Asset Pricing and Momentum: A South African Perspective

ABSTRACT

Both the capital asset pricing model and Fama and French’s (1993) three-factor model have consistently failed to explain momentum in stock returns, with only Carhart’s (1997) four-factor model having some success in this regard. This study examines whether an alternative three-factor model proposed by Chen, Novy-Marx, and Zhang (2011) and a five-factor model forwarded by Fama and French (2015), which both include profitability and investment as pricing factors, can explain momentum on the South African market. Consistent with international evidence, the pricing errors from these two models are lower and although these errors remain significant, the results reveal that profitability and, to a lesser extent, investment are important risk-based factors that must be considered in explaining the short-term continuation in stock returns.

KEYWORDS:

• Alternative three-factor model
• five-factor model
• momentum
• Johannesburg Stock Exchange

Acknowledgements

The authors would like to thank two anonymous reviewers for valuable feedback on earlier drafts of this paper.

Notes

1. Other studies such as Xing (2008), Li & Zhang (2010) and Novy-Marx (2013) have examined the links between investment or profitability and stock returns. However, the models of Chen et al. (2011) and Fama and French (2015) are the subject of attention in this study as they consider both factors together in an explicit pricing equation. As such, many of the arguments set out in these two studies are similar to those expressed in Xing (2008) and Li & Zhang (2010) with respect to investment and Novy-Marx (2013) with respect to profitability.

2. The JSE was in the top twenty on both measures using 2016 data obtained from the World Federation of Exchanges annual statistics.

3. Fama and French (2015) created 32 portfolios and Chen et al. (2011) 27 by using more splits on the investment and profitability ratios (and size in the case of the latter); however, given the smaller number of stocks on the JSE, creating too many portfolios would have given rise to undiversified portfolios thus necessitating the two-way split.

4. These results are not shown for the purposes of brevity but are available from the authors upon request.