Predicting Fama-French factors based on industry returns in Brazil

Abstract

There is a vast literature on the predictability of returns based on past information, and many asset pricing models have been tested, such as the Capital Asset Price Model (CAPM) and the three-factor asset pricing model of Fama and French. The purpose of this paper is to answer the question whether Fama-French’s size and value factors (SMB and HML) can be predicted by past returns of 16 portfolios formed by companies from the same industry in Brazil. Our analysis controls for different macroeconomic variables and firm characteristics, such as corporate governance practices, size, dividend yield, book-to-market, among others. The analysis reveals that 14 of 16 industries predict SMB one month ahead. Furthermore, the returns of a few industries predict the volatility of SMB and HML up to three months ahead of time. Considering the explanatory capability of the Fama-French model, the results of this research show that Brazilian industry returns contain valuable information for the SMB and HML factors, demonstrating that investors cannot absorb all the information in a timely manner, resulting in their gradual diffusion throughout the market.