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Drawbacks in the 3-Factor Approach of Fama and French (2018)

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  • David E. Allen

    (School of Mathematics and Statistics, University of Sydney, Australia2 Department of Finance, Asia University, Taiwan3School of Business and Law, Edith Cowan University, Australia)

  • Michael McAleer

    (Department of Finance, College of Management, Asia University, Taiwan5Discipline of Business Analytics, University of Sydney Business School, Australia6Econometric Institute, Erasmus School of Economics, Erasmus University Rotterdam, The Netherlands7Department of Economic Analysis and ICAE, Complutense University of Madrid, Spain8Department of Mathematics and Statistics, University of Canterbury, New Zealand9Institute of Advanced Sciences, Yokohama National University, Japan)

Abstract

This paper features a statistical analysis of the monthly three factor Fama/French return series. Rolling OLS regressions explore the relationship between the 3 factors, using data from July 1926 to June 2018, available on French’s website. The results suggest there are significant and time-varying relationships between the factors. A sub-sample from July 1990 to July 2018 is used to analyze the three series using two-stage least squares and the Hausman test to check for issues related to endogeneity. The empirical results suggest that the factors, when combined in OLS regression analysis, as suggested by Fama and French (2018), are likely to suffer from endogeneity. Ramsey’s RESET tests suggest a nonlinear relationship exists between the three series. We use two instruments to estimate the market betas, and compare them to betas estimated not using instruments. Non-parametric tests of the two sets of betas suggest significant differences. The results suggest that using these factors in linear regression analysis, as recommended by Fama and French [(2018). Choosing factors. Journal of Financial Economics, 128(2), 234–252] is problematic in that the estimated coefficients are highly sensitive to the correct model specification.

Suggested Citation

  • David E. Allen & Michael McAleer, 2023. "Drawbacks in the 3-Factor Approach of Fama and French (2018)," Annals of Financial Economics (AFE), World Scientific Publishing Co. Pte. Ltd., vol. 18(01), pages 1-26, March.
    • Handle: RePEc:wsi:afexxx:v:18:y:2023:i:01:n:s2010495222400012
    DOI: 10.1142/S2010495222400012
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    References listed on IDEAS

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    4. Francisco Barillas & Jay Shanken, 2018. "Comparing Asset Pricing Models," Journal of Finance, American Finance Association, vol. 73(2), pages 715-754, April.
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    7. Fama, Eugene F. & French, Kenneth R., 1993. "Common risk factors in the returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 33(1), pages 3-56, February.
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    More about this item

    Keywords

    Fama–French factors; correct specification; Ramsey’s RESET; Hausman tests; endogeneity; consistent standard errors;
    All these keywords.

    JEL classification:

    • C13 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Estimation: General
    • C14 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Semiparametric and Nonparametric Methods: General
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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