In Defense of Beta

1. What were the major findings of the article “ The Cross-section of Expected Returns,” by Fama and French?

a. Fama and French found that beta does a poor job of explaining "cross-sectional" variation in the average returns of stocks over the period 1963-90.

b. They also reported that two other easily measured variables-the book-to-market ratio and the market capitalization of equity-together explain a significant fraction of the variation in average returns over the same period. Over the longer period 1941-90, beta fares only a bit better.

c. Given the very high variability of the surprise component in actual returns, average returns over a given sample period- even one as long as 30 years- can deviate significantly from investors’ expectations.

d. Their estimate of expected return compensation based on data for the 1941-90 period is about 3% per year. However, the standard error of this estimate is nearly the same and because the conventional t-statistic is thus only about 1, they cannot reject the hypothesis that the expected risk premium is zero.

e. A substantial annual risk premium of 6% per year is about as likely as no risk premium. It means that the data permit a wide range of conclusions about the true slope of the risk-return relation.

2. What are the implications of their findings to investors?

a. If betas are at best weakly correlated with average returns, professional investors must reevaluate their investment strategies. Therefore, if Fama and French are right, it would make sense to shift out of high-beta stocks and into low-beta stocks. Such a strategy would reduce risk while having a minimal impact on expected return. Surely, if enough investors resort to this strategy, there will be downward pressure on the prices of high-beta stocks and upward pressure on the price of low-beta stocks. Because such price pressures would in turn cause high-beta stocks to earn higher returns and low-beta stocks to earn lower returns than before, the relation between beta and expected return would actually be strengthened rather than diminished. In this sense, the strategy contains the seeds of its own destruction, a familiar theme in efficient financial markets.

b. The prospect of using the book-to-market ratio and firm size to make more efficient portfolio investment decisions, If the relevance of the CAPM is in serious doubt. Consistent with an efficient markers framework, Fama and French view book-to-market and firm size as proxies for other (non-beta) risk factors for which the market compensates investors with higher returns. However, those inclined to believe in investor irrationality have seized on the surprising explanatory power of these variables as evidence of market inefficiency. In this "behavioralist" view of financial markets, investor excesses provide opportunities for other investors