One of the key predictions of modern finance is that expected returns on securities can be explained solely by their systematic risk (betas). Recent research (see Fama and French (1992, 1993)) has shown however that beta, the risk measure nominated by the Capital Asset Pricing Model (CAPM), has almost no ability to explain the cross-section of stock returns. Instead, there is considerable evidence that individual firm characteristics such as firm size, book to market (B/M) ratios and past stock returns are better predictors of the cross sectional variation in stock returns.
These findings have created much controversy in the literature over whether individual firm characteristics or factor loadings are more relevant in explaining the cross-section of stock returns. Daniel and Titman (1997) argue that firm characteristics are more important than factor loadings in explaining the cross section of average stock returns and suggest that characteristics may be proxies of market mispricing.
In contrast, Davis, Fama and French (2000) argue that firm characteristics such as size and B/M ratios are just proxies of factor loadings (betas) on priced risk factors.2 Using a longer time-period than Daniel and Titman, they conclude that factor loadings on size and B/M factors provide a better description of the cross-section of stock returns than the characteristics themselves.
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The Cross-Section of Expected Corporate Bond Returns: Betas or Characteristics?
