Is the investment factor a proxy for time-varying investment opportunities? The US and international evidence

Motivated from Fama’s (1991) conjecture of an explicit link between the cross-sectional and time-series stock return predictability, we investigate whether the investment factor constructed from the cross-section of stocks also has time-series predictive power for stock returns within Merton’s (1973) ICAPM framework. The evidence from both US and other G-7 countries (except Japan) suggests that the investment factor is a proxy for time-varying investment opportunities. We also find that the risk-return relation is positive and statistically significant after controlling for the covariance between the market factor and the investment factor.