Abstract

A three-factor model regime has replaced the CAPM regime in academic research. The CAPM regime may be said to have ended with Fama and French’s (1992) finding that market beta does not predict return. Strangely, the three-factor model has not received scrutiny relative to the ability of the model to predict return and variation in return for portfolios. In this paper we test the ability of the three-factor model to predict return and return variation. We find that portfolios can be formed on the basis of the three-factor that vary with expectations in terms of risk and return. We find, however, that the CAPM performs these goals with greater efficiency. In particular expected returns for extreme portfolios are poor predictors of actual returns. Raising questions about the use of the three-factor model to risk adjust. We dissect the three-factor model’s predictive ability and find that inclusion of the systematic risk variable dealing with the book-to-market ratio distorts predictions and that a model including the market beta and the factor loading dealing with firm size seems to predict more efficiently than either the three-factor model or the CAPM.

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