Abstract

A five-factor model directed at capturing the size, value, profitability, and investment patterns in average stock returns performs better than the three-factor model of Fama and French (FF, 1993). The five-factor model׳s main problem is its failure to capture the low average returns on small stocks whose returns behave like those of firms that invest a lot despite low profitability. The model׳s performance is not sensitive to the way its factors are defined. With the addition of profitability and investment factors, the value factor of the FF three-factor model becomes redundant for describing average returns in the sample we examine.

Scientific Portfolio AI- Generated Summary

The paper “A Five-Factor Asset Pricing Model” by Eugene F Fama and Kenneth R. French presents a comprehensive analysis of the five-factor model and its effectiveness in capturing the size, value, profitability, and investment patterns in average stock returns. The authors compare the five-factor model to the three-factor model of Fama and French and find that the five-factor model performs better in explaining the cross-section of average stock returns.

The five-factor model includes the market factor, size factor, value factor, profitability factor, and investment factor. The market factor captures the common variation in stock returns that is related to the overall market. The size factor captures the difference in returns between small and large stocks. The value factor captures the difference in returns between high and low book-to-market stocks. The profitability factor captures the difference in returns between high and low profitability stocks. The investment factor captures the difference in returns between high and low investment stocks.

The authors find that the five-factor model is able to explain the cross-section of average stock returns better than the three-factor model. The five-factor model has a higher R-squared and a lower pricing error than the three-factor model. The authors also find that the five-factor model is able to explain the returns of small stocks better than the three-factor model. However, the authors note that the five-factor model is not able to fully capture the behavior of small stocks, and that there may be other factors that are important in explaining the returns of small stocks.

The authors also analyze the performance of the value factor in the five-factor model. They find that the addition of the profitability and investment factors to the FF three-factor model improves the performance of the value factor. The authors note that the value factor in the five-factor model is not redundant with the profitability and investment factors, and that the value factor captures a unique source of variation in average stock returns.

Overall, the paper provides a comprehensive analysis of the five-factor model and its effectiveness in explaining the cross-section of average stock returns. The authors find that the five-factor model performs better than the three-factor model, and that the addition of the profitability and investment factors to the FF three-factor model improves the performance of the value factor. The paper provides important insights into the behavior of average stock returns and has important implications for asset pricing theory and practice.