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Fama and French [2015] proposed a new five-factor asset pricing model, which succeeded their highly influential (Fama and French [1993]) three-factor model. The three-factor model has strongly shaped thinking about asset pricing for more than 20 years, and every finance student is required to know and understand the model. Calculating alphas using the three-factor model has become standard practice in the asset pricing literature. Professor Fama even received the Nobel Prize in Economics for his contributions to this field. The new Fama and French model aims to explain some prominent and pervasive patterns in the cross section of stock returns that their three-factor model could not. The authors do not proclaim their new model to be the last word on asset pricing or suggest that it fully explains stock returns, but, for practical purposes, the five-factor model is likely to become the new benchmark in asset pricing in the years to come.
The three-factor model was inspired by Fama and French [1992], who found strong evidence for the existence of size and value premiums in the cross section of stock returns. Fama and French [1993] argued that these factors capture a dimension of systematic risk that is not captured by market beta in the capital asset pricing model (CAPM) and proposed to extend the CAPM with size (small minus big [SMB]) and value (high minus low [HML]) factors, resulting in a three-factor model. Since then, it has become common practice in the asset pricing literature to report not only one-factor alphas but also three-factor alphas. However, many such studies report three-factor alphas that are significantly different from zero, which suggests that the three-factor model is incomplete and that more factors are needed to accurately describe the cross section of stock returns.
Inspired by the mounting evidence that three factors will not suffice, Fama and French [2015] proposed augmenting their three-factor model with two additional factors, namely profitability (robust minus weak [RMW]) and investment (conservative minus aggressive [CMA]). This new five-factor model significantly raises the bar for new anomalies. Fama and French [2016a] argued that it effectively addresses the main shortcomings of the three-factor model.
We fully acknowledge that the five-factor model represents a significant step forward compared to the three-factor model, however, we argue that...