Evidence on the Characteristics of Cross Sectional Variation in Stock Returns

Firm sizes and book-to-market ratios are both highly correlated with the average returns of common stocks. Fama and French (1993) argue that the association between these characteristics and returns arises because the characteristics are proxies for non-diversifiable factor risk. In contrast, the evidence in this paper indicates that the return premia on small capitalization and high book-to-market stocks does not arise because of the co-movements of these stocks with pervasive factors. It is the characteristics rather than the covariance structure of returns that appear to explain the cross-sectional variation in stock returns