A Five-Factor Asset Pricing Model
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What they found
Two decades after their three-factor model, Fama and French added two more factors motivated by the dividend discount model: profitability (RMW, robust minus weak operating profitability) and investment (CMA, conservative minus aggressive asset growth). On U.S. stocks from 1963 to 2013, the five-factor model explained average returns better than the three-factor version, and the value factor became largely redundant once profitability and investment were included. The model still fails to explain the low returns of small firms that invest heavily despite low profitability.
What you can use
- Profitable companies that grow assets cautiously have earned higher returns than unprofitable, aggressively expanding ones.
- Once you account for profitability and investment, the classic value factor adds little in this sample.
- The model omits momentum entirely, which its critics consider a major gap.
Caveats
The authors' own tests reject the model in some sorts. Factor definitions are somewhat arbitrary and results vary internationally. A free version is on SSRN.
Tags: factor, factor-model, profitability, investment
Summaries are our own reading of the paper, not the authors' words. Educational only, not advice. Discuss it in Book Club.