The five-factor model in The Netherlands

This research attempts to answer the question: How does the five-factor model by Fama & French (2015) perform in predicting returns on the stock market of The Netherlands, and does it perform better than the three-factor model and CAPM? The first question is answered by constructing portfolios based on different company-specific characteristics. The research shows differences in stock returns of the different portfolios, although regression analysis shows little effectiveness of the risk factors in explaining stock returns. Based on this, the effectiveness of the five-factor model in the Dutch stock market cannot be validated. The added value of the five-factor model over the three-factor model and the CAPM is clear: the explanatory power increases by several different measures: a GRS test is performed, along with the comparison of the absolute α values and R2 values. The findings can be interpreted in different manners. The increased explanatory power of the five-factor model over the three-factor model and CAPM suggests the search for the correct risk factors needs to be continued. On the other hand, the disappointing performance of the five-factor model in an absolute sense possibly suggests that the factor-based approach is an inappropriate one when it comes to explaining Dutch stock returns.