Digesting Anomalies: An Investment Approach

Kewei Hou, Chen Xue, Lu Zhang

NBER Working Paper No. 18435
Issued in October 2012
NBER Program(s):   AP   CF   EFG

Motivated from investment-based asset pricing, we propose a new factor model consisting of the market factor, a size factor, an investment factor, and a return on equity factor. The new factor model outperforms the Carhart four-factor model in pricing portfolios formed on earnings surprise, idiosyncratic volatility, financial distress, net stock issues, composite issuance, as well as on investment and return on equity. The new model performs similarly as the Carhart model in pricing portfolios formed on size and momentum, abnormal corporate investment, as well as on size and book-to-market, but underperforms in pricing the total accrual deciles. The new model's performance, combined with its clear economic intuition, suggests that it can be used as a new workhorse model for academic research and investment management practice.

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This paper was revised on November 1, 2012

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Document Object Identifier (DOI): 10.3386/w18435

Published: Digesting Anomalies: An Investment Approach Kewei Hou, Chen Xue and Lu Zhang Rev. Financ. Stud. (2015) 28 (3): 650-705. doi: 10.1093/rfs/hhu068 First published online: September 26, 2014

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