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An Alternative Three-Factor Model Explained

Last Updated on 10 February, 2024 by Rejaul Karim

The paper “An Alternative Three-Factor Model” by Long Chen, Robert Novy-Marx, and Lu Zhang introduces a novel factor model that encompasses the market factor, an investment factor, and a return-on-equity factor to better comprehend the cross-section of expected stock returns.

The authors suggest that firms tend to invest more when profitability is high, and the cost of capital is low. Therefore, controlling for profitability, investment should hold a negative correlation with expected returns, while controlling for investment, profitability should display a positive correlation with expected returns.

This innovative three-factor model successfully reduces the abnormal returns of numerous anomalies-based trading strategies, often rendering them insignificant. The combination of the model’s efficacy and its strong economic rationale indicates its potential as a practical tool for generating expected return estimates, providing valuable insights for investors and researchers in the field of asset pricing.

Abstract Of Paper

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.

Original paper – Download PDF

Here you can download the PDF and original paper of An Alternative Three-Factor Model.

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Author

Long Chen
Cheung Kong Graduate School of Business; Luohan Academy

Robert Novy-Marx
Simon Business School, University of Rochester; National Bureau of Economic Research (NBER)

Lu Zhang
Ohio State University – Fisher College of Business; National Bureau of Economic Research (NBER)

Conclusion

In conclusion, the paper “An Alternative Three-Factor Model” by Long Chen, Robert Novy-Marx, and Lu Zhang introduces a groundbreaking factor model that incorporates the market factor, investment factor, and return-on-equity factor to enhance the understanding of the cross-section of expected stock returns.

The relationships between profitability, investment, and expected returns are carefully analyzed, leading to valuable insights into how firms invest under varying levels of profitability and cost of capital. The new three-factor model successfully diminishes the abnormal returns typically associated with multiple anomalies-based trading strategies, often to the point of insignificance.

The performance of this model, paired with its economic underpinnings, supports its potential for practical applications in deriving expected return estimates. This innovative approach presents a significant contribution to the field of asset pricing, providing a solid foundation for future research and investment strategy development.

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FAQ

Q1: What does the three-factor model introduced by Long Chen, Robert Novy-Marx, and Lu Zhang encompass, and how does it contribute to understanding expected stock returns?

The three-factor model includes the market factor, an investment factor, and a return-on-equity factor. It enhances the comprehension of expected stock returns by considering the relationships between profitability, investment, and expected returns. The model is designed to capture how firms invest based on varying levels of profitability and cost of capital.

Q2: How does the three-factor model perform in reducing abnormal returns associated with anomalies-based trading strategies, and what does this imply for its practical applications?

The new three-factor model successfully diminishes the abnormal returns of various anomalies-based trading strategies, often rendering them insignificant. This suggests the model’s efficacy in providing more accurate expected return estimates. The reduction in abnormal returns highlights its potential practical application for investors and researchers in the field of asset pricing.

Q3: What economic rationale supports the design and effectiveness of the three-factor model, and how does it contribute to the understanding of firm behavior in relation to profitability and investment?

The authors propose that firms tend to invest more when profitability is high and the cost of capital is low. Controlling for profitability, the model suggests that investment should be negatively correlated with expected returns, and controlling for investment, profitability should be positively correlated with expected returns. This economic rationale aligns with observed firm behavior and contributes valuable insights into how the model can be used to understand and estimate expected stock returns in practice.

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