Paper title: A Fama-MacBeth Analysis of CAPM, the Fama-French Three-Factor Model and the Fama-French Five-Factor Model on 25 Stock Portfolios
Abstract: This paper tests the Capital Asset Pricing Model (CAPM), the Fama-French three-factor model, and the Fama-French five-factor model using 25 size and book-to-market sorted portfolios over the period July 1963 to November 2013 to examine the comparative performance of these well-established asset pricing models in explaining cross-sectional variation of returns. I employ the Fama-MacBeth (1973) methodology to address cross-sectional correlation issues inherent in asset pricing tests. Empirical investigation reveals that market beta alone fails to capture the variation in average returns. In contrast, the Fama-French three-factor model, which incorporates size (SMB) and value (HML) factors alongside market risk, substantially improves explanatory power. Moreover, incorporating two more additional factors, profitability (RMW) and investment (CMA), - known as the Fama-French five-factor model - enhances explanatory power but the improvement is marginal. However, both models have lower root mean square alpha and higher average R-squared compared to CAPM. Fama-MacBeth approach of estimating coefficients confirms that book-to-market equity, profitability, and investment factors exhibit strong explanatory power for stock returns while market beta, and size factors do not sufficiently capture the heterogeneity in stock returns. The diminishing power of the size effect has significant implications for portfolio management strategies based on the size effect. This study corroborates the superiority of the five-factor model over three-factor model and single-factor CAPM in describing the cross-sectional pattern of stock returns for this extended sample period. Keywords: Asset pricing, CAPM, Fama-French three-factor model, Fama-French five-factor model, Fama-MacBeth, Cross-sectional returns, Size effect.
