Market-to-book Ratio in Stochastic Portfolio Theory

TL;DR

This paper explores how market-to-book ratios influence portfolio performance within Stochastic Portfolio Theory, introducing new functionally generated portfolios that incorporate book values and demonstrating their empirical relevance.

Contribution

It develops novel functionally generated portfolios based on auxiliary variables like book values, revealing the impact of the value factor on portfolio returns.

Findings

Value factor affects portfolio performance.

Empirical evidence supports the significance of book values.

Portfolios incorporating book values outperform size-only portfolios.

Abstract

We study market-to-book ratios of stocks in the context of Stochastic Portfolio Theory. Functionally generated portfolios that depend on auxiliary economic variables other than relative capitalizations ("sizes") are developed in two ways, together with their relative returns with respect to the market. This enables us to identify the value factor (i.e., market-to-book ratio) in returns of such generated portfolios when the auxiliary variables are stocks' book values. Examples of portfolios, as well as their empirical results, are given, with the evidence that, in addition to size, the value factor does affect the performance of the portfolio.