The Risk and Return from Factors

Abstract

The ability to identify which factors best capture systematic return covariation is central to applications of multifactor pricing models. This paper uses a common data set to evaluate the performance of various proposed factors in capturing return comovements. Factors as? sociated with the market, size, past return, book-to-market, and dividend yield help explain return comovement on an out-of-sample basis (although they are not necessarily associated with large premiums in average returns). Except for the default premium and the term pre? mium, macroeconomic factors perform poorly. We document regularities in the behavior of the more important factors, and confirm their influence in the Japanese and U.K. markets as well. I. Introduction This paper seeks to identify which factors are important for driving the com? mon variation in stock returns. We evaluate all the major factors that have been suggested in the existing empirical literature. Unlike earlier research that has been concerned with the determinants of expected returns, however, our main interest lies more in specifying the sources of return covariation regardless of whether they are priced or not. The identification of the sources of comovement and, hence, sources of portfolio risk, is an important issue for theoretical and applied reasons.