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Q: Cross-Section of Expected Stock Returns ( Answered 5 out of 5 stars,   0 Comments )
Subject: Cross-Section of Expected Stock Returns
Category: Business and Money > Finance
Asked by: johnleo-ga
List Price: $12.00
Posted: 08 Nov 2003 06:55 PST
Expires: 08 Dec 2003 06:55 PST
Question ID: 273817
I am interested in a discussion (and/or analysis) of a financial journal
article.  "The Cross-Section of Expected Stock Returns" by Eugene F.
Fama and Kenneth R. French, that appeared in the Journal of Finance

Specifically, I am interested in what was discussed, what the
implications are for the finance industry and the strengths and
weaknesses of the paper as perceived by other academics.
Subject: Re: Cross-Section of Expected Stock Returns
Answered By: omnivorous-ga on 08 Nov 2003 11:29 PST
Rated:5 out of 5 stars
Johnleo --

It's an interesting question, as Fama & French's article is considered
one of the most-important finance papers of the 1990s.  In the process
of doing the research, I found a Journal of Business article titled
"Impact: What Influences Finance Research?" (April 2003) that analyzes
the influence of particular journals and rates articles by influence. 
It uses citations of articles to rate importance and Fama & French's
article is  judged one of the 10 most-influential -- rating just above
Black-Scholes' seminal 1973 paper on the capital-asset pricing model

The article, according to Journal of Business, has been cited more
than 180 times in the past 10 years.  Further, it's ranked the second
most-influential on asset pricing and investment topics -- behind Cox,
Ingersoll & Ross' article, "A Theory of the Term Structure of Interest
Rates" and ahead of the Black-Scholes CAPM article ("The Pricing of
Options and Corporate Liabilities").

Okay, so much for the Sabermetrics of academia.


Fama, who teaches at the University of Chicago's Graduate School of
Business, and French, a professor at Dartmouth's Tuck Business School,
wrote that "beta" or risk of a portfolio didn't explain returns, as
financial theory would dictate.

Rather, their examination of the U.S. market from 1963 to 1990 showed
that value stocks have higher returns than growth stocks; smaller
stocks higher returns than growth stocks; small value stocks have the
highest returns.  They did the analysis by breaking stocks into four
quadrants -- large growth, large value, small value and small growth. 
The one exception to their model was "small growth" stocks -- which
had the worst performance of all.

If you want to approach this topic slowly, William Bernstein's article
below is an excellent introduction.  It also includes a brief mention
of how the conclusions have been applied by mutual fund companies,
including Dimensional Fund Advisors (for which Eugene Fama is an
advisor) and Vanguard (which ignores the research and concentrates on
diversification and lowering of transaction costs):
Efficient Frontier
"The Cross-Section of Expected Stock Returns: a 10th Anniversary
Reflection" (William Bernstein, 2002)

The article set off a wide range of academic analyses.  But it also
hit at an interesting time:
?	as Bill Clinton was campaigning for the presidency.  Clinton was one
of the governors whose studies of job-growth had found that small
companies do most of the job creation
?	the next 6 years returns were disastrous to small value stocks. 
Bernstein's article (above) notes that small value firms returns 13.9%
during the period vs. 20.5% for the highly-diversified Wilshire 5000.

The academic arguments against Fama and French included the following:


Not surprisingly Fischer Black, one of the inventors of CAPM, was one
of the first to fire back.  Fama's New York Times quote from February
1992 threw down the gauntlet, with Fama saying ""beta as the sole
variable explaining returns on stocks is dead."    Black says bluntly
that the beta is alive, accusing Fama & French of "data mining" a
particular period to get the results:
Journal of Portfolio Management, Fall 1993
"Beta and Return"
Fischer Black

In their critique of Fama-French, Kothari, Shanken & Sloan took aim at
the time period chosen is biased by 6-9% for the time period chosen:
Journal of Finance, March 1995
"Another look at the cross-section of expected stock returns"
S.P. Kothari; Jay Shanken; Richard G. Sloan

Dongcheal Kim's article argues that the Fama & French model had errors
in estimates of beta which would wipe out the apparent gains of small
cap and value stocks:
Journal of Finance, December, 1995
"The errors in the variables problem in the cross-section of expected
stock returns"
Dongcheol Kim

Clare, Priestley & Thomas also critiqued Fama & French for ignoring
econometric issues:
Applied Economic Letters, 1997
"Is Beta Dead?  The Role of Alternative Estimation Methods"
A Clare, R. Priestley, and S. Thomas

Journal of Banking & Finance, 1998
"Reports of Beta's Death Are Premature: Evidence from the U.K."
A. Clare, R. Priestley, and S. Thomas


It's long been known that an increase in size reduces financial costs
for a large number of reasons, ranging from cost of using financial
markets to the costs of analyzing firm information.  There are several
articles that try to reduce this impact:
University of Chicago Graduate School of Business
"Profitable Predictability in the Cross-Section Stock Returns" (July
28, 2003 working paper)
J. Douglas Hanna, Mark J. Ready

The following study suggests different returns with a change in
assumptions on transaction costs:
Financial Analysts Journal, May-June, 1995
"The Effects of Rebalancing on Size and Book-to-Market Ratio Portfolio Returns"
Patrick Dennis, Steven B. Perfect, Karl N. Snow, and Kenneth W. Wiles


There are a large number of supporters of the theories of Fama and
French.  Some of the subsequent studies include:

Financial Analysts Journal, July-August, 1993
"Is Beta Dead Again?"

Journal of Finance, 1994
"The Cross-Section of Realized Stock Returns: the pre-Compustate Evidence"
J. Davis

Journal of Business, 1994
"Economic Forces, Fundamental Variables and Equity Returns"
J. He and L. Ng

And, of course, Fama & French haven't been idle in expanding the range
of their study.  Eugene Fama comments on areas in which he's working
in this 1997 interview at the University of Chicago:
Dimensional Fund Advisers
Reprint from "Investment Gurus" (February, 1997)

Their subsequent articles have been:
Journal of Financial Economics, 1993
"Common Risk Factors in the Returns on Stocks and Bonds"
E. Fama and K. French

Journal of Finance, 1995
"Size and Book-to-market Factors in Earnings and Returns"
E. Fama and K. French

Journal of Finance, 1996
"Multifactor Explanations of Asset Pricing Anomalies"
E. Fama and K. French

Journal of Finance, 1998 
"Value Versus Growth: The International Evidence"
E. Fama and K. French

Google search strategy:
You might want to start with a Google search first, as Fama & French's
article had such a broad impact that you'll find 2,680 references
using the full title:
"Cross-Section of Expected Stock Returns"

You may also wish to construct compound searches with the title and
key academicians or topics, such as:
"transaction costs" + "Cross-Section of Expected Stock Returns"
"Malkiel" + "Cross-Section of Expected Stock Returns"

And of course, many of the studies referenced above are available --
at least in abstract form -- on the Internet.

To get to academic references, it's best to use footnotes from several
of the articles that appear from the Google search.  However,
specifically for academic papers there are specialized databases, such
as Expanded Academic ASAP, a fee-based online search owned by
Thomson-Gale.  It has about 2,400 academic journals indexed and is
available at many libraries free-of-charge.  The search was done with
the title of the article:
"Cross-Section of Expected Stock Returns"

There were 164 references to the article since June, 1992 in that
database.  Some of the articles (including the original) are only
available as abstracts but there are a number with full-text.

There are several investment firms established to use the academic
theories developed by the so-called Chicago school.  They too can be a
rich resource for understanding the implications of securities
research, with numerous follow-up studies linked:
Ibbotson & Associates
"Research Publications"

Dimensional Fund Advisers

There also are several papers on asset valuation which deal with the
Fama-French issues on the Federal Reserve pages, though the Fed covers
a VERY broad range of finance and currency issues.  It can be helpful
to search Fed papers by author:
The Federal Reserve Board
"Publications and Education Resources"

Best regards,

johnleo-ga rated this answer:5 out of 5 stars
Thank you for an excellent, comprehensive analysis.

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