An Alternative Three-Factor Model

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