Digesting Anomalies: An Investment Approach
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.
For helpful comments, we thank René Stulz, MikeWeisbach, IngridWerner, and other seminar participants at The Ohio State University. This paper is a new incarnation of the defunct work previously circulated under the titles "Neoclassical Factors," "An equilibrium three-factor model," "Production-based factors," "A better three-factor model that explains more anomalies," and "An alternative three-factor model." We are extremely grateful to Robert Novy-Marx for identifying a timing error in the empirical analysis of the defunct work. All remaining errors are our own. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.
Kewei Hou & Chen Xue & Lu Zhang, 2015. "Digesting Anomalies: An Investment Approach," Review of Financial Studies, vol 28(3), pages 650-705.