Do the Fama-French Factors Proxy for Innovations in Predictive Variables?
47 Pages Posted: 19 Mar 2005
Date Written: February 2005
The Fama-French factors HML and SMB are correlated with innovations in variables that describe investment opportunities. A model that includes shocks to the aggregate dividend yield and term spread, default spread, and one-month Treasury-bill yield explains the cross-section of average returns better than the Fama-French model. When loadings on the innovations in the predictive variables are present in the model, loadings on HML and SMB lose their explanatory power for the cross-section of returns. The results are consistent with an ICAPM explanation for the empirical success of the Fama-French portfolios.
JEL Classification: G12
Suggested Citation: Suggested Citation