Improving on Fama-French

In 1993, the Fama-French three-factor (beta, size and value) model replaced the single-factor capital asset pricing model (CAPM) and became the standard model in finance, explaining more than 90 percent of the variation of returns of diversified portfolios.

While the model was a big improvement over the CAPM, it couldn’t explain some major anomalies. In 1997, Mark Carhart augmented the three-factor model with a fourth factor: momentum. By addressing one of the biggest anomalies, the momentum factor made a large contribution to the explanatory power of the factor model.

The four-factor model has been the workhorse model since.

But like all models, even the four-factor model had problems—there were many anomalies that it couldn’t explain. Kewei Hou, Chen Xue and Lu Zhang, authors of the September 2012 study, “Digesting Anomalies: An Investment Approach,” proposed a new four-factor model that goes a long way toward explaining many of the anomalies that neither the Fama-French three-factor nor the four-factor models explain.

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