Explaining Return Variation in the Frankfurt Stock Exchange: The Q-Factor Model versus the Fama-French Five Factor Model

Abstract

This study evaluates the effectiveness of the q-factor model in explaining stock return variation in the German equity market and compares its performance to the CAPM and the Fama and French Five Factor (FF5) model. We base our portfolio construction on the characteristics highlighted by Hou et al. (2015), to create excess returns and factor premiums for the time period from 2004 to 2023. Hou et al.'s q-model includes the market, size, investment, and profitability factor. The methodology consists of testing the model's ability of explaining return variations through regression analysis, aiming for statistically insignificant and zero-alpha intercepts. Our findings suggest that the q-factor model outperforms the CAPM in the German stock market, as indicated by more insignificant alpha values and superior scores in the GRS tests. When comparing the q-factor model to the FF5, results are mixed. While the q-model yields a higher number of insignificant alphas in both portfolio and anomaly approach, it underperforms the FF5 in GRS-test significance. This ambiguity makes it challenging to fully determine whether adding the value factor to the q-factor provides a significant improvement over the q-factor model for explaining stock returns in the German market.