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An Alternative Three-Factor Model

32 Pages Posted: 19 May 2010 Last revised: 21 Jan 2014

Long Chen

Cheung Kong Graduate School of Business

Robert Novy-Marx

Simon Business School, University of Rochester; National Bureau of Economic Research (NBER)

Lu Zhang

Ohio State University - Fisher College of Business; National Bureau of Economic Research (NBER)

Date Written: April 2011

Abstract

A new factor model consisting of the market factor, an investment factor, and a return-on-equity factor is a good start to understanding the cross-section of expected stock returns. Firms will invest a lot when their profitability is high and the cost of capital is low. As such, controlling for profitability, investment should be negatively correlated with expected returns, and controlling for investment, profitability should be positively correlated with expected returns. The new three-factor model reduces the magnitude of the abnormal returns of a wide range of anomalies-based trading strategies, often to insignificance. The model's performance, combined with its economic intuition, suggests that it can be used to obtain expected return estimates in practice.

Keywords: Anomalies, Alphas, Factor Regressions, Asset Pricing Tests

JEL Classification: E44, G12, G14

Suggested Citation

Chen, Long and Novy-Marx, Robert and Zhang, Lu, An Alternative Three-Factor Model (April 2011). Available at SSRN: https://ssrn.com/abstract=1418117 or http://dx.doi.org/10.2139/ssrn.1418117

Long Chen

Cheung Kong Graduate School of Business ( email )

Oriental Plaza, Tower E3
One East Chang An Avenue
Beijing, 100738
China

Robert Novy-Marx

Simon Business School, University of Rochester ( email )

Rochester, NY 14627
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Lu Zhang (Contact Author)

Ohio State University - Fisher College of Business ( email )

2100 Neil Avenue
Columbus, OH 43210-1144
United States
585-267-6250 (Phone)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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