-market); a 4-factor model (adding momentum to the 3-factor model); a second 4-factor model (adding liquidity to the 3-factor-model); a third 4-factor model (market, size, investment, profitability); and, a 5-factor model (adding investment and profitability to the 3-factor model). Using monthly returns for the 278 source stock portfolios during January 1972 through December 2013, *they find that:* Keep Reading