Msc Thesis: Luuk Milius

Msc Thesis:

The Three Factor Model for Dutch Equities

Name: Luuk Milius

Administration number: s613758

Supervisor: Mr R.G.P. Frehen

Second reader: Mr M. Da Rin

Date: 15-11-2012

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Msc Thesis: Luuk Milius

Table of contents

Abstract 3

Introduction 4

State of literature 5

Data and methodology 8

Results 10

Conclusion 16

Bibliography 17

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Msc Thesis: Luuk Milius

Abstract

The main goal of the paper is to test how suitable the Three Factor Model of Fama &
French (1996) captures cross-sectional differences in returns for Dutch stocks for the period
of 1990-2010. Overall, the model captures most cross-sectional differences (average R2 of
90%). Systematic risk is not priced in the market and a size effect does not seem present for
the sample I used. A value premium does exist. Still, the Three Factor Model has a positive
and significant alpha, so the model can be improved. Therefore a momentum factor is
included. The momentum factor helps explaining cross-sectional differences in returns and
the alpha becomes insignificant after inclusion of this factor.

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Msc Thesis: Luuk Milius

Introduction

Since the introduction of the Three Factor Model by Fama & French (1996) many
practitioners accept the model and the implications that follow from it. Important to keep in
mind though, is that Fama & French (1992, 1996) used US data for the development of the
Three Factor Model and the bulk of other existing research relates to US portfolios as well.
There is not as much evidence available on the robustness of the Three Factor Model outside
the US market. As is argued by Bishop et al (2001, p. 192), the Three Factor Model needs
more time and further empirical investigation before it can be accepted as a credible theory-
based model. Furthermore, in response to the data-snooping hypothesis of Black (1993) and
MacKinlay (1995), Barber & Lyon (1997) observe that the best way to evaluate the data-
snooping hypothesis is to test the robustness of the results from Fama & French (1992, 1996)
for different time periods, different countries or a holdout sample. In this paper the Three
Factor Model will be tested for a different country and a different time period. The usefulness
of the Three Factor Model will not be fully known until sufficient new data becomes available
to provide a true out-of-sample check for the performance of this model (Campbell, Lo &
MacKinley, 1997).
Fama & French (1998) opt for a more global version of their Three Factor Model due
to market integration. Applying the implications from international asset pricing theory; if
there is market integration there should be one set of risk factors that explain expected returns
in all countries. In their paper they show that a world factor model leads to lower intercepts
and a higher than a model with a world market factor alone. However, Fama & French
(1998) do not compare this model to a country specific model as Griffin (2002) does. The
explanatory power of world factors could be driven by their country specific components. In
his paper Griffin (2002) finds that domestic models perform better in describing the cross
section of returns and provide more accurate pricing than the world model does.
Since it is better to use a country specific model than a world model, in response to the
data-snooping hypothesis and to provide an additional out-of-sample check to test the
robustness of the Three Factor Model (test the model for a different country and a different
time period) resulted in the development of the research question for this paper:

How well is the Three Factor Model of Fama and French suitable to describe cross-sectional
differences in returns for Dutch stocks listed on the Amsterdam Exchange (AEX)?

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Msc Thesis: Luuk Milius

Testing the model for the Dutch market does not only benefit the academic world, but
it will benefit practitioners active in the field of finance as well. It will give insight if
systematic risk, firm size and the book-to-market ratio are priced in the Dutch market. This
has implications for capital budgeting decisions and discount rates (is a small firm premium
necessary for example) for Dutch firms. The results can also influence investment decisions
for people who want to invest in Dutch stocks.
The Three Factor Model is tested using the method of Fama & Macbeth (1973). The
results from the time-series regression (first-pass regression) show that firm size and the ratio
of book-to-market equity seem to have an influence on returns and systematic risk does not
have an influence. The cross-sectional regression (second-pass regression) will show if this
really is the case. The cross-sectional regression shows that systematic risk is not priced in the
market, but firm size is neither. The only factor that seems to matter is the ratio of book-to-
market equity. So the CAPM is insufficient to describe returns for the Dutch market. There is
a small, but insignificant size effect and a value premium does exist. So stocks with a high
book-to-market ratio outperform stocks with a low book-to-market ratio. Furthermore, the
alpha of the model is positive and significant, so part of the returns are not explained.
Therefore, a momentum factor is added to the model and this model is tested as well.
It follows that inclusion of a momentum factor results in an improvement of the model as
indicated by the alpha of the model. The alpha becomes insignificant. There is no change in
the other factors. Systematic risk and size are still insignificant while the book-to-market ratio
remains its significance. The momentum factor itself is also significant, indicating that past
winners/losers continue to rise/fall even further.

State of literature

For a long time the asset pricing model of Sharpe (1964), Lintner (1965) and Black
(1972) was used to explain differences between returns and risk. The SLB model states that
expected returns on stocks are a linear function of the stocks exposure to market (or
systematic) risk (also known as ). This risk is the only risk that should be priced in the
market, since non-systematic risk can be diversified away. According to this model, market
risk is the only explanatory variable in the cross-section of expected returns.
However, this model is not able to explain the so called anomalies of stock returns.
Several academics have identified contradictions to the SLB model. Banz (1981) identified a
size effect. Firm size helps in explaining the cross-section of expected returns. Using market

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Msc Thesis: Luuk Milius

equity to measure the size of a firm, he finds that small firms have an average return that is
too high given their and large firms have an expected return that is too small given their .
Stattman (1980) and Rosenberg, Reid & Lanstein (1985) found another contradiction. They
state that average returns are positively related to the ratio of book equity to market equity.
Evidence for this is also found in the Japanese market by Chan, Hamao & Lakonishok (1991).
Next to this, Bhandari (1988) found that the amount of leverage of a firm is related to risk and
expected return. Finally, Basu (1983) shows that the earnings-price ratio can also help explain
differences in the cross-section of stock returns. According to the SLB model, market risk
should be the only factor that explains the cross-section of expected stock returns, but this is
clearly not the case.
After the establishment of these anomalies Fama & French (1992) tested these
predictions and they found that indeed market risk was not able to explain the cross-section of
expected returns, but other variables helped explaining the cross-section of returns as well.
Beta is insignificant for their sample period, so market risk does not explain the cross-section
of returns. This contradicts the SLB model. They tested the anomalies described above as well.
Their results show that size and book equity to market equity explain most of the variation in
the cross-section of expected returns.
In a later paper of Fama & French (1996) these results lead to the development of the
Three Factor Model. They established a model that is well able to describe the cross-section
of expected returns. The returns are related to three different variables. The excess return on a
market portfolio (Rm-Rf), The difference between the return on a portfolio of small stocks
and the return on a portfolio of large stocks and the difference between the return on a
portfolio of stocks with a high book to market value and the return on a portfolio of stocks
with a low book to market value. This resulted in the development of the following model for
the expected excess return on a security:

Where SMB stands for small minus big and HML for high minus low.
, and are the expected premiums on the small minus big, high
minus low and excess return on the market portfolio and , and are the factor
sensitivities estimated by a time-series regression. This is the Three Factor Model that is able
to explain the anomalies which could not be explained before.

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Msc Thesis: Luuk Milius

An explanation why these two new factors help to explain cross-sectional differences
is as follows. The small minus big factor is positive when small firm stocks have
outperformed the stocks of larger companies. This factor is a measure for size risk. Smaller
firms are less diversified and they cannot absorb negative financial events as good as large
firms can. This makes smaller firms riskier, which leads investor to ask a higher risk premium
for these kind of stocks. This is also called the size effect which is in line with the evidence
of Huberman & Kandel (1987).
The high minus low factor measures the value premium. If it is positive it indicates
that value stocks (high book-to-market ratio) have outperformed growth stocks (low book-to-
market ratio). Before firms go public they need to reach a certain minimum size. If, later they
have a high book-to-market ratio the market value has dropped. This is possible due to
negative events or unfavorable future prospects. Companies with a high book-to-market ratio
face greater risk and thus a higher risk premium is required for these firms. This is also called
the relative distress effect identified by Chan & Chen (1991). According to these two
explanations smaller firm stocks and value firm stocks are priced in the market.
Jegadeesh & Titman (1993) discovered another anomaly, the momentum effect. When
stock prices are rising they tend to rise even further and when stock prices are falling they
tend to fall even further. So a strategy involving buying stocks that performed well in the past
and selling stocks that performed poorly in the past generate positive returns. These returns
are not due to systematic risk or delayed stock price reactions to common factors. In a later
paper Carhart (1997) created a factor mimicking portfolio for the momentum effect like Fama
& French (1996) did for the size and value factor. The Three Factor Model can be extended
with the momentum factor resulting in the Four Factor Model for the expected excess return
on a security:

As is explained in the introduction, the model needs more time and further empirical
investigation before it can be accepted as a credible theory-based model. Therefore,
researchers and academics started to test the Three and Four Factor Model for areas other than
the US and for different time periods. There is quite strong evidence that the model describes
expected returns in other countries as well. For example, UK, France & Germany (Malin &
Veeraraghaven, 2004), Japan (Chan, Hamao & Lakonishok, 1991), Australia (Faff, 2004),
Hong Kong (Nartea et al, 2004), Spain (Pena et al, 2010), and also for wider sets of countries
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Msc Thesis: Luuk Milius

(Fama & French, 1998), (Rouwenhorst, 1998) (Griffin, 2002), (Moerman, 2005) and (Bauer
et al, 2010). Results differ for several countries and also for different time periods, but in most
instances support for both models is found.

Data and methodology

Fama & French (1992, 1996) suggest that the following model can be used to describe
the cross-section of expected returns on a stock or a portfolio of stocks:
(1)
where i = 1,..,N
Since I would like to test this model for the Dutch market the following hypotheses have been
developed:

H0: The Three Factor Model captures cross-sectional differences in expected returns for
Dutch equities.
H1: The Three Factor Model does not capture cross-sectional differences in expected returns
for Dutch equities.

More specifically, for the model to hold, I expect the coefficient for the alpha to be close to
zero, the beta coefficient should be insignificant and the SMB and HML coefficient should be
statistically different from zero.
To test the Three Factor Model for the Dutch market I gathered data available from
Datastream. I downloaded the monthly stock returns, a proxy for the risk-free rate (the one
month AIBOR), the book-to-market ratios of the equity value and the shares outstanding for
each company from 1990 to 2010. I included delisted stocks to circumvent the survivorship
bias.
From this data the necessary portfolios to test the model are constructed. I proceeded
in the following manner: For the market portfolio I did not use a proxy like the AEX-index,
but I created a market portfolio using all stocks available in my dataset. This results in a
portfolio that resembles the market better than a proxy. To create the SMB and the HML
factors all stocks are allocated at the end of June of each year to two groups (small [S] or big
[B]) based on whether the market equity (stock price times shares outstanding) in June is
higher or smaller than the median for that year. All stocks are also allocated to three groups
(low [L], medium [M] or high [H]) based on their book-to-market equity value in December

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Msc Thesis: Luuk Milius

of year t-1. Firms with negative book equity are excluded from this sort. The bottom 30% is
classified as low, the top 30% as high and the 40% in the middle as medium.
In this manner six size/book-to-market equity portfolios are created (S\L, S/M, S\H,
B\L, B\M and B/H). SMB is the difference between the average returns of the S\L, S\M and
S\H portfolios and the average of the returns on the B\L, B\M and B\H portfolios. HML is the
difference between the average returns of the S\H and B\H portfolios and the average returns
of the S\L and B\L portfolios.
Fama & French (1992, 1996) used a 5x5 sorting scheme to construct 25 portfolios
sorted on size and book-to-market equity. However, the Dutch market has far fewer listed
companies than the United States. In order to avoid potential biases I choose to use a 4x4
sorting scheme to construct 16 portfolios instead of 25. These portfolios are created in a
similar fashion as the six size/book-to-market equity portfolios except quartile breakpoints are
used for the allocation of stocks in this case.
To test the hypothesis the approach of Fama & Macbeth (1973), a two-pass regression,
is used. First, I will run the following time-series regression to obtain the alphas, betas, ss
and hs:
(2) where I =
1,..,N
Afterwards, I will estimate the following equation using as repressors the betas, ss and hs
from the first-pass regression:
(3) , where t = 1,..,T
This will tell me whether the Three Factor Model holds for the Dutch market or not.
Furthermore, I will also perform a GRS test as developed by Gibbons, Ross &
Shanken (1989). Each alpha can be tested separately, but the model implies that all alphas are
zero. Therefore, a joint test is much more powerful. The GRS test allows me to test whether
this is the case.
An extension of the Three Factor Model with a momentum factor, identified by
Carhart (1997), can be made. Making it a Four Factor Model. The momentum factor is
constructed as follows. The two size portfolios from the SMB and HML factor are taken and
three new portfolios (low [L], medium [M] and high [H]) are formed every month based on
the prior (2-12) return. The monthly prior (2-12) return breakpoints are the 30th and 70th
percentiles. In this manner six portfolios (S/L, S/M, S/H, B/L, B/M and B/H) can be formed
to create the momentum factor. It is the average return on the S/H and B/H portfolio minus
the average return on the S/L and B/L portfolio. To be included in a portfolio for month t, a
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Msc Thesis: Luuk Milius

stock must have a price for the end of month t-13, a good return for t-2 and the value of the
market equity must be known at the end of month t-1.
To test the Four Factor Model I will follow the same approach as for the Three Factor
Model. I will first run a time-series regression to obtain the alphas, betas, ss, hs and ms:
(4)
where i = 1,..,N
Afterwards, I will estimate the following equation using as repressors the betas, ss, hs and
ms form the first-pass regression:
(5) , where t = 1,..,T
A GRS test to test if all alphas are jointly zero will be applied for the Four Factor Model as
well.

Results

Table 1 shows summary statistics of the 16 portfolios formed on size and book-to-
market equity. What follows from the table is if you move from the portfolio with the lowest
book-to-market ratio to the portfolio with the highest book-to-market ratio the returns of these
portfolios tend to increase. This holds for all book-to-market portfolios irrespective of the size.
The change in returns for portfolios sorted on different sizes is not too evident. The portfolios
formed on size for the second and third book-to-market portfolio show a small decrease in
their returns as firm size becomes bigger. For the fourth book-to-market portfolio this is more
evident. However, the first book-to-market portfolio shows the opposite. Smaller firms have
higher returns in this particular case. From the summary statistics it follows that returns seem
to be higher for value stocks, but a size effect is not too straightforward.
It is also suggested by Fama & French (1992, 1996) that higher returns are associated
with higher levels of risk. Small firms and value firms are supposed to be riskier and therefore
investors require a higher risk premium for these securities (as explained in section 2).
However, this is not straightforward from the table. First of all, a size effect does not seem too
evident, so do investors really require a higher risk premium for smaller firms. Second of all, I
included the standard deviation of each portfolio as a measure of riskiness. Smaller firms are
indeed riskier, but if this is really priced by investors will follow from the cross-sectional
regression later in this paper. For value stocks the evidence is contradictory. The standard
deviations decrease, indicating value stocks are less risky than growth stocks, as opposed to
what Fama & French (1992, 1996) suggest.

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Msc Thesis: Luuk Milius

Table 1: Summary statistics

The table displays the average returns and the standard deviations for the different portfolios sorted on
size and book-to-market equity.

Book-to-market equity
Size Low 2 3 High Low 2 3 High
Means Standard deviations
Small 0.488 1.200 1.285 1.409 8.514 7.158 5.803 5.465
2 0.821 1.023 1.267 1.193 7.428 5.816 5.168 5.305
3 0.848 1.104 1.180 1.113 6.917 5.368 4.859 5.002
Big 1.072 1.059 1.016 1.166 6.124 4.976 5.310 4.842

Tables 2 and 3 show the results from the first pass, time-series regression without and
with the momentum factor, respectively.
If both models describe expected returns the alpha intercepts should be (close to) zero.
Both tables show that the models leave a large negative return unexplained for portfolios in
the smaller size and lowest book-to-market quartile and a large positive return for stocks in
the biggest size and highest book-to-market portfolio. In the other cases the intercepts are
close to zero. Furthermore, the alpha intercepts of all portfolios are not statistically different
from zero except from the two smallest portfolios in the lowest book-to-market equity quartile.
This should not be the case, since all intercepts should be zero. However, this also occurs in
the work of Fama & French (1996) and other empirical tests of the Three and Four Factor
Model. In that sense my results do not deviate from other papers.
Furthermore, the GRS test for the Three Factor Model has a test statistic of 3.779 with
a p-value of 0.000003141. This indicates, at a significant level, that not all alphas are equal to
zero. Thus, there is still a part of expected returns that is not explained by the model. The
same holds for the Four Factor Model. The GRS test statistic has a value of 3.225 with a p-
value of 0.0000482 for the Four Factor Model.
Even though the models do not capture all the variation in the returns on the portfolios,
both models still capture most of the variation as indicated by the R2s of the regressions. In
one particular case the R2 is 95%. The average R2 of the Three Factor Model is 90.15% while
the average R2 for the Four Factor Model is 90.24%. So the inclusion of the momentum factor
contributes only little to the explanatory power of the Four Factor Model.

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Msc Thesis: Luuk Milius

Table 2: Results from time-series regression (first-pass regression) for the Three Factor Model
The table displays the results from the time-series regression of the 16 portfolios excess returns over the
excess market return, SMB and HML factor ( ,
where i = 1,..,N).
Book-to-market equity
Size Low 2 3 High Low 2 3 High
Alpha T-statistic
Small -0.721 -0.012 0.099 0.193 -4.20 -0.10 1.02 1.86
2 -0.298 -0.141 0.080 -0.065 -2.76 -1.34 0.84 -0.66
3 -0.141 0.002 0.059 -0.064 -1.32 0.02 0.51 -0.51
Big 0.164 -0.008 -0.137 0.057 1.59 -0.07 -1.04 0.48

Book-to-market equity
Size Low 2 3 High Low 2 3 High
Beta T-statistic
Small 1.119 0.939 0.866 0.830 28.77 32.59 39.37 35.40
2 1.119 0.974 0.909 0.937 45.78 40.82 42.00 41.46
3 1.087 1.022 0.961 0.971 44.86 36.09 36.75 34.07
Big 1.058 1.024 1.096 0.986 45.26 38.75 36.64 36.58

Book-to-market equity
Size Low 2 3 High Low 2 3 High
s T-statistic
Small 1.314 1.292 1.025 0.973 25.17 33.41 34.71 30.92
2 0.983 0.821 0.720 0.731 29.95 25.63 24.78 24.10
3 0.717 0.448 0.339 0.331 22.04 11.78 9.67 8.66
Big 0.424 0.200 0.135 0.186 13.52 5.63 3.37 5.13

Book-to-market equity
Size Low 2 3 High Low 2 3 High
h T-statistic
Small -0.347 -0.007 0.265 0.469 -6.36 -0.16 8.61 14.29
2 -0.340 0.189 0.460 0.623 -9.93 5.65 15.17 19.68
3 -0.460 0.239 0.496 0.658 -13.56 6.01 13.55 16.46
Big -0.408 0.338 0.539 0.547 -12.47 9.14 12.85 14.46

Book-to-market equity
Size Low 2 3 High
R squared
Small 0.903 0.925 0.934 0.915
2 0.950 0.922 0.919 0.916
3 0.943 0.871 0.866 0.850
Big 0.933 0.870 0.853 0.857

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Msc Thesis: Luuk Milius

Table 3: Results from time-series regression (first-pass regression) for the Four Factor Model
The table displays the results from the time-series regression of the 16 portfolios excess returns over the
excess market return, SMB, HML and MOM factor (
, where i = 1,..,N).
Book-to-market equity
Size Low 2 3 High Low 2 3 High
Alpha T-statistic
Small -0.644 -0.019 0.085 0.160 -3.74 -0.14 0.86 1.53
2 -0.239 -0.112 0.092 -0.062 -2.22 -1.05 0.94 -0.61
3 -0.102 0.042 0.065 -0.070 -0.95 0.34 0.55 -0.55
Big 0.149 0.013 -0.083 0.048 1.42 0.11 -0.63 0.4

Book-to-market equity
Size Low 2 3 High Low 2 3 High
Beta T-statistic
Small 1.086 0.942 0.872 0.844 26.81 30.98 37.61 34.34
2 1.094 0.961 0.904 0.936 43.25 38.37 39.61 39.22
3 1.071 1.004 0.958 0.974 42.22 33.84 34.72 32.38
Big 1.064 1.015 1.073 0.990 43.2 36.47 34.36 34.8

Book-to-market equity
Size Low 2 3 High Low 2 3 High
s T-statistic
Small 1.321 1.291 1.023 0.970 25.56 33.28 34.59 30.92
2 0.988 0.824 0.721 0.731 30.61 25.76 24.75 24.03
3 0.721 0.451 0.340 0.331 22.28 11.92 9.66 8.61
Big 0.423 0.202 0.141 0.185 13.45 5.68 3.53 5.09

Book-to-market equity
Size Low 2 3 High Low 2 3 High
h T-statistic
Small -0.375 -0.004 0.271 0.482 -6.82 -0.1 8.59 14.43
2 -0.362 0.178 0.456 0.622 -10.54 5.23 14.7 19.2
3 -0.475 0.224 0.494 0.660 -13.79 5.55 13.18 16.15
Big -0.403 0.331 0.518 0.550 -12.04 8.75 12.22 14.23

Book-to-market equity
Size Low 2 3 High Low 2 3 High
m T-statistic
Small -0.087 0.007 0.016 0.037 -2.58 0.29 0.84 1.83
2 -0.066 -0.033 -0.013 -0.004 -3.14 -1.58 -0.7 -0.2
3 -0.044 -0.045 -0.007 0.008 -2.1 -1.84 -0.3 0.3
Big 0.017 -0.023 -0.061 0.010 0.82 -1 -2.35 0.43

Book-to-market equity
Size Low 2 3 High
R squared
Small 0.906 0.925 0.934 0.916
2 0.952 0.923 0.919 0.916
3 0.944 0.873 0.866 0.850 13
Big 0.933 0.870 0.856 0.857
Msc Thesis: Luuk Milius

The results show furthermore that the beta coefficient does not change that much for
different portfolios. Though the changes in the SMB and HML factors are more evident. The
SMB factor declines for bigger firms and for firms that have a higher book-to-market ratio.
The HML factor increases for portfolios that have higher book-to-market ratios. For the
momentum factor a clear pattern cannot be found. This indicates that systematic risk does not
have an influence on average returns, but other factors have. Since the beta coefficient
remains close to constant for different portfolios, but the coefficient of the SMB and HML
factors change considerably for different portfolios sorted on size and book-to-market equity.
The HML coefficients are negative for the first book-to-market equity quartile and
positive for the other quartiles (except for the smallest firms in the second quartile). This is in
line with the results of Fama & French (1996) and other papers. However, the SMB
coefficients are not completely in line with other academic research. The coefficients for the
biggest firms are negative in the results of Fama & French (1996). A possible explanation for
this can be that Fama & French (1996) use breakpoints of market equity of NYSE stocks to
allocate all US stocks (NYSE, AMEX and Nasdaq) to a certain size portfolio. Another
explanation can be that in the US more super sized firms (firms with a big amount of
market equity) exist than in The Netherlands. This may influence the results. Furthermore,
Rouwenhorst (1998) reports that the momentum effect is stronger for small firms than for
large firms, so I expect to find higher coefficients for smaller firms. The results show support
for the findings of Rouwenhorst (1998). The coefficients of the second, third and fourth book-
to-market equity quartiles become smaller as size increases. These results need to be
interpreted with caution since most of the test-statistics indicate that the results are
insignificant.
The results of the cross-sectional regression for the Three and Four Factor Model are
displayed in tables 4 and 5, respectively. What follows from the Three Factor Model is that
beta and SMB are insignificant. So systematic risk, as stated by the CAPM, does not explain
average returns for the sample period. A similar argument can be made for firms that differ in
size. The coefficient is positive, indicating that smaller firms earn higher returns than larger
ones, but the size coefficient is insignificant though. The value premium is positive, so high
book-to-market firms earn higher returns and this is also priced in the market. The alpha is
positive and significant, indicating that the model can be improved, since part of the returns
are left unexplained.

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Msc Thesis: Luuk Milius

After inclusion of the momentum factor the beta coefficient and the SMB coefficient
remain insignificant and the HML coefficient remains significant. However, the alpha
coefficient becomes smaller and loses its significance. So the Four Factor Model does a better
job in explaining cross-sectional differences in returns than the Three Factor Model does. The
momentum factor itself is also positive and significant. Stocks that have outperformed other
stocks tend to do so the next period as well and vice versa.

Table 4: Results from cross-sectional regression (second-pass regression) for the Three Factor Model
The table displays the results from the cross-sectional regression of the portfolios excess returns over
the excess market return coefficient, SMB coefficient and HML coefficient (
, where t = 1,..,T).

Alpha Beta SMB HML

1.265 -0.485 0.025 0.472
Test statistic 2.602 -0.870 0.132 2.605

Table 5: Results from cross-sectional regression (second-pass regression) for the Four Factor Model
The table displays the results from the cross-sectional regression of the portfolios excess returns over
the excess market return coefficient, SMB coefficient, HML coefficient and MOM coefficient (
, where t = 1,..,T).

Alpha Beta SMB HML MOM

0.933 -0.182 0.008 0.442 2.863
Test statistic 1.844 -0.316 0.040 2.395 3.583

The value premium is also persistent in other countries for different periods. This can
explain why the value premium still exists for the current sample. Fama & French (1998)
found that value stocks outperform growth stocks in twelve of thirteen major markets,
including the Dutch market for the 1975-1995 period. In a later paper by Bauer et al (2010) is
shown that the value premium is persistent in a later sample period for US stocks as well
(1985-2002).
In the same paper of Bauer et al (2010) is shown that the size effect disappeared for
the US market. Van Dijk (2011) states that recent empirical studies assert that the size effect
disappeared after the early 1980s. The size effect for the Dutch market has been tested by
Doeswijk (1997). He found a small size effect (0.13) but it is not statistically significant.
Carhart (1997) shows that momentum is present in the US market and afterwards
Rouwenhorst (1998) tested this for the European market. In a sample of 12 European

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Msc Thesis: Luuk Milius

countries (including The Netherlands) during the period 1980-1995 he found that momentum
is present in all countries. This is in line with the results I found for my dataset. The value
premium and momentum seems persistent while the size effect has disappeared.

Conclusion

I tested the Three Factor Model as developed by Fama & French (1992, 1996) for the
Dutch market. It provides an out-of-sample check since it is tested for a different market and a
different time period (1990-2010). I found that beta is insignificant and thus systematic risk is
not priced. So the CAPM does not hold for the Dutch market. The same holds for the size
effect, smaller firms do not earn a significant higher return than larger firms. A value
premium does exist. Value stocks earn a higher return than growth stocks. After testing the
Three Factor Model I included a fourth factor, the momentum factor. After inclusion of this
factor, beta and the size factor remain insignificant and the value factor remains significant.
The momentum factor itself is significant as well and improves the model as is indicated by
the alpha. The alpha coefficient loses its significance and thus is not statistically different
from zero.
These findings are important for professionals active in the field of corporate finance
and investments. For capital budgeting, setting the discount rate and investment decisions for
example. To determine the correct discount rate the CAPM is insufficient. Not only a firms
sensitivity to market risk matters. Furthermore, many practitioners add a small firm premium
to the discount rate, but it is not clear whether a size effect really exists (at least not for the
sample period I choose). For investment decisions a similar argument can be made. Small
firms do not necessarily outperform larger firms. However, value firms do outperform growth
firms and a momentum strategy seems to work as well.
There is one important limitation of the method used that needs to be taken into
account. The model assumes that the loadings on market risk, SMB, HML and the momentum
factor are roughly constant over time. This can be an issue, since variation through time in
these coefficients can occur, because companies (and the constructed portfolios as well) can
wander between growth and distress. It is possible that a model which allows for time
variation of the factor loadings does a better job in explaining the cross-section of expected
returns and maybe the Three Factor Model will suffice to capture differences in the cross-
section of expected returns in that particular instance.

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Msc Thesis: Luuk Milius

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