Applied Economics

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Panel data analysis of multi-factor capital asset

pricing models

Tariro Makwasha, Jill Wright & Param Silvapulle

To cite this article: Tariro Makwasha, Jill Wright & Param Silvapulle (2019): Panel
data analysis of multi-factor capital asset pricing models, Applied Economics, DOI:
10.1080/00036846.2019.1619019

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APPLIED ECONOMICS
https://doi.org/10.1080/00036846.2019.1619019

Panel data analysis of multi-factor capital asset pricing models

Tariro Makwashaa, Jill Wrightb and Param Silvapulleb
a
Industry Capability Network, Melbourne Vic, Australia; bDepartment of Econometrics and Business Statistics, Monash Business School,
Melbourne Vic, Australia

ABSTRACT KEYWORDS
In this article, we propose MFCAPM panel models with fixed effects and test theories associated Multi-factors; time fixed
with risk exposures and anomalies postulated by Fama and French, and we assess their out-of- effects; volatility risk; risk
sample predictive performances. Based on the portfolios formed by French, we construct 10 exposure; predictability
panel models, each consisting of 10 portfolios grouped by size deciles, and another 10 panels by JEL CLASSIFICATION
value deciles. In the presence of cross-section dependence, the MFCAPM panel model is esti- C33; G11; G12
mated by the feasible generalized least squares (FGLS) method for the sample period 1963(1)-
2018(9). The results show that the market, firm-size and value risk exposures are significant and
robust across three-, five- and six-factor panel models. Significant time-fixed effects indicate that
there are several portfolios resilient to dot.com bubble peak in 2000, while some others resilient
to GFC in 2007. We estimate the models for the in-sample period 1963(1)–1999(12) and generate
the out-of-sample portfolio returns for the period 2000(1)–2018(9). We find that portfolio returns
forecasts generated by the six-factor panel model are superior to other MFCAPM panel models,
mostly due to the momentum factor (investor behaviour) explaining large return variations and
volatility exposures. The findings have implications for investors, security traders and portfolio
risk managers.

I. Introduction French (1996) found that the three-factor model suc-

cessfully explains the returns variations of the 25
The capital asset pricing model (CAPM), which is
portfolios sorted by size and book-to-market, and
also known as beta pricing model, advocated by
this three-factor model has been widely used in resol-
Sharp (1964), Lintner (1965) and Black, Jenson and
ving various expected return puzzles and empirical
Scholes (1972), is central to portfolio management,
irregularities.
risk management, capital budgeting applications and
Part B shows that the time-fixed effects for size-
trading of securities. In this simple one-factor model,
sorted panels are largely positive. Even during the
the expected return in excess of risk-free interest rate
dot.com crisis peak in 2000, the time fixed effects
is assumed to be linearly related to the expected excess
of several panels are strongly positive indicating
return on market portfolio of all risky assets. Since the
that these panels did not weigh heavily on tech-
inception of this model, testing for the validity of the
nology stocks, except for the Panel S5 which has
CAPM has been one of the most researched topics in
the negative time-fixed effects. Surprisingly, dur-
the empirical finance literature. However, several stu-
ing the GFC around 2007, a similar pattern
dies found anomalies where the size and firm specific
emerges, although two of the size-sorted Panels
characteristics such as leverage, dividend-yield, earn-
S1 and S9 showed significantly negative time
ing-to-price ratio and book-to-market ratio explain
fixed effects.
the asset returns variations (see, e.g. Banz 1981; Fama
Moreover, Novy-Marx (2013) and TiTman,
and French 1992). To accommodate these anomaly
Wei, and Xie (2004) found that the three-factor
effects, Fama and French (1993, 1996) introduced the
model is incomplete because its factors miss most
model with three factors, namely, returns on market,
of the variations in average returns associated with
returns on a small minus big (SMB) portfolio, and
profitability and investment. This finding, along
returns on a high minus low (HML) portfolio.
with the dividend discount model, motivated
Subsequently, several studies including Fama and

CONTACT Param Silvapulle param.silvapulle@monash.edu Department of Econometrics and Business Statistics, Monash Business School, Melbourne
Vic, Australia
© 2019 Informa UK Limited, trading as Taylor & Francis Group
2 T. MAKWASHA ET AL.
Fama and French (2015) to propose the five-factor
model by adding profitability and investment fac-
tors to the popular three-factor model. For
a diversified portfolio of US equities, the five-
factor model explained about 95% of the variation
of returns. This, however, does not mean that
a passive fund manager should robotically buy
the securities that meet the fund’s parameters
and sell the securities that no longer meet the
parameters. Jegadeesh and Titman (1993) intro-
duced a factor known as momentum, the tendency
of securities that have outperformed (or under-
performed) the market over a 3- to 12-month
period to continue to outperform (or underper-
form) the market. In other words, momentum is
the tendency of past winners to keep winning and
past losers to keep losing relative to their peers.
Unlike the other factors, momentum has no ade-
quate risk-based explanation, but there is
a possible behavioural explanation of under-
reaction to new information. Fama and French
(2012) found that momentum is present in all
the major international markets except for Japan.
In this article, we propose MFCAPM panel
models with fixed effects and tests the theories
associated with risk exposures and anomalies
hypothesised by Fama and French (1993, 2012,
2015). We construct 10 panel models with each
panel consisting of 10 portfolios sorted by size,
and then study the results by forming 10 panels
based on the same 100 portfolios but sorted by
value. Furthermore, under the panel MFCAPM,
we study the three-, five- and six-factor models;
see the section on Data description for details.
Additionally, we include the idiosyncratic volatili-
ties of portfolios and estimate the volatility risk
exposures. The predictive performances of the
MFCAPM panel models are also assessed based
on their ability to generate out-of-sample portfolio
return forecasts.
This article contributes significantly to the
empirical MFCAPM literature by employing
a panel data modelling framework to study the
multifactor models. The panel data approach to
MFCAPM has several advantages over the widely
studied univariate multifactor modelling: (i) we
1
If the cross-section size is large (N > 20), then the method developed by Pesaran (2006) is applicable. The simulation study presented in this article indicates
that if the cross-section size is 20 or less, then Pesaran’s method does not work regardless of the length of the time series.
include annual time-fixed effects in the panel
models to capture the effects of market-wide
events such as crises and financial regulations on
portfolio returns. Soja, Tham, and Wang (2018)
present theoretical and empirical evidence to show
that in the absence of time fixed effects the panel
model parameter estimates are inconsistent and
inefficient; (ii) the panel model use much more
data (cross-section and time series) than the uni-
variate counterparts; (iii) the presence of cross-
section dependence among portfolios in the
panel model can be taken into account in the
estimation which improves estimates of factor
risk exposures; and (iv) multi-collinearity problem
encountered in the univariate models due to high-
correlation among factors (Fama and French
2015) would not arise in the panel models; see
Hsiao (2014, Chapter 1). As the cross section
dependence among portfolios is present, we esti-
mate the panel models of N = 10 by the FGLS
method.1
Although the Fama-French models were tested
across different time periods, a few studies exam-
ined their strength and validity during crises (see,
e.g. Jagannathan and Wang 1996; Petkova 2011).
Our study aims to evaluate the sensitivity of the
factor models to the dot-com crisis peaked in 2000
and the GFC in 2007, through the time fixed
effects and the models’ ability to generate out-of-
sample return forecasts around these crises.
Recently, Fama and French (2016) investigated
several anomalies in the five-factor model but
identified in the literature as creating problems
also in the three-factor model. These anomalies
include volatility, momentum, net share issues
and accruals. Our study determines whether the
multi-factor models adequately capture the varia-
bility in average returns on portfolios sorted on
the additional factors such as size and value. Fama
and French (1993, 1996, 1998, 2015) used univari-
ate time series specifications to study these mod-
els, which were estimated by the OLS method.
Several studies have also applied quantile regres-
sion and generalised method of moments (Allen
and Singh 2011; Faff 2004) to overcome the pro-
blems associated with the three-factor CAPM

model. However, there is limited literature on the
use of panel data models for testing the three-
factor model and extensions (see, e.g. Serlenga
et al. [2002]).
The study by Fama and French (2016) shows
that HML becomes weak and redundant in the
presence of momentum factor, mostly due to
these two factors being highly correlated. As dis-
cussed in a previous paragraph, such problems
would not arise in our study as we employ multi-
factor panel models.
This article is organised as follows. The next
section provides a brief review of literature.
Section 3 describes the multifactor panel models,
estimation and forecasting methods. Section 4
describes the data series used in this study.
Section 5 reports MFCAPM panel model estimates
and the forecasts and analyses the results. Section
6 concludes the article. The results are reported in
tables and graphs.
II. A brief review of the literature
Since the 1960s, several extensions of CAPM
model have been developed to explain variations
in expected asset returns. Explaining and under-
standing why these differences occur is fundamen-
tal to investor portfolio selection, portfolio
management and financial asset pricing models.
A large part of the literature focuses mostly on one
class of asset pricing models, namely linear beta
factor models. These models are based on the
assumption that the average excess asset/portfolio
returns are explained by the levels of exposures of
systematic (market) risk, and size and value risks.
Examples of these models include the single-factor
CAPM, the three-factor and its extensions to five-
factor models and others.
The CAPM states that the differences in
expected asset returns are fully explained by the
differences in betas, which indicate exposures to
systematic market risk (Lintner 1965; Markowitz
1959; Sharpe 1964). This implies that high beta
stocks are risky and investors will only purchase
them if they are associated with higher returns.
Subsequent improvements to the single-factor
CAPM were made by Fama and French (1992,
1993; 1995) based on evidence from Banz (1981)
citing a significant size effect, from Basu (1977)
APPLIED ECONOMICS 3
identifying a value effect using earnings-price ratio
as the proxy for value, and from Chan and Chen
(1991) on the presence of relative distress risk in
explaining differences in asset/portfolio returns.
Fama and French (1992) argued that the systema-
tic market risk explains some of the differences in
excess asset returns but not all and reported
a significant firm size effect (market equity, ME)
and value effect (BE/ME). This seminal work led
to the Fama-French three-factor model.
The widely accepted three-factor model states
that the variability in expected excess asset returns
across stock portfolios is a result of market, size
and value risk factors. The size, defined as market
capitalisation or equity (ME), is measured as stock
price times the number of stocks at the end of
June in year t. In this context, ‘small’ refers to
stocks with small market capitalisation, while
‘big’ refers to those with large market capitalisa-
tion. The book-to-market equity ratio compares
a firm’s book value (book equity, BE) to its market
equity (ME), which is calculated as the ratio of the
most recent BE to ME for the same period
(December of year t
1).
Empirical evidence showed that value stocks
(stocks with high book-to-market) have higher
returns than growth stocks (stocks with low book-
to-market), while small stocks have higher returns
than larger stocks (Fama and French 1992, 1996).
This evidence justified the inclusion of a size and
value proxies in the three-factor model.
Building on the single-factor CAPM, size and
book-to-market equity ratio were added to form
five-factor model defined as:
Rit
RFt ¼ ai þ bi ½RMt
RFt  þ si SMBt
þ hi HMLt þ eit ; t
¼ 1; . . . ; Tfori ¼ 1; . . . ; N
where Rit
RFt is the excess asset return at time
t (in months), RFt is the one-month risk free US
treasury bill, RMt
RFt is excess return on the
market portfolio at time t. RMt is the monthly
returns on the market portfolio, SMBt is a proxy
for the size risk (small minus big firm size), HMLt
proxy for the value risk, (high minus low book-to-
market equity ratio), and bi , si , and hi represent
the exposures to portfolio returns i of excess mar-
ket risk, size risk and value risk respectively.
4 T. MAKWASHA ET AL.
Generally, the above model is estimated by OLS to
find risk exposures of three factors to N assets’
returns separately using univariate time series
models.
Following the success of the Fama-French
three-factor model in explaining the variation in
stock returns, several studies tested the signifi-
cance of the factors in both the US and global
context at different time periods. The primary
aim of these studies was to determine the signifi-
cance and magnitude of the risk exposures asso-
ciated with three factors. Over time, there has
been evidence in support of the Fama-French
three-factor model in the United States, the
United Kingdom, Australia and across Europe.
However, there is conflicting evidence on the
magnitude, significance and economic interpreta-
tions of the factors included in the model. Kothari,
Shanken, and Sloan (1995) identified differences
in the strength of the book-to-market factor expo-
sure over time. MacKinlay (1995) suggests that
stock characteristics, not risks, are priced in the
cross-section of average returns and therefore the
risk-based the three-factor model does not hold.
Black (1993) and Kothari, Shanken, and Sloan
(1995) argue that the performance of the Fama-
French three-factor model is data specific and
susceptible to survival bias, while other studies
showed sensitivities to modelling approaches
(Black 1993; Clare, Priestley, and Thomas 1997;
Jagannathan and Wang 1996).
Fama and French (2015) augmented the three-
factor model with two additional factors, profit-
ability and investment, based on evidence from
research findings by Chen, Novy-Marx, and
Zhang (2011). Additionally, Chan and Chen
1991) find that the three-factor model fails to
capture some of the variation in asset returns
due to profitability and investment. This finding,
along with the explanation of the relationship
between profitability, investment and expected
returns outlined in the dividend discount
model, motivated the development of the five-
factor model. The five-factor model aims to cap-
ture the exposures of firm size, stock value
(book-to-market equity ratio) risks, as well as
the profitability and investment risk exposures
on average asset returns. The Fama-French five-
factor model is specified as:
Rit
RFt ¼ ai þ bi ½RMt
RFt  þ si SMBt þ hi HMLt
þ ri RMWt þ ci CMAt þ eit
where the additional factor RMWt (robust minus
weak) is the portfolios mimicking return differences
between robust profitability stocks and weak profit-
ability stocks at time t and CMAt (conservative minus
aggressive) is the return difference between conserva-
tive investment firms (low capital investment) and
aggressive investment firms (high capital investment)
at time t. The related risk exposures are ri and ci
respectively. The profitability measure is a proxy for
operating profitability, whereas the annual growth
rate of total assets is a proxy for investment. In this
framework, Fama and French (2015) used univariate
time series analysis to evaluate the effect and strength
of the five-factor model in explaining asset returns
variations. They use data from NYSE, AMEX and
NASDAQ for the period 1963–2013.
Moreover, Fama and French (2015) analysed the
sensitivity of the models to factor construction. This is
achieved through several approaches such as portfo-
lios formed on size, book-to-market and operating
profitability; portfolios formed on size, book-to-
market and investment; and portfolios formed on
size, operating profitability and investment. The size
breakpoint, similar to the three-factor model, is the
NYSE median market capitalisation, while the profit-
ability and investment factors are constructed in
a similar manner to the HML factor in the three-
factor model; see Fama and French (2015) for details.
The largest improvement was evident in portfolios
formed on size, operating profitability and invest-
ment. The authors explained that this is likely to be
attributable to the fact that these variables were not
targeted in the three-factor model. This finding sug-
gests a three-factor model will perform poorly if
applied to a portfolio with strong profitability and
investments. Our article uses the currently popular
panel data modelling approach to investigate risk
exposures arising from various factors to portfolio
returns.
Methodology
In this section, we specify fixed effects panel
MFCAPM models, define the dependent and
explanatory variables, and then state assumptions
associated with fixed effects panel models. We also

briefly discuss the estimation method and the
diagnostic tests for checking the violation of
assumptions about the error term.
We consider the three-factor panel model,
Rit
RFt ¼ αi þ λt þ b½RMt
RFt  þ sSMBt
þ hHMLt þ v^ σit þ εit ;
where t ¼ 1; . . . ; T and i ¼ 1; . . . ; N; αi is the
cross-section fixed effect and λt is the yearly time
fixed effects. In this setting, the number of time fixed
effects will be reduced to the integer part of T/12.
That is, t* = 1,2,3,. . .[T/12], and σ^it is the idiosyn-
cratic volatility of excess portfolio return i, and ν is
the volatility risk exposure (Bakshi and Kapadia
2003; Ang et al., 2006). The volatility is estimated
from the EGARCH(1,1) process:


 εit
1
ln σ 2it ¼ δ0 þ γ1 ln σ 2it
1 þ δ1 pffiffiffiffiffiffiffiffiffi
" σ 2it
1
rffiffiffi#
jεit
1 j 2 homoscedastic and finite (see, e.g. Hsiao (2014)
þ δ2 pffiffiffiffiffiffiffiffiffi

σ it
1
2 π
The EGARCH process was proposed by Nelson
(1991). In the EGARCH model, the conditional
variance σ 2it is an asymmetric function of lagged
disturbances.
The first four variables and the corresponding
coefficients in the above model are defined in the
previous section. The error term eit is i.i.d. with con-
stant variance. To explain the panel data estimation
methodology, we introduce the notation X4,it =
{½RMt
RFt ; SMBt ; HMLt ; σ^it }, and write the
dependent variable yit = [Rit
RFt ; and the four
dimensional parameter vector Θ4 = {b, s, h, ν}.
Then, the extended three-factor model can be
written as:
0
yit ¼ αi þ λt þ Θ 4 X4;it þ εit : (1)
The Fama-French five-factor model specified as:
Rit
RFt ¼ αi þ λt þ b½RMt
RFt  þ si SMBt
þ hi HMLt þ ri RMWt þ ci CMAt
þ v^σ it þ eit
where the extra factors RMW and CMA in the
above model are defined in the previous section.
Let X6,it = {X4,it, RMWt, CMAt} and Θ6 = {Θ4, r, c}.
The extended five-factor model can be writ-
ten as:
APPLIED ECONOMICS 5
0
yit ¼ αi þ λt þ Θ 6 X6;it þ εit : (2)
Fama-French six-factor model is defined as:
Rit
RFt ¼ αi þ λt þ b½RMt
RFt  þ si SMBt
þ hi HMLt þ ri RMWt þ ci CMAt
þ wi WMLt þ v^ σ it þ eit
where the extra term WML is defined in the sec-
tion on Data Description. Let X7,it = {X6,it, WMLt}
and Θ7 = {Θ6, w}.
Thus, the extended six-factor model can be
written as:
0
yit ¼ αi þ λt þ Θ 7 X7;it þ εit (3)
We assume that E½εit jXit  ¼ 0, where Xit are either
deterministic and bounded or satisfy certain
moment conditions, the error terms are cross-
sectional independent, serially uncorrelated and
the conditional variance of the error term is
and Baltagi (2008a) for further details).
In line with the literature, we use our panel model
framework to test the sizes and the signs of risk
exposures associated with the Fama-French factors,
as well as the idiosyncratic volatility factor. We also
test the significance of the annual time fixed effects
on returns across the sample period. In particular,
we investigate whether the major crises such as the
dot.com and the GFC impacted portfolio returns.
Diagnostic tests
The panel models are estimated by the least squares
dummy variable (LSDV) method first, using the data
described in the next section. Then, diagnostic checks
are carried out on the residuals. As N = 10 for all
panel models, Breusch-Pagan LM test results indicate
the presence of cross sectional dependence in all 20
panel models. Additionally, the results of Breusch
Godfrey/Wooldridge LM and Breusch Pagan LM
test respectively indicate the presence of serial corre-
lation and heteroscedasticity in all panel models; see
Breusch (1978), Breusch and Pagan (1980), Godfrey
(1978), and Wooldridge (2002) for details. Therefore,
to obtain consistent and efficient panel model esti-
mates, the FGLS method is used for estimating the
panel models. A method proposed by Beck and Katz
(1995) is used to obtain the panel corrected standard
errors (PCSE).
6 T. MAKWASHA ET AL.

Feasible generalised least squares (FGLS) estimation To generate h-months ahead out of sample fore-
method cast, consider the estimated MFCAPM panel
In the presence of significant cross-section depen- model:
dence, we apply the FGLS method, which is a two-
stage approach to estimation of fixed effects panel ^yiTþh ¼ α ^ h ¼ 1; 2; ::::; M:
^i þ ^λTþh þ XiT 0 β;
model. In the first stage, the model is estimated by where M is the total number of monthly out-of-
the LSDV method to obtain consistent but ineffi- sample forecasts. To define the annual time fixed
cient model estimates. Then, we estimate the var- effects in generating forecasts, we consider
iance-covariance matrix, Ω, of residuals. In h* = 1,2,. . .,M/12 and, if M is not a multiple of
the second stage, the estimate of Ω is used to 12, then it is the integer part.
obtain the GLS estimator of β. Thus, it is known
as the FGLS estimation method. ^εiTþh ¼ yiTþh
^yiTþh ; h ¼ 1; 2; ::::; M:
To explain the FGLS estimator, consider the The MAE and RMSE respectively are defined as
panel model, follows:
0
yit ¼ αi þ λt þ Θ 7 X7;it þ εit ; i ¼ 1; 2; . . . ; N; t 1 XN X M
¼ 1; 2; . . . ; T; and t  ¼ 1; 2; . . . ; ½T=12 MAE ¼ jbεiTþh j; h ¼ 1; 2; ::::; M:
MN i¼1 h¼1
(4)
vffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
To simplify the explanation of the estimation u N M
1 uX X 2
method, we re-specify the above model as follows: RMSE ¼ t bε iTþh ; h ¼ 1; 2; &::; M
MN I¼L h¼1
0
yit ¼ β Xit þ εit : (5)
For assessing the out-of-sample forecasting perfor-
where β is the set of parameters and Xit is the set mance of the MFCAPM models, we consider in-
of all the variables in model (4). The LSDV esti- sample period 1963(1)–1999(12) for estimation,
mator is: and out-of-sample period 2000(1)–2016(9) for
!
1 forecasting. This sample split is attractive as the
XN X T
^
β ¼  it
XÞ
ððXit
XÞðX  Þ out-of-sample-forecasting performances of the
LSDV
i¼1 t¼1 models can be assessed around crises such as
X
N X
T dot.com crisis in 2000, GFC in 2007 and EU
 it
yÞÞ
ððXit
XÞðy debt crisis in 2009.
i¼1 t¼1 We use the rolling windows method to generate
Define the estimate of error variance-covariance 1-step ahead out-of-sample portfolio returns predic-
b where bε is the vector of
matrix as, covð^ε^ε0 Þ ¼ Ω; tions. We estimate the fixed effects panel model for
residuals. This variance-covariance matrix is then the in-sample period 1963(1) −1999(12) by FGLS and
used to obtain the FGLS estimator of β as follows: generate forecasts for the period 2000(1)–2018(9).
! The forecasting performance of the MFCAPM panel
XN X T 

1

1 models were assessed using the MAE and RMSE
^
β ¼  Ω
ðXit
XÞ ^ ðXit
XÞ

FGLS measures; see Baltagi (2008b) for details.
i¼1 t¼1
X T 
N X 

1
 ^ 
ðXit
XÞΩ ðyit
yÞ Data description
i¼1 t¼1
The monthly data used in this study covers
1963(1)–2018(9). The performance of the panel
Assessing out-of-sample forecasting performance MFCAPM is tested, using 100 Fama-French port-
Recall the model (3) with fixed effects clearly folios sorted on size and book-to-market. The
specified, portfolios are constructed at the end of June
each year, and include intersections of 10 portfo-
yit ¼ αi þ λt þ Xit 0 β þ εit
lios formed on size which is measured by market

equity (ME) and 10 portfolios formed on book-to-
market equity ratio (BE/ME), a proxy for value.
The size breakpoints for year t are the NYSE
market equity deciles at the end of June. The
book-to-market is the book equity for the last
financial year t–1 divided by ME for December
of t–1. The value breakpoints are NYSE deciles
(French 2016c).
In order to define appropriate factors for the
three-factor model, Fama and French use sorts to
allocate NYSE, AMEX and NASDAQ stocks into
two size and three book-to-market groups. The size
breakpoint is the median NYSE market equity at the
end of each financial year, so that big stocks are
those above the median and small are below
(French 2016b). The low book-to-market (growth)
stocks are below the 30th percentile value for NYSE
firms, the median (neutral) are the medium 40 per-
cent and the high book-to-market (value) stocks are
in the highest 30 percent of NYSE firms as shown in
the table below. This can be summarised as follows:
Percentiles for definition of Fama-French factors
Book-to-market equity Size (breakpoint is median of NYSE market
ratio equity)
Small Big
Lowest 30% (Low) Small and Low (SL) Big and Low (BL)
Medium 40% (Median) Small and Median Big and Median
(SM) (BM)
Highest 30% (High) Small and High (SH) Big and High (BH)
Thus six value-weighted portfolios are defined.
For example, SL is the value-weighted return on
the stocks with size below the NYSE median, and
book-to-market in the bottom 30 percent. Similar
definitions apply for SM, SH, BL, BM, BH.
Explanatory variables in MFCAPM panel models
In the three-factor model, factors are defined as:
The size effect, small minus big (SMBt) is
defined as:
SMBt ¼ ðSL þ SM þ SH Þ=3

ðBL þ BM þ BH Þ=3
The value proxy, high minus low (HMLt) is
defined as:
HMLt ¼ ðSH þ BH Þ=2
ðSL þ BLÞ=2
APPLIED ECONOMICS 7
The market excess return (RM-RF) is the excess
return of all listed firms on the NYSE, AMEX or
NASDAQ.
In the five-factor panel model, we also take
account of operating profitability (OP) and invest-
ment (INV). In this case, the SMBt factor is
defined as:


SMBt ¼ SMBðBE=MEÞ þ SMBðOPÞ þ SMBðINV Þ =3
where the three different components of SMB
relate to sorting by size and each of BE/ME, OP
and INV respectively. Details of the definitions of
the components can be found in French (2016b).
The HMLt factor is similar in construction to that
in the three-factor model.
The factor RMWt = Robust minus Weak profit-
ability) relates to a portfolio formed from sorting
by size and operating profitability. The factor
CMAt = Conservative minus Aggressive invest-
ment relates to a portfolio formed from sorting
by size and investment (see French 2016a for
further discussion).
Momentum
The momentum factor is defined as the expected
return on the two high prior returns, or ‘winner’
portfolios: small and winners (SW) and big and
winners (BW), minus the two low prior returns or
‘loser’ portfolios: small and losers (SL) and big and
losers (BL):
WMLt ¼ ðSW þ BW Þ=2
ðSL þ BLÞ=2
The construction of the momentum factor is dis-
cussed in details in Fama and French (2016).
Panel of portfolios construction
In order to evaluate the performance of fixed effects
MFCAPM panel models with three, five and six
factors as well as the portfolio-specific volatility
risk, we consider 100 portfolios constructed by
Fama and French as intersections of size (ME) and
book-to-market (BE/ME) deciles. In this study, 10
panels are formed as follows. The 10 portfolios
within the lowest size decile form Panel S1, those
within the subsequent decile form Panel S2 and so
on up to Panel S10. French (2016c) excludes the
firms with negative book equity from the portfolios
and provides justification. Thus, the size increases
8 T. MAKWASHA ET AL.
across the Panel S1 to Panel S10, and each individual
panel consists of 10 portfolios ranging from low
book-to-market to high book-to-market. This
implies that the portfolio book-to-market categories
within an individual panel range from low to high
book-to-market, while the size decile is constant in
each panel. The panels sorted on size are referred to
as Panels S1–S10.
To assess the sensitivity of model performance to
size panel construction, another set of 10 panels,
Panels V1–V10, are also similarly constructed by
reversing the roles of ME and BE/ME. In this case,
for example Panel V1 consists of 10 portfolios all
containing stocks in the lowest book-to-market dec-
ile, with each portfolio corresponding to a different
size decile. Panels V1–V10 are referred to as panels
sorted on value (or BE/ME).
The dependent variable is the excess monthly
portfolio returns (Rit – RFt) where Rit is the
returns on portfolio i and RFt is the risk-free
interest rate. We estimate the panel model (5)
with the sets of X variables to include fixed effects,
three, five and six factors as well as the returns
volatilities, constituting three-, five- and six-factor
panel models. Thus, three sets of models were
estimated for all Panels S1–S10 and Panels V1–
V10. Moreover, we find some missing data for
Panels V9 and V10 from 1965(10)–1967(7) and
1968–1969 up to the late 1990s. Therefore, we
estimated unbalanced panels.
III. Empirical results and analysis
The panel models are estimated by the FGLS
method, with panel corrected standard errors
(PCSE); the details are given in the section on meth-
odology. Tables 1–6 report the estimates of factor
risk exposures. Tables 7 and 8 report the MAE and
RMSE estimates for assessing the out-of-sample pre-
dictive performance of panel models. Moreover,
Figures 1–6 Parts A show the plots of line-graphs
indicating the trends of these exposures across the
Table 1. Estimates of risk premiums of three-factor (size-panel) models with individual and time fixed effects and volatility risk.
Factors Panel S1 Panel S2 Panel S3 Panel S4
Volatility risk 0.410 −0.065 −0.194 0.090
Market risk 0.849 1.045 1.062 1.055
Size risk 1.161 0.976 0.840 0.734
Value risk 0.321 0.444 0.480 0.402
Notes: Bold and italics indicate statistical significance at the 5% and 10% nominal levels respectively. Each panel consists of 10 portfolios
size-sorted panels and then across the value sorted
panels. Additionally, Figures 1–6 Parts B show the
plots of the time fixed effects that are significant at
the 5%.
Three-factor panel model with fixed effects and
volatility risks
Size sorted panels
The estimated risk exposures are reported in Table
1 and also represented by line graphs in Figure 1
part A. Market betas are slightly above 1.0 for all
the panels, except for the lowest size decile (Panel
S1) which has the minimum market risk exposure
of 0.849. The systematic size risk exposure takes
its highest value of 1.161 for the smallest cap Panel
S1 and declines to a negative value of −0.214 for
Panel S10. This decline is the expected size-related
behaviour. The value risk exposure, on the other
hand, is positive and varies from 0.134 for Panel
S10 to 0.480 for Panel S5 without any specific
trend across the size panels. These results show
that although the market betas are largely greater
than one for all panels, the SMB and HML factors
also explain significant variations in the portfolio
returns. The volatility risk exposure is significant
and positive for Panels S1 and S8 and negative for
S3, thus showing no relationship to size.
Value sorted panels
Comparing the risk exposures in Table 2 and line
graphs in Figure 2 Part A with those in Table 1
and Figure 1 Part A, it is clear that the market
betas for value-sorted panels are more or less the
same as for the size-sorted panels. As expected
from the construction of these panels sorted by
value, the systematic value risk exposure is nega-
tive for the lowest value panel V1 and then
increases and reaches close to one for the largest
value panel V10. The size risk exposure is positive
for all 10 panels and the volatility exposure is weak
(although significant) only for five panels.
Panel S5 Panel S6 Panel S7 Panel S8 Panel S9 Panel S10
0.059 0.077 0.003 0.130 0.062 0.035
1.066 1.072 1.101 1.107 1.046 1.028
0.585 0.403 0.263 0.152 −0.022 −0.214
0.407 0.367 0.348 0.321 0.273 0.134
 APPLIED ECONOMICS 9

Table 2. Estimates of risk premiums of three-factor model with individual and time fixed effects and volatility risk (sensitivity test).
Factors Panel V1 Panel V2 Panel V3 Panel V4 Panel V5 Panel V6 Panel V7 Panel V8 Panel V9 Panel V10
Volatility risk −0.016 0.000 0.085 0.135 0.297 0.099 0.164 0.180 0.152 0.052
Market risk 1.173 1.114 1.076 1.074 1.042 1.018 1.000 0.987 1.051 1.165
Size risk 0.617 0.507 0.479 0.458 0.419 0.459 0.444 0.522 0.610 0.799
Value risk −0.507 −0.106 0.109 0.252 0.358 0.461 0.556 0.631 0.734 0.934
Notes: Bold and italics indicate statistical significance at the 5% and 10% nominal levels respectively. Each panel consists of 10 portfolios

Table 3. Estimates of risk premiums of five-factor (size-panel) models with individual, annual time effects and volatility risk.
Factors Panel S1 Panel S2 Panel S3 Panel S4 Panel S5 Panel S6 Panel S7 Panel S8 Panel S9 Panel S10
Volatility risk 0.466 −0.059 −0.237 −0.091 −0.040 0.019 −0.017 0.128 0.045 −0.035
Market risk 0.830 1.035 1.057 1.053 1.070 1.069 1.112 1.111 1.055 1.039
Size risk 1.123 0.986 0.871 0.776 0.631 0.444 0.315 0.178 0.024 −0.181
Value risk 0.357 0.500 0.533 0.464 0.445 0.424 0.356 0.328 0.275 0.119
Profitability risk −0.152 0.033 0.110 0.150 0.168 0.144 0.187 0.094 0.164 0.113
Investment risk 0.466 −0.059 −0.237 −0.091 −0.040 0.019 −0.017 0.128 0.045 −0.035
Notes: Bold and italics indicate statistical significance at the 5% and 10% nominal levels respectively. Each panel consists of 10 portfolios

Table 4. Estimates of risk premiums of five-factor (value-panel) models with individual, annual time effects and volatility risk.
Factors Panel V1 Panel V2 Panel V3 Panel V4 Panel V5 Panel V6 Panel V7 Panel V8 Panel V9 Panel V10
Volatility risk −0.006 0.104 0.072 −0.028 0.233 0.078 0.122 0.153 0.126 0.049
Market risk 1.117 1.098 1.082 1.083 1.054 1.027 1.011 0.986 1.045 1.159
Size risk 0.562 0.514 0.512 0.505 0.474 0.502 0.485 0.554 0.638 0.820
Value risk −0.309 −0.027 0.122 0.274 0.376 0.468 0.551 0.663 0.795 0.985
Profitability risk −0.245 0.011 0.119 0.172 0.195 0.150 0.147 0.107 0.096 0.068
Investment risk −0.469 −0.182 −0.014 −0.028 −0.016 0.002 0.025 −0.061 −0.124 −0.106
Notes: Bold and italics indicate statistical significance at the 5% and 10% nominal levels respectively. Each panel consists of 10 portfolios

Table 5. Estimates of risk premiums of six-factor (size-panel) models with individual effects.
Factors Panel S1 Panel S2 Panel S3 Panel S4 Panel S5 Panel S6 Panel S7 Panel S8 Panel S9 Panel S10
Volatility risk 0.375 −0.137 −0.289 −0.023 −0.103 0.001 −0.059 0.091 0.061 −0.033
Market risk 0.811 1.015 1.041 1.037 1.055 1.053 1.097 1.095 1.043 1.028
Size risk 1.131 1.005 0.891 0.793 0.645 0.460 0.331 0.195 0.038 −0.170
Value risk 0.276 0.415 0.445 0.385 0.371 0.348 0.280 0.253 0.212 0.067
Profitability risk −0.101 0.087 0.157 0.195 0.209 0.189 0.232 0.140 0.199 0.142
Investment risk −0.042 −0.047 −0.033 −0.057 −0.005 −0.053 0.063 0.056 0.063 0.080
Momentum −0.167 −0.170 −0.157 −0.142 −0.141 −0.145 −0.144 −0.146 −0.115 −0.093
Notes: Bold and italics indicate statistical significance at the 5% and 10% nominal levels respectively. Each panel consists of 10 portfolios

Table 6. Estimates of risk premiums of six-factor (value-panel) models with individual, annual time fixed and volatility effects.
Factors Panel V1 Panel V2 Panel V3 Panel V4 Panel V5 Panel V6 Panel V7 Panel V8 Panel V9 Panel V10
Volatility risk −0.015 0.026 0.032 0.061 0.176 0.054 0.084 0.105 0.060 0.051
Market risk 1.097 1.079 1.065 1.066 1.036 1.012 0.997 0.972 1.029 1.137
Size risk 0.592 0.539 0.537 0.526 0.497 0.522 0.498 0.571 0.657 0.846
Value risk −0.403 −0.115 0.046 0.190 0.300 0.404 0.493 0.609 0.727 0.890
Profitability risk −0.189 0.066 0.164 0.224 0.242 0.188 0.182 0.140 0.138 0.127
Investment risk −0.395 −0.111 0.047 0.039 0.045 0.053 0.071 −0.017 −0.069 −0.028
Momentum −0.187 −0.177 −0.150 −0.167 −0.155 −0.128 −0.115 −0.109 −0.136 −0.188
Notes: Bold and italics indicate statistical significance at the 5% and 10% nominal levels respectively. Each panel consists of 10 portfolios

In Figure 2 Part B, the value-sorted panels again
indicate that the time fixed effects are largely posi-
tive though there are more exceptions in this case.
In particular, during the dot.com crisis the V10
(highest value) panel had deeply negative time
effect in 2000, and also during the GFC. Clearly,
the responses of three-factor panels formed by
size-sorted portfolio to various exposures are
vastly different from those panels formed by
value-sorted panels.
We note that the way in which the three-factor
exposures impacted the size and value sorted
panel models are consistent across the five- and
six-factor panel models. Therefore, in what
10 T. MAKWASHA ET AL.

Table 7. Out-of-sample forecasting evaluation of multifactor panel models of portfolios sorted by value.
S1 S3 S5 S7 S10
No. of factors MAE MSE MAE RMSE MAE RMSE MAE RMSE MAE RMSE
3 factors 0.342 0.188 0.328 0.158 0.304 0.153 0.243 0.228 0.234 0.184
5 factor 0.331 0.165 0.319 0.142 0.289 0.151 0.233 0.218 0.221 0.179
6 factors 0.328 0.164 0.321 0.145 0.286 0.152 0.231 0.215 0.209 0.177
Performances around crises:
Dot.com crisis period (2000–2001)
3 factors 0.553 0.365 0.582 0.328 0.318 0.165 0.304 0.167 0.235 0.146
5 factor 0.437 0.284 0.481 0.311 0.418 0.215 0.299 0.181 0.201 0.109
6 factors 0.459 0.315 0.482 0.311 0.414 0.209 0.298 0.178 0.211 0.116
GFC period
(2007–2008)
3 factors 0.487 0.267 0.501 0.251 0.321 0.176 0.317 0.168 0.244 0.149
5 factor 0.392 0.228 0.423 0.238 0.282 0.161 0.313 0.164 0.215 0.225
6 factors 0.395 0.231 0.421 0.239 0.283 0.157 0.299 0.162 0.211 0.223
EU debt crisis period
(2009–2010)
3 factors 0.451 0.262 0.452 0.298 0.318 0.275 0.383 0.185 0.342 0.241
5 factor 0.402 0.199 0.423 0.309 0.295 0.199 0.294 0.158 0.245 0.138
6 factors 0.405 0.201 0.425 0.315 0.289 0.196 0.287 0.153 0.241 0.133
Note: The multifactor panel data models also include individual specific effects, time fixed effects and volatilities
MAE is the mean absolute prediction errors
RMSE is the root mean squared errors.
S1, S3, S5, S7 and S10 are the panel data models formed by size sorted portfolios
The in-sample estimation period covers 1964–1999 and the out-of-sample forecasting period covers 2000–2018

Table 8. Out-of-sample forecasting evaluation of multifactor panel models of portfolios sorted by value.
V1 V3 V5 V7 V10
No. of factors MAE RMSE MAE RMSE MAE RMSE MAE RMSE MAE RMSE
3 factors 0.362 0.181 0.322 0.179 0.298 0.199 0.231 0.172 0.199 0.193
5 factor 0.301 0.148 0.246 0.148 0.251 0.172 0.203 0.151 0.177 0.161
6 factors 0.311 0.152 0.242 0.137 0.246 0.167 0.191 0.144 0.181 0.163
Performances around crises:
Dot.com crisis period
(2000–2001)
3 factors 0.431 0.313 0.539 0.335 0.313 0.251 0.298 0.178 0.223 0.122
5 factor 0.414 0.268 0.461 0.311 0.418 0.215 0.223 0.147 0.214 0.107
6 factors 0.407 0.251 0.388 0.304 0.397 0.215 0.218 0.133 0.207 0.107
GFC period
(2007–2008)
3 factors 0.463 0.227 0.483 0.248 0.319 0.181 0.314 0.162 0.224 0.139
5 factor 0.342 0.189 0.418 0.241 0.259 0.168 0.235 0.151 0.212 0.119
6 factors 0.331 0.188 0.341 0.233 0.242 0.166 0.198 0.142 0.194 0.108
EU debt crisis period
(2009–2010)
3 factors 0.399 0.258 0.432 0.279 0.354 0.262 0.359 0.181 0.304 0.209
5 factor 0.363 0.216 0.399 0.255 0.337 0.171 0.299 0.156 0.241 0.149
6 factors 0.359 0.188 0.358 0.228 0.285 0.143 0.263 0.148 0.232 0.141
Note: The multifactor panel data models also include individual specific effects, time fixed effects and volatilities
MAE is the mean absolute prediction errors.
RMSE is the root mean squared errors.
V1, V3, V5, V7 and V10 are the panel data models formed by value sorted portfolios
The in-sample estimation period covers 1964–1999 and the out-of-sample forecasting period covers 2000–2018

follows, we will discuss the results of exposures of
additional factors included in the five- and six-
factor models.
Five-factor panel models with fixed effects and
volatility risks
The results in Table 3 indicate that the profitabil-
ity (RMW) risk exposure is largely positive.
However, it is negative only for the smallest cap
Panel S1. On the other hand, the investment risk
(CMA) exposure is very close to zero for size-
sorted panels, except it is positive for Panels S1
and S3 and negative for S3. These trends are also
noticeable in Figure 3 Part A.
In contrast to the results for size-sorted panels,
Table 4 and Figure 4 Part A show that the profit-
ability exposure is significant for most value-
 APPLIED ECONOMICS 11

Part A: Risk exposure by size decile

1.4

1.2

1.0

0.8

Risk exposure
0.6

0.4

0.2

0.0
S1 S2 S3 S4 S5 S6 S7 S8 S9 S10
-0.2

-0.4 Size (small cap - high cap)

Market risk exposure SMB risk exposure HML risk exposure Volatility risk exposure

Part B: Annual time fixed effects by size decile

3

1
Time fixed effect

0
1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

2010

2015

2020
-1
Year

-2
S1 S2 S3 S4 S5 S6 S7 S8 S9 S10

-3

Figure 1. Three-factor model with individual, time and volatility effects: size-sorted panels.

sorted panels, except it is negative for Panel V1 sorted panel models (Tables 5 and 6 and
and insignificant for Panel V2. The investment Figures 5 and 6 Part A). There are some nota-
risk exposure is deeply negative for the two lowest ble similarities and differences in the results of
value Panels V1 and V2 as well as the two highest size-sorted and value-sorted panel models. In
value Panels V9 and V10. In the size-sorted five- both sets, the profitability risk exposures are
factor panels, the time fixed effects are mostly positive and significant in the presence of
positive. The exception is that the smallest cap momentum factor, and negative for panels S1
panel had negative time fixed effects during crises. and V1. However, the investment factor expo-
It is noteworthy that in the value-sorted panels, sures are significant only for four size-sorted
there are few negative effects and a large number panel models, while they are significant for all
of positive effects during crises. value-sorted panels. But the significance and
magnitudes of the exposures of investment
and profitability factors do depend on whether
Six-factor panel models with fixed effects and
they are size-sorted panels or value-sorted
volatility risks
panels. The time-fixed effects of six-factor
In the six-factor panel models, the exposure of
models are more or less the same as in the five-
the additional factor, momentum, is significant
factor models (Figure 6 Part B).
and negative for all size-sorted and value-
12 T. MAKWASHA ET AL.

Part A: Risk exposure by value decile

1.4
1.2
1.0
0.8

Risk exposure
0.6
0.4
0.2
0.0
V1 V2 V3 V4 V5 V6 V7 V8 V9 V10
-0.2
-0.4
-0.6
Value (Low book-to-market to high book-to-market)

Market risk exposure SMB risk exposure HML risk exposure Volatility risk exposure

Part B: Annual time fixed effects by value decile

4

2
Time fixed effect

0
1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

2010

2015

2020
-1 Year

V1 V2 V3 V4 V5 V6 V7 V8 V9 V10
-2

Figure 2. Three-factor model with individual, time and volatility effects: value-sorted panels.

In summary, the estimates of the multifactor risk negative and explains large return variations and
exposures are consistent across all the panel models, volatilities in all panel models.
either sorted by size or value, we studied in this
article. Although numerically small, the volatility Out-of-sample prediction of MFCAPM panel models
risk exposure is significant in more size-sorted Following the out-of-sample prediction method
panels than in value-sorted panels. Moreover, the discussed in the section on methodology, we esti-
time fixed effects are positive/negative depending mate the MFCAPM models for selected size-
on if the panels are sorted by size or value. In sorted and value-sorted panels for the in-sample
particular, size sorted portfolio returns are mostly period 1963(1)–1999(1). The out-of-sample return
resilient during the 2001 dot.com crisis, while only predictions are generated by the three MFCAPM
Panels S5, S9, and S10 have deep negative time-fixed panel models. Specifically, we use the rolling
effects in the 2007 GFC. A noteworthy observation widow method to generate 1-step ahead returns
is that the momentum factor – that represents predictions by the panel models formed with size-
investor behaviour – is consistently significant and sorted portfolios2 S1, S3, S5, S7, and S10, and then

2
We generate out-of-sample returns forecasts only these selected portfolios to reduce the insurmountable computing time and the selected panels are
adequate to draw conclusions about the relative predictability of MFCAPM panel models studied in this article.
 APPLIED ECONOMICS 13

Part A: Risk exposure by size decile

1.2

1.0

0.8

Risk exposure
0.6

0.4

0.2

0.0
S1 S2 S3 S4 S5 S6 S7 S8 S9 S10
-0.2

-0.4
Size: from small cap to high cap

Market risk exposure SMB risk exposure HML risk exposure

Volatility risk exposure RMW risk exposure CMA risk exposure

Part B: - Annual time fixed effects by size decile

4

2
Annual time effects

0
1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

2010

2015

2020
-1 Year

-2
S1 S2 S3 S4 S5 S6 S7 S8 S9 S10
-3

Figure 3. Five-factor model with individual, time and volatility effects: size-sorted panels.

with value-sorted portfolios V1, V3, V5, V7, and MFCAPM panel models around the major crises
V10. The out-of-sample predictions are generated such as dot.com, GFC and EU debt crises. We
for the period 2000(1)–2018(9). We computed find statistical evidence to suggest that six-factor
MAEs and RMAEs for the MFCAPM panels model marginally outperforms the five-factor
used in this exercise. The results are reported in model for the size-sorted panel, especially for
Tables 7 and 8 for the size sorted panels and value the big cap panels. We find overwhelming evi-
sorted panels, respectively. dence that six-factor model vastly outperforms
The results show that the predictive perfor- the other models for the value sorted panels, in
mance of the both five-factor and six-factor particular during crises.
models are the same for most of the size sorted
and value sorted panels. The former model is
IV. Conclusion
clearly outperforming the latter model for the
small size cap panels. The value sorted six-factor In this article, we propose fixed effects
panel model is consistently outperforming the MFCAPM panel data models and test theories
value sorted five-factor model. We have also associated with risk exposures and anomalies
assessed the predictability performances of the postulated by Fama and French (1993, 2015).
14 T. MAKWASHA ET AL.

Part A: Risk exposure by value decile

1.4

1.2

1.0

0.8

Time fixed effect

0.6

0.4

0.2

0.0
V1 V2 V3 V4 V5 V6 V7 V8 V9 V10
-0.2

-0.4

-0.6
Value

Market risk exposure SMB risk exposure HML risk exposure

Volatility risk exposure RMW risk exposure CMA risk exposure

Part B: Annual time fixed effects by value decile

4

2
Annual time effects

0
1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

2010

2015

2020
-1
Year

-2

V1 V2 V3 V4 V5 V6 V7 V8 V9 V10
-3

Figure 4. Five-factor model with individual, time and volatility effects: value-sorted panels.

We apply these panel models to 100 portfolios framework in comparison to the univariate
of US firms, constructed by French as intersec- model; eliminating multicollinearity problem
tions of size and book-to-market deciles. We arising from highly correlated explanatory vari-
form 10 panel models with each panel consisting ables; and including the annual time-fixed effects
10 portfolios sorted by size, and then study the to uncover the impacts of major crises on port-
robustness of the results by forming panels folio returns. Clearly, the rich panel model spe-
based on portfolios sorted by value. There are cification would produce much more reliable
several advantages in adapting panel data factor exposure estimates than the univariate
approach to MFCAPM over widely studied uni- counterpart.
variate multifactor modelling. They include The FGLS estimates of MFCAPM panel
exploiting the cross section dependence among models show that market risk, firm size risk,
portfolios of asset returns to improve the model and value risk exposures are highly significant
estimation; using huge information in the panel and more or less same across the three-, five-,
 APPLIED ECONOMICS 15

PartA: Risk exposure by size deciles

1.4

1.2

1.0

0.8

0.6

0.4

0.2

0.0
S1 S2 S3 S4 S5 S6 S7 S8 S9 S10
-0.2

-0.4

Market risk exposure SMB risk exposure HML risk exposure

Volatility risk exposure RMW risk exposure CMA risk exposure
Momentum

Part B: Annual time fixed effects by size decile

3

2
Annual time effects

0
1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

2010

2015

2020
-1
Year
-2

-3
S1 S2 S3 S4 S5 S6 S7 S8 S9 S10

Figure 5. Six-factor model with individual, time and volatility effects: size-sorted panels.

and six-factor models. The profitability and explain large return variations and portfolio
investment risk exposures are significant in sev- volatilities. In the out-of-sample prediction,
eral five- and six-factor panel models. The the overall results indicate that the five- and
momentum factor (representing investor beha- six-factor panel models perform more or less
viour) is significant in all panels. A noteworthy the same in general. In particular, the six-factor
observation is that in the presence of momen- model’s predictive performance is superior to
tum factor the both profitability and invest- the three- and five-factor models during crises.
ment risk exposures became significance in all The findings have implications for investors,
value-sorted panels and in several size-sorted portfolio managers and security/portfolio
panels. Consequently, six-factor panel models traders.
16 T. MAKWASHA ET AL.

Part A: Risk exposure by value deciles

1.4

1.2

1.0

0.8

0.6

0.4

0.2

0.0
V1 V2 V3 V4 V5 V6 V7 V8 V9 V10
-0.2

-0.4

-0.6
Market risk exposure SMB risk exposure HML risk exposure
Volatility risk exposure RMW risk exposure CMA risk exposure
Momentum

Part B: Annual time fixed effects by value deciles

3
2.5
2
Annual time effects

1.5
1
0.5
0
1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

2010

2015

2020
-0.5
-1
Year
-1.5
-2

V1 V2 V3 V4 V5 V6 V7 V8 V9 V10

Figure 6. Six-factor model with individual, time and volatility effects: value-sorted panels.

Acknowledgments Factor Models and Financial Risk Measures, 176–193.

London: Palgrave Macmillan.
We wish to thank the referee, Vasilis Sarafidis and the partici- Ang, A., R. Hodrick, Y. Xing, and X. Zhang. 2006. “The
pants of the 17th Panel Data Conference, Thessaloniki, 5– Cross-Section of Volatility and Expected Returns.”
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