The winners of the 2024 Hillsdale Investment Management – CFA Society Toronto Research Award are Kodjovi Assoe, PhD, CFA, School of Management, Université du Québec à Montréal; Najah Attig, PhD; and Oumar Sy, PhD, Faculty of Management, Dalhousie University, for their research paper entitled Navigating Canada’s Factor Zoo. 

Asset pricing factors are essential tools for investment managers, providing valuable insights into the underlying drivers of asset returns, security selection, and portfolio construction. Exploration of asset-pricing factors originated in the early 1960s when the capital asset pricing model (CAPM) of William Sharpe, subsequent Nobel Prize winner, and John Lintner posited that only sensitivity to the market factor determines differences in expected returns among financial securities. Empirical research in the 1980s and 1990s challenged this prediction, and Eugene Fama and Kenneth French introduced factors related to firm size and value, resulting in a three-factor asset-pricing model. This was followed by a five-factor model incorporating profitability and investment as additional factors. Since then, asset-pricing research has evolved into a battleground of factor models, each striving to refine our understanding of expected return determination. 

The “Factor Zoo” 

The comparison of different asset-pricing models has recently brought critical empirical attention to determining which factors best explain expected returns. Hundreds of factors have been posited, and the identification of the most pivotal factors is a focal point of ongoing research, debate, and controversy. In his American Finance Association Presidential Address in 2011, US economist John H. Cochrane, author of the book Asset Pricing, termed the plethora of asset-pricing factors the “factor zoo.” 

The award winners’ research delves into the battle of factors in Canadian capital markets, employing spanning tests to evaluate seventeen factors from ten factor models for 1991–2022. It contributes to the literature in this field by providing Canada-based evidence on the relative performance of the major asset-pricing models. 

Their work adds significant value for several reasons: 

1. It focuses on a single country, permitting a more homogeneous sample concerning financial and economic development, legal structure, corporate governance, and industrial structure, which may affect the relevance of factors in expected returns. 
2. Non-US evidence adds value, as existing literature focuses mainly on US data. 
3. International asset-pricing studies tend to overlook the need for country-specific results. For example, blending the Canadian market, which accounts for around 3 percent of the world market, with the world’s largest market in the North American region does not bring out the specifics of the Canadian market because the US data may dominate all the factors. Canadian markets differ significantly from their US counterparts in size, scope, industry structure, corporate governance, and regulatory environment, which may influence market preferences for specific factors. It is noteworthy in this context that ownership concentration is higher in Canadian firms than in US firms, and the Canadian corporate governance regime is perceived as weaker than its US counterpart. These differences may influence market preferences, leading to a valuation discount for equities listed in Canada compared to those cross-listed in the US and Canada. 

A six-factor model proves effective for pricing in Canadian markets 

Overall, the award winners’ analysis of a wide-ranging set of old and new factors reveals the prominence of a six-factor asset-pricing model (SFPM) for explaining asset return behaviour in Canada. This SFPM effectively prices Canadian securities, combining market, size, monthly updated value, return on equity, expected growth, and post-earnings announcement drift (PEAD) factors. Robustness tests confirm the non-redundancy of these factors in explaining Canadian returns. The SFPM emerges as the top performer in explaining documented anomalies in the Canadian markets, outperforming other available models in most metrics. While it fails to explain the extreme return differentials of portfolios sorted by value, it contributes significantly to defining the profitability of market anomalies in Canada. 

The researchers’ findings highlight the value of the newly proposed factor models in capturing unique market dynamics and emphasize the need for a comprehensive asset-pricing approach tailored to the Canadian market. Their conclusions carry significant implications for investors, emphasizing the importance of a diversified approach to factor investing, incorporating timely information into investment decisions, and considering the impact of construction methods on factor estimation and significance. 

A valuable tool for navigating the complexities of the Canadian markets 

The SFPM, designed with practitioners in mind, offers practical applicability by incorporating relevant factors essential for effective asset pricing in Canada. It serves as a valuable tool for investors navigating the complexities of the Canadian market, albeit with considerations for real-world implementation challenges. By integrating factors from various models, their study demonstrates the importance of combining factors to provide a more comprehensive understanding of stock market intricacies. The study adds to the literature by providing insights into the relevance of and interactions among prominent factors. This emphasizes the need to assess the performance of asset-pricing models in diverse contexts and underscores the value of combining factors from different models to encapsulate stock market intricacies. This understanding is crucial for researchers seeking to construct comprehensive models and practitioners aiming to develop effective investment strategies in diverse financial environments. Future research will undoubtedly explore additional factors and refine existing models to further enhance our understanding of asset-pricing dynamics in various contexts. The award judging panel commended the high quality of the award winners’ academic research and cited it for being both “actionable” and “Canadian market specific.” 

Chris Guthrie, CFA, CEO of Hillsdale Investment Management, commented, “With test results from 1991 to 2022, this award-winning paper provides an excellent reminder of the skills required to successfully navigate all equity markets today. Attention to local market conditions, knowledge of investor preferences, frequent updates of valuation data, determination of relevancy, as well as both model diversity and parsimony are just a few of the highlights of the authors’ findings. Most importantly, many traditional factors once thought to be drivers of Canadian equities are shown to be subsumed over this recent time period. Truly a must-read for any Canadian equity manager or manager of managers.”