Prominent Asset Pricing Models and Anomaly Portfolio Returns

The Capital Asset Pricing Model (CAPM) of Treynor (1961, 1962), Sharpe (1964), Lintner (1965), and Mossin (1966) established a new field in finance known as asset pricing. The first general equilibrium model of asset prices, it rapidly became popular with academics and spread to professionals in the financial markets. Even though early empirical evidence was weaker than predicted by theory in terms of the relation between market beta risk and real world stock returns, the CAPM dominated asset pricing for almost three decades and yielded a Nobel Prize in Economics for Sharpe in 1990. But in the 1990s, Fama and French (1992, 1993, 1995, 1996, 1998) published a series of papers that documented extensive empirical evidence using U.S. stock returns over decades that the CAPM did not work—that is, average stock returns were not related to beta. In its place, Fama and French proposed a three-factor model that augmented the market factor with size and value factors. These new factors were intended to explain market anomalies wherein small firms tended to have higher returns than big firms over time and value firms had higher returns than growth firms. To explain these anomalies, they developed innovative long/short portfolios of stocks with small market capitalization minus those with large market capitalization as well as value stocks’ returns minus growth stocks’ returns. Upon adding these long/short portfolios as factors in the three-factor model, the ability to explain stock returns of anomaly portfolios was much improved. Subsequently, as other market anomalies were identified by researchers, asset pricing models advanced to include more long/short portfolio factors. So-called emphmultifactor modelsMultifactor models appeared to be able to explain stock market anomalies. As discussed in Chapter 2 , what happened next was surprising. The number of anomalies identified by researchers exploded into the hundreds and overwhelmed the ability of asset pricing models to keep up with them. While anomalies could be grouped into categories and then factors developed to explain different categories of anomalies, at the time of this writing, the large number of anomalies discovered by researchers are causing major gaps in asset pricing models. Behavioralists propose that psychological explanations can close these major gaps in asset pricing models. However, a fundamental rift is occurring in finance as behavioralists argue investors are not always rational and financial markets not always efficient, whereas asset pricing model researchers assume rational investors and efficient markets. In this chapter we review prominent asset pricing models that help to explain anomaly portfolio returns. In forthcoming chapters, we show that that widely accepted multifactor modelsMultifactor models do not explain hundreds of anomalies’ returns. By contrast, a new model dubbed the ZCAPM by KolariKolari, J.W., Liu, and Zhang (2021)Liu, W. well explains virtually all of these anomalies.