Does the Fama–French Five-Factor Model Explain Excess Returns? Evidence from non-Financial Firms in Sri Lanka

This study examines whether the Fama–French Five-Factor model explains variation in expected excess returns of non-financial firms listed on the Colombo Stock Exchange (CSE) in Sri Lanka. The primary objective is to determine whether the five risk factor proxies: market risk premium, size, value, profitability, and investment significantly explain variations in the excess returns. The sample consists of 80 non-financial firms observed over the period 2020–2024. Quarterly data were obtained from company financial reports and the Colombo Stock Exchange (CSE). The dependent variable is excess return, while the independent variables are market risk premium, size, value, profitability, and investment factor. Descriptive statistics show negative mean, maximum, and minimum values for both excess returns and market risk premiums during the study period, reflecting adverse market conditions caused by the COVID-19 pandemic and Sri Lanka’s economic crisis. This highlights increased market volatility and reduced investor confidence. The panel dataset was analyzed using econometric techniques, including descriptive statistics, correlation analysis, and panel regression modeling. The Hausman test was used to determine the appropriate model specification, confirming that the Fixed Effects model is the most suitable for addressing unobserved heterogeneity. The model explains 58.64% of the variation in excess returns, indicating considerable explanatory power. The market risk premium and size factors have a statistically significant positive effect on excess returns, while value, profitability, and investment factor do not show statistically significant relationships. This suggests that these characteristics may be underpriced in the CSE. The findings indicate that market beta and firm size are key determinants in equity portfolio strategies. Policymakers are encouraged to strengthen corporate transparency and disclosure practices to improve market efficiency and ensure that stock prices more accurately reflect firms’ underlying fundamentals. Overall, the study demonstrates the partial applicability of the Fama–French Five-Factor model in Sri Lanka’s emerging market and suggests future research directions, such as incorporating liquidity risk and macroeconomic variables to further enhance asset pricing models.