Rethinking Asset Growth in Asset Pricing Models

Measures of asset growth add considerable explanatory power to asset pricing models, but wait, there’s a twist. The formulation for measuring asset growth in risk models, such as the 5-Factor Fama-French (FF5F) or the Hou-Xue-Zhang (HXZ), do not necessarily align with traditional measures of firm investment even though they seem to be a good statistical fit. Accordingly, there is one central question in this research: Is asset growth an appropriate and persuasive indicator for investment activity in asset pricing models? The authors argue persuasively that the asset growth factor widely adopted in risk/return models likely misses the mark. Indeed, the performance of the factor models developed by Hou et al. (2015) and Fama and French (2015) were found to be critically dependent on how each constructs the investment factor.

The Use of Asset Growth in Empirical Asset Pricing Models

• Michael Cooper, Huseyin Gulen, and Mihai Ion
• Journal of Financial Economics
• A version of this paper can be found here
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What are the research questions?

1. Are traditional measures of asset growth appropriate and persuasive indicators for investment activity in asset pricing models?

What are the Academic Insights?

1. IT DEPENDS. The central question addressed by the research is confirmed. While models utilizing asset growth do in fact show strong empirical performance, the performance did not necessarily align with investment behavior defined by theory, but instead appeared more like behavior associated with short-term assets such as inventory and accounts receivable. Tests of the HXZ and FF5F models using alternative investment measures (i.e. capital expenditures) reduced model performance. For example, the Sharpe ratio for the HXZ model exhibited a significant decline of -0.078, when capital expenditures replaced asset growth. Similar results occurred when PPE and measures of intangible capital were used as proxies for asset growth. Two measures made the cut. Inventory and accounts receivable not included in traditional investment measures performed equally as well as asset growth. The authors concluded that asset growth captures unique information that IS unexplained by other traditional measures. A summary of Sharpe ratios obtained from tests of models HXZ and FF5F and various asset growth measures can be found in Table 1 below. Given that subcomponents of growth like inventory and accounts receivable retain model performance, the authors argue that performance actually reflects the dynamics of financing reflected in asset growth and not asset growth itself.

Why does it matter?

The contribution of this research lies in the examination of the theoretical foundations of widely used risk models that explain the cross-sectional behavior of stock returns. If asset growth is an inappropriate proxy for investment, then it is reasonable to assume that other measures will better reflect the underlying growth characteristics in equity securities. Will those measures be identified?

The most important chart in the paper

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained.  Indexes are unmanaged and do not reflect management or trading fees, and one cannot invest directly in an index.

Abstract

We show that the performance of the new factor models of Hou et al. (2015) and Fama and French (2015) depends crucially on how their investment factor is constructed. Both models use growth in total assets to measure investment. Their ability to price the cross-section of returns decreases significantly when the investment factor is constructed using traditional investment measures, or measures that also account for investment in intangibles. In contrast, we find that factors based on growth in inventory and accounts receivable contain the bulk of the pricing information in the asset growth factor. We show evidence that the superior performance of the asset growth factor seems to be attributable to its ability to capture aggregate shocks to equity financing costs.