What difference do new factor models make in portfolio allocation?

This paper compares the Hou-Xue-Zhang four-factor model with the Fama-French five-factor model from an investing perspective both in-and out-of-sample. Without margin requirements and model uncertainty, the Hou-Xue-Zhang model outperforms the Fama-French model. However, the outperformance could become negligible if an investor is subject to margin requirements and model uncertainty. The Hou-Xue-Zhang model shows similar power as the Fama-French model in describing the covariance matrix of asset returns. Overall, the two models do not make a difference for investing in a realistic setting.

Automated summary

This paper compares the Hou-Xue-Zhang four-factor model with the Fama-French five-factor model from an investing perspective in both in-and out-of-sample settings. The study finds that without margin requirements and model uncertainty, the Hou-Xue-Zhang model outperforms the Fama-French model. However, the difference becomes negligible if an investor is subject to margin requirements and model uncertainty. The study also highlights that both models have similar capabilities in describing the covariance matrix of asset returns, suggesting that they do not make a significant difference in a realistic investing setting.