Factor Models and the Growth of Asset Pricing Anomalies

Summary

The note asks whether traditional factor models become less adequate as markets grow more complex and new return patterns emerge. It cites the Fama-French three-factor model, which captures broad cross-sectional return patterns in the mid-1990s but does not explain momentum or a range of later documented anomalies.

The proposed implication is that researchers may need an expanding set of factors to describe stock returns. This is posed as a question rather than established through new analysis: the note offers no tests distinguishing genuine market complexity from changes in research methods, data, or anomaly discovery. Readers should treat the idea of a continually growing factor set as a hypothesis, not a demonstrated conclusion.

Key ideas

• The note questions whether older factor models remain adequate as markets evolve.
• The Fama-French three-factor model is described as leaving momentum and later anomalies unexplained.
• An expanding factor set is proposed as a possible response to increasingly complex return patterns.
• The document raises the issue without testing the cause or necessity of factor growth.

Tags

# Are factor models playing a chasing game?


# Are factor models playing a chasing game?












Might be an obvious question (and taking inspiration from Digesting Anomalies: An Investment Approach by Hou et al. (2014, RFS)), but are factor models playing a chasing game?

In the paper, the authors write the following paragraph:

In a highly influential article, Fama and French (1996) show that, except for momentum, their 3-factor model, which consists of the market factor, a factor based on market equity (small-minus-big, SMB), and a factor based on book-to-market equity (high-minus-low, HML), summarizes the cross section of average stock returns as of the mid-1990s. Over the past 2 decades, however, it has become clear that the Fama-French model fails to account for a wide array of asset pricing anomalies.

Is it possible that as we progress through time, financial markets become more complex and therefore factor models (of the old) become insufficient to explain the cross-section of returns (and new asset pricing anomalies that appear in these returns as a result)?

Therefore, we can always expect a growing factor zoo to be necessary to meaningfully capture the cross-section of returns.

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.