Tijdschrift voor Economie en Management vol:XLIX issue:4 (Nov.) pages:789-846
We show that the results of a CAPM test are quite sensitive to the details of the test design. Especially crucial are the aspects related to the weight one gives to small, low-reputation stocks when constructing both the factor portfolios and the test or style portfolios whose returns are to be explained. To fit our observed returns we need to redesign the size and distress factor portfolios into two factor portfolios each, one for extremely small or distressed stocks relative to non-extreme stocks, and one for moderately small or distressed stocks versus larger or growth companies. This alternative model does a better job in pricing stocks, both in the US and internationally, than the standard four-factor CAPM model with factor portfolios designed following Fama and French (1992, 1993, 1995, 1996a, 1996b, 1998, 2000), Carhart (1997), Jegadeesh and Titman (1993) and Rouwenhorst (1999).