A four-factor model based on factor momentum

Abstract

By focusing on the momentum effect in China, we introduce a novel four-factor model grounded by factor momentum. We address this by progressively exploring three key questions. Firstly, we identify a significant momentum premium. In contrast to the US, where momentum forms over a period of 2–12 months, the formation period for momentum in China spans 7–12 months. Moreover, among various momentum factors, factor momentum stands out as the most significant, effectively explaining stock momentum, industry momentum, and regional momentum, whereas the reverse is not true. Secondly, we find that there exists a notable orthogonality between factor momentum and non-momentum factors in China, implying that factor momentum can hardly be explained by non-factor momentum, and vice versa. Thirdly, leveraging this orthogonality, we establish a four-factor model. Expanding upon the MKT and SMB factors, the model additionally includes a mispricing factor and a momentum factor. GRS tests demonstrate that this model outperforms traditional Fama-French three-factor model, Carhart four-factor model, Q-4 factor model, and the three-factor model proposed by Liu et al. (2019).