A Better Three-Factor Model that Explains More Anomalies

Abstract:     
A new three-factor model consisting of the market factor and common factors formed on investment and return on assets goes a long way in summarizing the cross-sectional variation of expected stock returns. The model substantially outperforms traditional asset pricing models in describing average returns across testing portfolios formed on short-term prior returns, financial distress, net stock issues, asset growth, and earnings surprises. The model also performs roughly as well as the Fama-French model in accounting for average returns across portfolios formed on valuation ratios, industry, and CAPM betas. The model's performance, combined with its economic intuition, suggests that it can be used to obtain expected return estimates in practice.

Keywords: Anomalies, alpha, q-theory, factor regression, investment-based asset pricing

JEL Classifications: E44, G12, G14

Accepted Paper Series