Covariances vs. characteristics: what does explain the cross section of the German stock market returns?

Abstract

The characteristics book-to-market equity ratio, size and momentum are highly correlated with the average returns of common stocks. Fama and French (J Financ Econ 33(1):3–56, 1993), (J Finance 50(1):131–155, 1995) and (J Finance 51(1):55–84, 1996) argue (for size and the book-to-market equity ratio) that the relation between returns and characteristics arises because the characteristics are proxies for exposures to common risk factors. We examine the question whether the characteristics or the covariance structure of returns explain the cross-sectional dispersion in German stock market returns. Our results suggest that widely accepted factors SMB, HML or WML are not priced.

Risk models vs characteristic models from an investor’s perspective

“…Panel C reports the average of the risk factor returns, their standard deviations and also the p value of a t test against the null hypothesis of zero average for the risk factors returns. The values reported in Panel C are very similar to the values of Fieberg et al (2016b) for the German stock market. The largest risk factor premium exhibits WML, followed by the market factor and HML, whereas the null hypothesis of zero average is not rejected for SMB.…”

“…The characteristic premium u for the momentum characteristic is the largest, followed by value premium for BE/ME. The insignificant characteristic premium for size is also reported by Schrimpf et al (2007) Fieberg et al (2016b). The lack of the size premium is also supported by the results in Panel C of Table I.…”

“…data selection follows closely the description of related works on German stock market (Artmann et al [2012a], Fieberg et al [2016b]). Our sample is based on Thomson Reuters research lists (FGER1, FGER2, FGERDOM), dead lists (DEADBD1, DEADBD2, DEADBD3, DEADBD4, DEADBD5, DEADBD6) and Worldscope lists (WCOPEBD).…”

An investor’s perspective on risk-models and characteristic-models

“…They argue that the covariance structure of returns rather than the characteristics appears to explain the cross-sectional variation in stock returns. More recently, Fieberg et al (2016) show that the cross-section of German stock market returns is better explained by the characteristic model than by a covariance model. International evidence is provided by Hou et al (2011).…”

“…The construction of the risk factors SMB, HML and WML for the German stock market follows closely the procedure as described in Fieberg et al (2016). The market return R M for each month is the return on the value-weighted portfolio of all sample stocks in that month.…”