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 arise because the characteristics are proxies for nondiversifiable factor risk. In contrast, evidence is presented that indicates the return premia on small capitalization and high book-to-market stock does not arise because of the comovements 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.