Determination of expected stock returns has been studied by many papers. The literature has mainly considered the US case even though more recently there have been analyses from international markets. Some research has also been conducted with data from emerging markets. There is a consensus about the relevance of multiple factors in the determination of expected stock returns, both for the US and for other markets.
A long debate regards the interpretation of the empirical factors. Some researchers try to provide a structural interpretation in terms of compensation for risk. Others contend that the results cannot only be interpreted from the point of view of risk because market sentiment is also important. Daniel, Hirshleifer and Subrahmanyam (2001) study a market populated by overconfident traders and arbitrageurs and find that expected returns should be cross sectionally explained by the Fama French factors, some of which, particularly book-to-market, can however be interpreted as proxies for sentiment and security mispricing.
Sentiment has received attention from several authors. Baker and Wurgler (2006) predict that investor sentiment has larger effects on securities whose evaluations are highly subjective and difficult to arbitrage and find that when beginning of-period sentiment is low (high), subsequent returns are relatively high (low) for small stocks, young stocks, high volatility stocks, unprofitable stocks, non-dividend-paying stocks, extreme growth stocks and distressed stocks. Baker and Wurgler build a sentiment indicator combining several variables and then show that the level of this indicator is associated with the subsequent return of stocks grouped in various portfolios.
The sentiment story is reinforced by two observations: (a) weak evidence in favour of the effect of the sentiment indicator on time variability of beta and (b) logical inconsistency in explaining switching risk premia on the basis of a one factor model. Baker and Wurgler (2007) show that the sentiment indicator is correlated in the expected way with the returns of portfolios sorted on volatility and also with the market. Moreover in both cases the indicator may be used for forecasting.
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Determinants of Mutual Fund Performance Persistence: A Cross-Sector Analysis
