Impacts of Frictions on Factor Models of Stock Returns

How much does accounting for equity factor portfolio maintenance frictions affect usefulness of factor models of stock returns. In their March 2021 paper entitled “Model Selection with Transaction Costs”, Andrew Detzel, Robert Novy-Marx and Mihail Velikov examine effects of transaction costs on six leading models of stock returns:

1. FF5 – Fama-French 5-factor model (market, size, book-to-market , investment and accruals-based profitability, reformed annually).
2. FF6 – FF5 plus a momentum factor.
3. HXZ4 – Hou, Xue, and Zhang 4-factor model (market, size, investment and profitability, all reformed monthly).
4. BS6 – Barillas-Shanken 6-factor model (market, size, book-to-market reformed monthly, investment, return on equity and momentum).
5. FF5_C – FF5 with a cash flow-based profitability factor.
6. FF6_C – FF6 with a cash flow-based profitability factor.

They compare model effectiveness based on maximum squared Sharpe ratio (SR²), which measures how closely a model approaches the in-sample efficient frontier for all test assets. They measure transaction costs using stock-level effective bid-ask spread. Using data to calculate all factors employed by the six models and effective spreads during January 1972 through December 2017, they find that: (more…)