EMPIRICAL STUDY OF FAMA-FRENCH THREE-FACTOR MODEL

AND CARHART FOUR-FACTOR MODEL IN INDONESIA

Tatang Ary Gumanti1, Bambang Sutrisno2, Andreas3, Denny Bernardus4

1
Universitas Jember
Jl. Kalimantan No. 37, Jember, Indonesia
email: tatangag@unej.ac.id
2
Universitas Muhammadiyah Jakarta
Jl. KH. Ahmad Dahlan, Ciputat Jakarta Selatan, Indonesia
email: bsutrisno.umj@gmail.com
3
Universitas Riau
Jl. Binawidya Km. 12.5, Simpang Panam, Pekanbaru, Indonesia
email: tanandreas61@gmail.com
4
Universitas Ciputra
UC Town, Citraland, Made, Sambikerep, Surabaya , Indonesia
email: denny@ciputra.ac.id

ABSTRACT
This research compares the performances of the Fama-French three-factor and Carhart four-
factor models on the Indonesian stock market. It employs ordinary least square (OLS) with
monthly time-series data from July 2005 to June 2015. The results document that the Carhart
four-factor model performs better than Fama-French three-factor model in explaining the
portfolio excess returns in Indonesia. The momentum factor displays a weak effect on the
portfolio excess returns. The results are robust to the equally-weighted method.
Keywords: asset pricing, three-factor model, size, book-to-market, momentum

INTRODUCTION

The Capital Asset Pricing Model (CAPM) introduced by Sharpe (1964), Lintner (1965),
Mossin (1966), and Black (1972) contribute significantly to the understanding of risk
relationships with returns for academia and practitioners. The return of an asset in the CAPM
model is determined only by systematic risk, i.e., beta. The expected return on risk assets is
predicted to be positively related to beta. The main purpose of CAPM is to determine the
required rate of return on an investment. The market equilibrium by Markowitz (1952)
confirms two things, the positive relationship between expected return and beta, and beta as
the only measure of risk.
Initially, empirical tests generally support the argument that beta is the only predictor of
cross sectional differences in stock portfolio returns (Fama and MacBeth, 1973). However,
later empirical findings suggest that not only the beta can explain stock returns, but there are
other factors that can explain stock returns variation and eventually develop other asset pricing
models. A number of studies have found that firm characteristics may be a significant
explanatory factor on average returns, such as firm size (Banz, 1981; Reinganum, 1981),
earnings to price ratio (Basu, 1983), leverage (Bhandari, 1988 ), or book-to-market equity ratio
(Stattman, 1980; Rosenberg et al., 1985; Chan et al., 1991).
Encouraged by the above findings, an article that has a major impact on systematic risk
validity as a measure of stock risk is Fama and French (1992) who use size, leverage, earnings
to price ratio, book-to-market equity ratio and beta. They generate two main results. Firstly,

Electronic copy available at: https://ssrn.com/abstract=3314684

when beta is allowed to vary unrelated to size, the positive linear relationship between beta and
return will disappear as opposed to CAPM prediction. Secondly, because beta is not good at
explaining returns, Fama and French compare the explanatory power of size, leverage, earnings
to price ratio, book-to-market equity ratio, and conclude that the size and the ratio of book-to-
market equity are the variables that have the strongest relationship with return and can explain
the cross-section of the average stock return well. However, some researchers assume that the
results of Fama and French research occur due to data snooping (Black, 1993; MacKinlay,
1995). Kothari et al. (1995) argue that there could be a bias in the data processing and beta
measurement error. Nevertheless, many researchers have reached the conclusion that the effect
of size and book-to-market is real through observation with US data.
In their further research, Fama and French (1993) try to provide answers using a risk-
based concept and show that the size and book-to-market factors could explain significant
amount of variation in stock returns. They develop previous research using a time-series
regression approach to US stock data for the period 1963 to 1991. Fama and French (1993)
propose a three-factor asset pricing model. The three-factor model includes market factor
(excess market return), size factor (SMB), and book-to-market (HML) factor. Small minus big
(SMB) is a return on a small stock portfolio minus a return on a large stock portfolio, while
high minus low (HML) represents a return on the portfolio of value stocks minus returns on
the portfolio of growth stocks. The Fama and French’s study is interesting because it can show
that the premium return associated with size and book-to-market ratio is compensated for risk,
in line with the spirit of the Intertemporal Capital Asset Pricing Model (Merton, 1973).
Subsequent studies show that a three-factor model can explain the cross section of stock
returns well. These include Fama and French (1996, 1998), Liew and Vassalou (2000), Griffin
and Lemmon (2002), Lettau and Ludvigson 2001, and Petkova (2006). Therefore, the three-
factor model of Fama and French has become a reference model in asset pricing literature.
Momentum effect, the effect where winner stocks (loser) continue to show good
performance (bad), becomes one of the most contentious issues as anomaly. The momentum
strategy applied by investors who buy high-yielding stocks and sell low-yielding stocks over
the previous three to twelve months could generate significant returns on most stock markets.
In response to momentum as revealed by Jegadesh and Titman (1993), Carhart (1997)
constructs a risk factor related to momentum effect (WML), and propose a four-factor model
by adding this risk factor to the Fama-French three-factor model. WML is the difference in
yield on the winner stock portfolio with the loser stock portfolio. Carhart (1997) reveals that
the four-factor model, compared with the Fama-French (1993) three-factor model, can reduce
the pricing error of the portfolio that is sorted with returns on 1 year lag.
According to our knowledge, there is no study directed to compare the performance of
the Fama-French three-factor model and the four factors of Carhart in the Indonesian stock
market using the most recent data. Therefore, this study aims to compare the performance of
three-factor Fama-French model and four Carhart factors in the Indonesian stock market during
the period July 2005 to June 2015. The results show that the four-factor model of Carhart is
better than the Fama-French three-factor model in explaining the excess return portfolio in
Indonesia. The momentum factor shows a weak effect on the excess return portfolio. The
results of the study are robust on the equally-weighted method.
The paper is organized as follows. Section two presents the literature review. This is
followed by the research methods of the study. Section four provides results and discussion.
Final section concludes the paper.

Electronic copy available at: https://ssrn.com/abstract=3314684

LITERATURE REVIEW

The three-factor model of Fama-French (1993) states that the excess return portfolio is
explained by three asset pricing factors, i.e., market, size (SMB), and book-to-market (HML).
Market factors represent the difference between market return and risk-free rate. Small Minus
Big (SMB), represents the difference of return on the portfolio of small cap stock shares with
large capitalized portfolio return.
The three-factor model of Fama-French (1993) can be expressed in the following model:

𝑅𝑖𝑡 − 𝑅𝑓𝑡 = 𝑎𝑖 + 𝑏𝑖 (𝑅𝑚𝑡 − 𝑅𝑓𝑡 ) + 𝑠𝑖 𝑆𝑀𝐵𝑡 + ℎ𝑖 𝐻𝑀𝐿𝑡 + 𝑒𝑖𝑡 (1)

where 𝑅𝑖𝑡 is return of securities or portfolio i for period t, 𝑅𝑓𝑡 is risk free rate for period
t, 𝑅𝑚𝑡 is market portfolio return for period t, 𝑆𝑀𝐵𝑡 is size factor (Small Minus Big) for period
t, 𝐻𝑀𝐿𝑡 is book-to-market factor (High Minus Low) for period t, and 𝑒𝑖𝑡 is error term of
securities or portfolio i of period t.
The Fama-French three-factor model is basically the development of CAPM, by adding
size (SMB) and book-to-market (HML) factors into the CAPM model. SMB is a risk measure
of the company, where the stock of small companies is expected to be more sensitive. On the
other hand, HML represents a higher risk exposure for stocks of firms with high book value-
to-market ratios (value stocks) and lower for firm stocks with low book-to-market ratios
(growth stocks).
Jegadeesh and Titman (1993) document that the momentum strategy generates an
average yield of 1% per month over the next 3-12 months. The momentum strategy is a system
by purchasing stocks or other financial securities that have high returns during the previous 3-
12 months, and sell those stocks or other securities that have low returns for the same period.
In an attempt to capture the momentum yield, Carhart (1997) adds a factor to the Fama-French
(1993) three-factor model.
The four-factor model of Carhart can be expressed in the following equation:

𝑅𝑖𝑡 − 𝑅𝑓𝑡 = 𝑎𝑖 + 𝑏𝑖 (𝑅𝑚𝑡 − 𝑅𝑓𝑡 ) + 𝑠𝑖 𝑆𝑀𝐵𝑡 + ℎ𝑖 𝐻𝑀𝐿𝑡 + 𝑤𝑖 𝑊𝑀𝐿𝑡 + 𝑒𝑖𝑡 (2)

where 𝑅𝑖𝑡 is return of securities or portfolio i for period t, 𝑅𝑓𝑡 is risk free rate for period t, 𝑅𝑚𝑡
is market portfolio return for period t, 𝑆𝑀𝐵𝑡 is size factor (Small Minus Big) for period t, 𝐻𝑀𝐿𝑡
is book-to-market factor (High Minus Low) for period t, 𝑊𝑀𝐿𝑡 is momentum factor (Winner
Minus Loser) for period t, and 𝑒𝑖𝑡 is error term of securities or portfolio i of period t.
Subsequent studies were conducted based on the results of Carhart’s study (1997).
Wermers (1997) and Daniel et al. (2001) find evidence that the fourth factor of Carhart (1997)
can investigate strategies that spur persistence in mutual fund performance. Brav et al. (2000)
document that the four-factor model has the ability to explain underperformance in returns on
the samples of companies conducting an initial public offering (IPO) and seasoned equity
offering (SEO). Kim and Kim (2003) report that a four-factor model can explain the abnormal
pattern of returns after earnings announcements, which are sorted with standardized
unexpected earnings (SUE).
Awwaliyah and Husodo (2011) test the validity of three-factor Fama-French and four
factor Carhart models using US data from January 1963 to December 2010. They find that the
four-factor model of Carhart was better than the Fama-French three-factor model in explaining
the variation of excess return of stock portfolio in the US. Fama and French (2012) test the
effect of size, value, and momentum in 23 developed countries that are divided into 4 regions,
namely North America, Japan, Asia Pacific, and Europe. Fama and French examine the data

Electronic copy available at: https://ssrn.com/abstract=3314684

covering from November 1989 to March 2011 and report that there is value premium and return
momentum in all regions except in Japan. They assert that asset pricing is not integrated in all
four areas. Cakici et al. (2013) examine the effects of value and momentum in 18 developing
countries divided into three regions: Asia, Latin America, and Eastern Europe for the period
from January 1990 to December 2011. The results provide strong evidence of value effects in
all regions and momentum effects in all regions except Eastern Europe. In addition, Cakici et
al. document that local factors show much better performance than global factors, indicating
market segmentation in developing countries.

RESEARCH METHOD

Data
This study uses data obtained from Datastream databases. The use of the Datastream
database helps with survivorship bias because Datastream samples include active and non-
active companies (Cakici et al., 2013). The research period is July 2005-June 2015. This study
uses monthly data. The data used in this study include the stock closing price, the number of
shares outstanding, the Indonesian capital market Composite Stock Price Index, the book value
of equity, and the risk-free interest rate using monthly data of 90 days of Bank Indonesia
Certificates.
The criteria for determining the sample follow Fama and French (1992, 1993, 2012). This
study excludes stocks that fall within the financial sector. This study excludes stocks in the
financial sector because high leverage is common to financial firms, but that does not apply to
non-financial companies, where high leverage would indicate financial difficulties. This study
also drops stocks with negative equity because negative equity may also indicate that a
company is experiencing financial difficulties.

Research variables
The independent variables in this research are asset pricing factors that include market,
size (SMB), book-to-market (HML), and momentum (WML) factors. The calculation of return
of each asset pricing factor is determined using the value-weighted method. Explanation of
each factor is described as follows.
a. Market Factor (Rm – Rf)
Market factor represents the difference of each market's return on risk-free interest rate.
b. Size factor (SMB)
SMB (Small Minus Big) is intended to illustrate the risk factors associated with firm size.
SMB represents the difference of each month of average returns on three portfolios over
small share capitalization with average returns on three portfolios with large share
capitalization. SMB calculation is formulated as follows.

(𝑆𝑚𝑎𝑙𝑙 𝑉𝑎𝑙𝑢𝑒+𝑆𝑚𝑎𝑙𝑙 𝑁𝑒𝑢𝑡𝑟𝑎𝑙+𝑆𝑚𝑎𝑙𝑙 𝐺𝑟𝑜𝑤𝑡ℎ)

𝑆𝑀𝐵 = −
3
(𝐵𝑖𝑔 𝑉𝑎𝑙𝑢𝑒+𝐵𝑖𝑔 𝑁𝑒𝑢𝑡𝑟𝑎𝑙+𝐵𝑖𝑔 𝐺𝑟𝑜𝑤𝑡ℎ)
(3)
3
c. Faktor Book-to-market (HML)
HML (High Minus Low) is meant to capture the risk factors associated with the book-to-
market ratio. HML is the monthly difference between the average returns on two portfolios
that have high book-to-market ratios with average returns on two portfolios with low book-
to-market ratios. The HML calculation uses the following formula.

(𝑆𝑚𝑎𝑙𝑙 𝑉𝑎𝑙𝑢𝑒+𝐵𝑖𝑔 𝑉𝑎𝑙𝑢𝑒) (𝑆𝑚𝑎𝑙𝑙 𝐺𝑟𝑜𝑤𝑡ℎ+𝐵𝑖𝑔 𝐺𝑟𝑜𝑤𝑡ℎ)

𝐻𝑀𝐿 = − (4)
2 2

Electronic copy available at: https://ssrn.com/abstract=3314684

d. Momentum factor (WML)
WML (Winner Minus Loser) is intended to capture the risk factors associated with the
momentum effect. WML represents the average return on two previous high portfolio
returns reduced by two low average portfolio returns. Portfolios are rebalanced every month.
WML calculation is formulated as follows

(𝑆𝑚𝑎𝑙𝑙 𝐻𝑖𝑔ℎ+𝐵𝑖𝑔 𝐻𝑖𝑔ℎ) (𝑆𝑚𝑎𝑙𝑙 𝐿𝑜𝑤+𝐵𝑖𝑔 𝐿𝑜𝑤)

𝑊𝑀𝐿 = − (5)
2 2
This study calculates the excess return from portfolio 25 Size-B/M as the dependent
variable. Portfolio 25 Size-B/M, formed at the end of every June, is the interaction of five
portfolios formed on the size (market capitalization) with five portfolios formed on the book-
to-market ratio. Size for June of year t is the multiplication of stock price in June year t with
the number of shares outstanding in June of year t. B/M for June in year t is the book value of
equity at the end of fiscal year t-1 on market capitalization in December year t-1. The
calculation of portfolio return using the value-weighted method. The portfolio will be rebalance
annually at the end of June year t. Table 1 presents an overview of the establishment of 25 Size-
B/M portfolios.

Tabel 1. Representation of 25 portfolios based on Size-B/M

B/M (Low-High)
Low 2 3 4 High
Small S-L S-2 S-3 S-4 S-H
2 2-L 2-2' 2-3' 2-4' 2-H
Size (Small-Big) 3 3-L 3-2' 3-3' 3-4' 3-H
4 4-L 4-2' 4-3' 4-4' 4-H
Big B-L B-2 B-3 B-4 B-H

Empirical model
The empirical models used in this study are the three-factor model Fama-French (1993)
and the four-factor model Carhart (1997), as described in equations 1 and 2 (previous section).
This research uses ordinary least square estimation method (OLS) which adjusted to
Newey and West (1987). Through this standard error adjustment, the OLS method becomes
more robust on issues of heteroscedasticity and autocorrelation. This study uses several criteria
in comparing the Fama-French three-factor model and the four factors of Carhart in Indonesia.
Following Merton (1973), a well-estimated asset pricing model produces an insignificant
intercept. This study tested this by computing the F-statistic of the GRS test (Gibbons, et al.,
1989). The formula for calculating the GRS test is as follows.

𝑇 𝑇−𝑁−𝐿 𝛼′ ∑−1 𝛼
𝐺𝑅𝑆 = (𝑁) ( 𝑇−𝐿−1 ) [1+ 𝜇′ Ώ−1 𝜇] ~ 𝐹(𝑁, 𝑇 − 𝑁 − 𝐿) (6)

where T is the number of observations, N is the number of described portfolios, L is the number
of explanatory factors, α is the vector of the intercept of regression, Σ is the covariance matrix
of the residual of regression, μ is the vector of the mean of explanatory, and Ώ is the covariance
matrix of Explanatory factors. The null hypothesis states that all the regression intercepts are
zero, GRS test statistics has the F distribution with degrees of freedom N and T-N-L.
Following the recommendation of Lewellen et al. (2010), this study also calculates
Sharpe Ratio (SR (α). The formula for calculating Sharpe Ratio is as follows.

Electronic copy available at: https://ssrn.com/abstract=3314684

𝑆𝑅(α) = (𝛼 ′ 𝑆 −1 𝛼)1/2 (7)

where α is the column vector of 25 regression intercepts produced by each model when
applying the Size-B/M portfolio, and S is the covariance matrix of the residual regression.
Smaller Sharpe Ratio values indicate that an asset pricing model is better. This study also
compares the average adjusted R2, the mean absolute value of the intercept, and the average
standard error of the intercept to indicate which model is better.

RESULTS AND DISCUSSION

Descriptive statistics
The statistical summary for each independent variable (asset pricing factor) during the
period of July 2005 - June 2015 (120 observations) is presented in Table 2. The monthly
average of market factor (Rm - Rf) is 0.69%, the average of the size factor (SMB) is 0.06% per
month, the average of the book-to-market (HML) factor per month is 0.01%, and the
momentum factor has an average value per month of 0.03%. All factors have a positive average
value. This indicates that the market, size, book-to-market, and momentum factors have a
premium to compensate for risk.

Table 2. Summary statistics for monthly factor percent returns

Rm - Rf SMB HML WML
Mean 0.69 0.06 0.01 0.03
Median 1.33 0.04 0.01 0.00
Maximum 19.37 1.40 3.90 1.99
Minimum -32.19 -0.72 -1.50 -0.31
Std dev. 6.42 0.28 0.56 0.24

The correlation between factors is shown in Table 3. The book-to-market and momentum
factors are positively correlated with market factors, while the size factor is negatively
correlated with market factors. The book-to-market and momentum factors are negatively
correlated with the size factor. The momentum factor is positively correlated with the book-to-
market factor.

Table 3. Correlation between asset pricing factors

Rm - Rf SMB HML WML
Rm - Rf 1 -0.25 0.14 0.11
SMB -0.25 1 -0.56 -0.01
HML 0.14 -0.56 1 0.06
WML 0.11 -0.01 0.06 1

Table 4 shows the average monthly excess return (the excess return of the Bank Indonesia
Certificates monthly interest rate) for a 25 value-weighted portfolio of independently sorted of
stocks into 5 Size groups and 5 Book-to-Market groups (B/M). In each of the B/M columns of
Table 4, the average excess return generally decreases from the stocks in the small market
capitalization group to the stocks in the large market capitalization group. This shows the size
effect. The average relationship of return with B/M, called the value effect, is only indicated

Electronic copy available at: https://ssrn.com/abstract=3314684

by stocks in the Size 4 group where the average excess return increases from 0.22% to 0.83%.
The value effect is found to be inconsistent in the size effect.

Table 4. Average monthly percent excess returns for 25 Size-B/M portfolios

Low 2 3 4 5
Small 2.60 1.41 0.72 0.52 0.24
2 0.92 1.31 0.28 0.31 0.48
3 0.58 0.53 0.48 0.42 0.33
4 0.22 0.32 0.31 0.43 0.83
Big 0.10 0.19 0.31 0.60 -0.18

Stationarity Test
The result of test of stationarity with Augmented Dickey-Fuller (ADF) method at data
level is presented in Table 5. The test result on each research variable shows that all research
variables have t-stat value smaller than critical value. That is, all research variables have been
stationary (do not have root units) on the data level.

Table 5. Result of test of stationarity using Augmented Dickey-Fuller

Panel A: Independent variable (Explanatory returns)
Rm - Rf -8.56
SMB -8.69
HML -8.94
WML -11.23
Panel B: Excess return of 25 Size-B/M portfolios
Low 2 3 4 High
Small -6.23 -10.82 -6.08 -5.03 -8.67
2 -5.37 -7.81 -10.58 -7.26 -11.81
3 -4.77 -4.28 -8.55 -9.10 -10.81
4 -6.45 -15.39 -5.44 -11.58 -6.30
Big -9.26 -11.31 -6.51 -8.28 -8.27
Critical values:
α = 1% -3.49
α = 5% -2.89
α = 10% -2.58

Regression result for Fama-French three-factor model

Table 6 summarizes the results of the monthly excess return regression of the Size-B/M
portfolio on the returns of the Fama-French three factors. There are eighteen statistically
significant intercept, while the remainder (seven intercepts) are insignificant. This result is not
in accordance with Merton's criterion (1973), where most of the intercept of 25 portfolios are
significant. This indicates that the Fama-French three-factor model cannot capture all the
variations of the excess return of the stock portfolio.
All coefficients of market factors are positive, indicating that market factors have a
positive effect on excess return of stock portfolios. There are only three coefficients of

Electronic copy available at: https://ssrn.com/abstract=3314684

insignificant market factors. That is, market factors can capture almost all variations of excess
return of stock portfolio. The coefficient of market factors tends to be smaller for smaller
capitalized stocks. This finding is consistent with Halliwell et al. (1999), but inconsistent with
Fama-French (1993).
This study finds eleven coefficients of size factor (SMB) are statistically significant,
either at the level of 1%, 5%, or 10%. That is, almost half of the SMB coefficients on the Size-
B / M 25 portfolio are able to explain the excess return of the stock portfolios. There is no
apparent pattern that can be observed from the SMB coefficients.
There are eleven coefficients of the book-to-market factor (HML) that are statistically
significant. This indicates that the HML factor can explain the excess return of the stock
portfolio almost half of the 25 Size-B/M portfolios. Similar to the coefficient of SMB, there is
no clear pattern of observable HML coefficients.
The adjusted values of R2 range from 1% to 82%. The average adjusted R2 for the Fama-
French three-factor model is 26%. GRS statistics are significant at the 1% level, which
indicates that the intercepts simultaneously are not equal to zero. Sharpe ratio for the Fama-
French three-factor model is 1.33. The average absolute values of the intercept and the average
standard errors of intercepts are 0.43 and 0.25, respectively.

Regression result for Carhart four-factor model

The regression estimation results for the four-factor model of Carhart are shown in Table
7. There are nineteen statistically significant intercepts, while six intercepts are insignificant.
These findings indicate that the Fama-French four-factor model cannot account for all the
variations in the excess return of the stock portfolio. In other words, there are other factors to
consider in determining the right asset pricing model for the Indonesian stock market. An
interesting finding is that the intercept of a large-capitalized portfolio of stocks is almost
insignificant, indicating that large-cap stocks can better explain the excess return portfolio than
small capitalized stocks.
All coefficients of market factors are positive, which give the indication that market
factors have a positive effect on excess return of stock portfolios. Similar to the Fama-French
three-factor model, there are only three coefficients of the insignificant market factor. Market
factors can capture almost all the variations of excess return of stock portfolios in Indonesia.
Consistent with the Fama-French three-factor model, the coefficients of market factors on the
four-factor model of Carhart tend to be smaller for smaller capitalized stocks.
This study finds twelve coefficients of size factor (SMB) are statistically significant. That
is, half of the SMB coefficients on 25 portfolios are capable to explain the excess returns of
stock portfolios. There is no apparent pattern that can be observed from the SMB coefficient.
There are twelve coefficients of significant book-to-market (HML) factors. This indicates
that the HML factor can explain the excess returns of the stock portfolios almost half of the 25
Size-B/M portfolios. As with the SMB coefficients, there is no clear pattern of observable HML
coefficients.
There are only seven momentum coefficients (WML) that are statistically significant.
This finding shows that momentum factor has a weak effect on the variation of excess return
of stock portfolios in Indonesia. There is no apparent pattern that can be observed in the WML
coefficients.
The adjusted values of R2 range from 0.2% to 83%. The average adjusted R2 value for
the four-factor model of Carhart is 28%. GRS statistics are significant at 1% level, indicating
that 25 intercepts simultaneously are not equal to zero. The Sharpe ratio for the four-factor
Carhart model is 1.32. The average absolute values of the intercept and the average standard
error of intercepts are 0.43 and 0.25, respectively.

Electronic copy available at: https://ssrn.com/abstract=3314684

Comparison of asset pricing models
As shown in Tables 6 and 7, the average adjusted R2 value for the four-factor model of
Carhart is greater than the Fama-French three-factor model. This supports the superiority of
the Carhart four-factor model. The average absolute value of the intercept and the average
standard error of intercepts for the two models of magnitude are the same so that this study
cannot compare which asset pricing model is better based on the two criteria. When referring
to GRS statistic, both models produce F-statistic which is significant at 1% level. However, the
GRS statistic score for the four-factor Carhart model is smaller than the Fama-French three-
factor model, which may be interpreted that the four-factor model of Carhart is stronger. The
Sharpe ratio for the Carhart four-factor model is smaller than the Fama-French three-factor
model, where these findings confirm the superiority of the Carhart four-factor model compared
with the Fama-French three-factor model. Overall, the results of this study prove that the
Carhart four-factor model is better than the Fama-French three-factor model in explaining the
variation of excess return of stock portfolios in Indonesia.

Electronic copy available at: https://ssrn.com/abstract=3314684

 Table 6. Regression results for Fama-French three-factor model
B/M Low 2 3 4 High Low 2 3 4 High Low 2 3 4 High Low 2 3 4 High Low 2 3 4 High
Size α b s h Adjusted R2
Small 2.38a 0.88c 0.49c 0.37c 0.18c 0.11 0.17a 0.08 0.05a 0.04c 2.78 6.82 2.97 1.84a 0.59c -2.37 1.13 0.44 0.63c 0.13 0.01 0.15 0.05 0.09 0.19
2 0.64a 0.70b 0.17b 0.22c 0.27c 0.19a 0.21c 0.08c 0.06c 0.10c 2.58b 8.07a 1.11b 0.65a 2.34a -0.51 -0.62 0.30 0.27b 1.00a 0.09 0.24 0.19 0.36 0.21
3 0.51b 0.40b 0.14 0.26c 0.14 0.09c 0.07c 0.11c 0.08c 0.09c 0.24 1.18 4.22 1.70 1.97c -0.54 0.84a 1.25 0.67b 0.75c 0.07 0.09 0.24 0.26 0.35
4 0.12a 0.18c 0.26c 0.29c 0.54 0.09c 0.08c 0.07c 0.11c 0.14 0.68a 1.29b 0.17 0.87a 2.20 0.15 0.52b 0.17b 1.33c 7.84b 0.37 0.27 0.35 0.44 0.33
Big 0.08c 0.07 0.20 -0.20 -1.10 0.04c 0.15b 0.24c 0.78c 0.82c 0.00 0.30 -0.90 4.02 4.71 0.01 -0.08 0.39 3.16 8.96c 0.82 0.19 0.59 0.24 0.40
|α| = 0.43; s(α) = 0.25; Adj R2 = 0.26; GRS = 6.09c; SR(α) = 1.33
Note:
α is the regression intercept, whereas b, s, and h are the coefficients of market factors (Rm - Rf), size, and book-to-market, respectively. GRS is
GRS statistic, SR (α) is the Sharpe ratio for intercept, | α | is the average absolute value of the intercept, and s (α) is the average standard error of
the intercept. An intercept is expressed in percent. a, b, c denote significant at 10%, 5%, and 1%, respectively.

Table 7. Regression results for Carhart four-factor model

B/M Low 2 3 4 High Low 2 3 4 High Low 2 3 4 High Low 2 3 4 High Low 2 3 4 High
Size α b s h w
Small 2.35a 0.88c 0.48c 0.35c 0.18c 0.11 0.17b 0.08 0.04b 0.04c 2.69 6.79c 2.95 1.76a 0.60c -2.42 1.11 0.43 0.59b 0.13 1.42 0.38 0.36 1.19 -0.18
2 0.67a 0.67b 0.18b 0.22c 0.20b 0.19b 0.21c 0.08c 0.06c 0.08c 2.67b 8.00a 1.14b 0.63a 2.09c -0.46 -0.66 0.32a 0.26b 0.85c -1.36 1.06 -0.59b 0.27 3.90b
3 0.48b 0.42b 0.17a 0.28c 0.15 0.08c 0.08c 0.11c 0.08c 0.10c 0.14 1.25 4.29 1.75 2.00c -0.60 0.88b 1.29 0.70b 0.77c 1.54c -1.08 -1.10 -0.79a -0.47a
4 0.11a 0.17c 0.26c 0.31c 0.59 0.09c 0.08c 0.07c 0.11c 0.15 0.67a 1.26b 0.18 0.92b 2.38 0.14 0.50a 0.18b 1.36c 7.95b 0.25 0.58a -0.19 -0.73 -2.88
Big 0.07c 0.05 0.18 -0.23 -1.08 0.04c 0.14b 0.23c 0.77c 0.82c 0.00 0.24 -0.96 3.93 4.79 0.01 -0.11 0.35 3.10 9.01c 0.09b 0.94 0.90 1.44 -1.36
B/M Low 2 3 4 High
Size Adjusted R2
Small 0.00 0.14 0.04 0.12 0.19
2 0.09 0.23 0.20 0.36 0.53
3 0.10 0.10 0.25 0.28 0.36
4 0.37 0.28 0.35 0.45 0.33
Big 0.83 0.20 0.60 0.23 0.39
|α|= 0.43 ; s(α) = 0.25; Adj R2 =
0.28; GRS = 5.99c; SR(α) = 1.32
Note:
α is the regression intercept, whereas b, s, h, and w are the coefficients of market factors (Rm - Rf), size, book-to-market, and momentum,
respectively. GRS is GRS statistic, SR (α) is the Sharpe ratio for intercept, | α | is the average absolute value of the intercept, and s (α) is the average
standard error of the intercept. An intercept is expressed in percent. a, b, c denote significant at 10%, 5%, and 1%, respectively.

10

Electronic copy available at: https://ssrn.com/abstract=3314684

Robustness test
This study tested the robustness of the research results described above through the use
of the equally-weighted method in calculating the asset pricing and excess return portfolios of
25 Size-B/M factors. This robustness test needs to be done to see if the regression estimation
result using the value-weighted method is consistent with the regression estimation result using
the equally-weighted method. Table 8 presents the summary of the regression results for the
Fama-French three-factor model (FF3) and the Carhart four-factor model using the equally-
weighted method.

Table 8. Robustness test using equally-weighted method

GRS SR(α) |α| s(α) Adj R2
c
FF3 4.16 0.69 0.41 0.53 0.35
c
Carhart 3.88 0.67 0.38 0.53 0.37
c
indicates significant value at 1% level.

As shown in Table 8, the GRS statistics on both models are significant at the 1% level,
but the GRS value statistic for the Carhart four-factor model is smaller than the Fama-French
three-factor model. The average adjusted R2 for the Carhart model is greater than the Fama-
French model. The Sharpe ratio on the Carhart model is smaller than the Fama-French model.
The average absolute value of the intercept on the Carhart model is smaller than the Fama-
French model. The average standard errors of intercept for both models generate the same
magnitude of 0.53. Thus, robust test results on the equally-weighted method show that the
Carhart four-factor model is superior in explaining the excess return of the stock portfolios in
Indonesia than the Fama-French three-factor model.

CONCLUSION

This study compares the performance of Fama-French three-factor model and Carhart
four-factor model in explaining the excess return of stock portfolio in Indonesia during the
period of July 2005 to June 2015. To do so, this study compares GRS statistic, Sharpe ratio,
the average adjusted R2, the mean absolute value of the intercept, and the average standard
error of intercept on both models. This study uses time-series regression with monthly data
frequency.
The findings show that the Carhart-four factor model is better in explaining the excess
return of stock portfolios in Indonesia than the Fama-French three-factor model. This finding
supports Awwaliyah and Husodo (2011) using US stock market data. This result is robust when
tested using equally method in calculating asset pricing factor and excess return portfolio.
Although the four-factor model of Carhart is superior to the Fama-French three-factor model,
the results suggest that there are other factors to consider in determining asset pricing models
that better capture stock return variations in the Indonesian stock market.
Future studies may use other proxies of risk-free interest rates, such as government bond
yields with the tenure of less than one year. Further research can also compute J-statistics to
see the significance of the regression intercept with generalized method of moments (GMM)
technique, given the assumptions in GRS statistics that cannot be held identical in the
practitioner's world, independent, and normal distributed asset returns (Cochrane, 2005:234).

11

Electronic copy available at: https://ssrn.com/abstract=3314684

REFERENCES
Awwaliyah, I. N., & Husodo, Z. A. (2011). On the robustness of the extended Fama-French
three factor model. Unpublished Working Paper. Universitas Indonesia.
Banz, R. W. (1981). The relationship between return and market value of common stocks.
Journal of Financial Economics, 9(1), 3-18. doi:https://doi.org/10.1016/0304-
405x(81)90018-0
Basu, S. (1983). The relationship between earnings yield, market value, and return for NYSE
common stocks: further evidence. Journal of Financial Economics, 12(1), 129-156.
doi:https://doi.org/10.1016/0304-405x(83)90031-4
Bhandari, L. C. (1988). Debt/equity ratio and expected common stock returns: Empirical
evidence. Journal of Finance, 43(2), 507-528. doi:10.1111/j.1540-
6261.1988.tb03952.x
Black, F. (1993). Beta and return. Journal of Portfolio Management, 20(1), 8-18.
doi:10.3905/jpm.1993.409462
Brav, A., Geczy, C., & Gompers, P. A. (2000). Is the abnormal return following equity
issuances anomalous? Journal of Financial Economics, 56(2), 209-249.
doi:https://doi.org/10.1016/s0304-405x(00)00040-4
Cakici, N., Fabozzi, F. J., & Tan, S. (2013). Size, value, and momentum in emerging market
stock returns. Emerging Markets Review, 16(3), 46-65.
doi:https://doi.org/10.1016/j.ememar.2013.03.001
Carhart, M. M. (1997). On persistence in mutual fund performance. Journal of Finance, 52(1),
57-82. doi:10.1111/j.1540-6261.1997.tb03808.x
Chan, L. K., Hamao, Y., & Lakonishok, J. (1991). Fundamentals and stock returns in Japan.
Journal of Finance, 46(5), 1739-1789. doi:10.2307/2328571
Cochrane, J. H. (2005). Asset Pricing (Revised Edition). New Jersey: Princeton University
Press.
Daniel, K., Titman, S., & Wei, K. C. (2001). Explaining the cross-section of stock returns in
Japan: Factors or characteristics? Journal of Finance, 56(2), 743-766.
doi:10.1111/0022-1082.00344
Fama, E. F., & French, K. R. (1992). The cross-section of expected stock returns. Journal of
Finance, 47(2), 427-465. doi:10.2307/2329112
Fama, E. F., & French, K. R. (1993). Common risk factors in the returns on stocks and bonds.
Journal of Financial Economics, 33(1), 3-56. doi:https://doi.org/10.1016/0304-
405x(93)90023-5
Fama, E. F., & French, K. R. (1996). Multifactor explanations of asset pricing anomalies.
Journal of Finance, 51(1), 55-84. doi:10.1111/j.1540-6261.1996.tb05202.x
Fama, E. F., & French, K. R. (1998). Taxes, financing decisions, and firm value. Journal of
Finance, 53(3), 819-843. doi:10.1111/0022-1082.00036

12

Electronic copy available at: https://ssrn.com/abstract=3314684

Fama, E. F., & French, K. R. (2012). Size, value, and momentum in international stock returns.
Journal of Financial Economics, 105(3), 457-472.
doi:https://doi.org/10.1016/j.jfineco.2012.05.011
Fama, E. F., & MacBeth, J. D. (1973). Risk, return, and equilibrium: Empirical tests. Journal
of Political Economy, 81(3), 607-636. doi:ttps://doi.org/10.1086/260061
Gibbons, M. R., Ross, S. A., & Shanken, J. (1989). A test of the efficiency of a given portfolio.
Econometrica, 57(5), 1121-1152. doi:10.2307/1913625
Griffin, J. M., & Lemmon, M. L. (2002). Book-to-market equity, distress risk, and stock
returns. Journal of Finance, 57(5), 2317-2336. doi:10.1111/1540-6261.00497
Halliwell, J., Heaney, J., & Sawicki, J. (1999). Size and book to market effects in Australian
share markets: A time series analysis. Accounting Research Journal, 12(2), 122-137.
Jegadeesh, N., & Titman, S. (1993). Returns to buying winners and selling losers: Implications
for stock market efficiency. Journal of Finance, 48(1), 65-91. doi:10.1111/j.1540-
6261.1993.tb04702.x
Kothari, S. P., Shanken, J., & Sloan, R. G. (1995). Another look at the cross-section of expected
stock returns. Journal of Finance, 50(1), 185-224. doi:10.1111/j.1540-
6261.1995.tb05171.x
Lettau, M., & Ludvigson, S. (2001). Resurrecting the (C)CAPM: A cross-sectional test when
risk premia are time-varying. Journal of Political Economy, 109(6), 1238-1287.
doi:https://doi.org/10.1086/323282
Liew, J., & Vassalou, M. (2000). Can book-to-market, size and momentum be risk factors that
predict economic growth? Journal of Financial Economics, 57(2), 221-245.
doi:https://doi.org/10.1016/s0304-405x(00)00056-8
Lintner, J. (1965). The valuation of risk assets and the selection of risky investments in stock
portfolios and capital budgets. Review of Economics and Statistics, 47(1), 13-37.
doi:http://dx.doi.org/10.2307/1924119
MacKinlay, A. C. (1995). Multifactor models do not explain deviations from the CAPM.
Journal of Financial Economics, 38(1), 3-28. doi:https://doi.org/10.1016/0304-
405x(94)00808-e
Markowitz, H. (1952). Portfolio selection. Journal of Finance, 7(1), 77-91.
doi:10.1111/j.1540-6261.1952.tb01525.x
Merton, R. (1973). An Intertemporal Capital Asset Pricing Model. Econometrica, 41(5), 867-
887. doi:10.2307/1913811
Mossin, J. (1966). Equilibrium in a capital asset market. Econometrica, 34(4), 768-783. doi:
10.2307/1910098
Newey, W. K., & West, K. D. (1987). A simple, positive semi-definite, heteroscedasticity and
autocorrelation consistent covariance matrix. Econometrica, 55(3), 703-708.
doi:10.2307/1913610

13

Electronic copy available at: https://ssrn.com/abstract=3314684

Petkova, R. (2006). Do the Fama-French factors proxy for innovations in predictive variables?
Journal of Finance, 61(2), 581-612. doi:10.1111/j.1540-6261.2006.00849.x
Reinganum, M. R. (1981). Misspesification of capital asset pricing: empirical anomalies based
on earnings yield and market values. Journal of Financial Economics, 9(1), 19-46.
doi:https://doi.org/10.1016/0304-405x(81)90019-2
Rosenberg, B., Reid, K., & Lanstein, R. (1985). Persuasive evidence of market inefficiency.
Journal of Portfolio Management, 11(3), 9-16. doi:10.3905/jpm.1985.409007
Sharpe, W. F. (1964). Capital asset prices: A theory of market equilibrium under conditions of
risk. Journal of Finance, 19(3), 425-442. doi:10.1111/j.1540-6261.1964.tb02865.x
Stattman, D. (1980). Book values and stock returns. The Chicago MBA: A Journal of Selected
Papers, 4(1), 25-45.
Wermers, R. (1997). Momentum investment strategies of mutual funds, performance
persistence, and survivorship bias. Unpublished Working Paper. University of
Colorado.

14

Electronic copy available at: https://ssrn.com/abstract=3314684