A revised comparison between FF five-factor model and three-factor model,based on China's A-share market

TL;DR

This paper empirically compares the FF five-factor model and the three-factor model using China's stock data from 2005 to 2020, demonstrating the five-factor model's superior explanatory power for excess returns.

Contribution

It provides a comprehensive empirical analysis of the five-factor model's effectiveness in China's stock market, including orthogonalization of factors and detailed explanations of their significance.

Findings

HML and CMA factors remain significant in many portfolios

The five-factor model better explains excess returns than the three-factor model

Analysis of China's market policies and investor behavior supports the model's relevance

Abstract

In allusion to some contradicting results in existing research, this paper selects China's latest stock data from 2005 to 2020 for empirical analysis. By choosing this periods' data, we avoid the periods of China's significant stock market reforms to reduce the impact of the government's policy on the factor effect. In this paper, the redundant factors (HML, CMA) are orthogonalized, and the regression analysis of 5*5 portfolio of Size-B/M and Size-Inv is carried out with these two orthogonalized factors. It found that the HML and the CMA are still significant in many portfolios, indicating that they have a strong explanatory ability, which is also consistent with the results of GRS test. All these show that the five-factor model has a better ability to explain the excess return rate. In the concrete analysis, this paper uses the methods of the five-factor 25-group portfolio returns calculation, the five-factor regression analysis, the orthogonal treatment, the five-factor 25-group regression and the GRS test to more comprehensively explain the excellent explanatory ability of the five-factor model to the excess return. Then, we analyze the possible reasons for the strong explanatory ability of the HML, CMA and RMW from the aspects of price to book ratio, turnover rate and correlation coefficient. We also give a detailed explanation of the results, and analyze the changes of China's stock market policy and investors' investment style recent years. Finally, this paper attempts to put forward some useful suggestions on the development of asset pricing model and China's stock market.