Betas versus characteristics: A practical perspective

Abstract

We apply a new dummy‐variable method to examine which factor exposures (betas) and characteristics provide independent information for US stock returns in the context of the multifactor models of Hou, Xue, and Zhang and of Fama and French. We find that betas related to market, size, value, momentum, investment, and profitability factors are not priced. In contrast, firm characteristics related to size, value, investment, and profitability have significant and independent explanatory power, suggesting that they are important in determining expected returns. Finally, the cross‐sectional effect of momentum is subsumed when the return on equity is factored in.

Event studies in international finance research

“…There is no consensus among researchers about the true underlying model, so tests based on (24) may be subject to the bad-model problem. This implies that researchers must explore the robustness of their results to various models: the purely local CAPM, the world CAPM, the international CAPM with exchange rate risk (Solnik, 1974), the global five-factor model (Fama & French, 2017), a local characteristics-based model (Lewellen, 2015), a global characteristicsbased model (e.g., Hou et al, 2011;Nazaire et al, 2020). Given that measured abnormal returns (alphas) usually depend on the pricing model used, we recommend that researchers exercise caution when deriving strong conclusions from a long-term event study.…”

“…This is the ''bad-model problem'' described by Fama (1998). The bad-model problem is likely to be more acute in international finance, given higher uncertainty about which model -e.g., Sharpe-Linter's CAPM, the world CAPM (Grauer et al, 1976), the international CAPM with exchange rate risk (Solnik, 1974), the local q-factor model (Hou et al, 2015), the global version of the five-factor model (Fama & French, 2017), or the global characteristics model (Hou, Karolyi, & Kho, 2011;Nazaire, Pacurar, & Sy, 2020) -best describes the behavior of expected international stock returns. Even if we choose one model, its performance will vary over time with the state of the global economy because the level of market integration and cross-border activity is affected strongly by the global outlook (e.g., Doidge et al, 2020;Milesi-Ferretti & Tille, 2011).…”

Using the Capital Asset Pricing Model and the Fama–French Three-Factor and Five-Factor Models to Manage Stock and Bond Portfolios: Evidence from Timor-Leste

“…Therefore, the benefits of diversification, which significantly reduces the risk of an increase in excessive returns, are high (Bessler et al 2021). In addition to the systematic risk factors, there are other factors, namely the Fama-French model factors, such as beta in conjunction with market factors, size, value, momentum, investment, and profitability, which are discussed in the study by Nazaire et al (2020) to examine which factor exposures (betas) and characteristics provide independent information for US stock returns in a multifactor context and to identify betas associated with unweighted market factors, size, value, momentum, investment, and profitability. In contrast, firm characteristics associated with size, value, investment, and profitability have significant and independent explanatory power, suggesting that they are important in determining expected returns.…”