Today’s post will begin a two-part series that explores the research examining risk-based explanations for the value premium, which, unlike the risk-based explanations of the size premium, have been a bit controversial.
In June 1992, the paper “The Cross-Section of Expected Stock Returns” was published in the Journal of Finance. The authors, Professors Eugene F. Fama and Kenneth R. French, demonstrated that size (market capitalization) and the book-to-market ratio (BtM) had more explanatory power for stock returns than did market beta (exposure to stock market risk)—the traditional measure of risk.
While Fama and French didn’t attempt to identify the source of the incremental returns (premiums) provided by exposure to size and value (high BtM) stocks, they did posit that size and BtM are proxies for risk. The premiums, therefore, are compensation for risk-taking. Thus, the size and value premiums have often been called risk premiums.
While there has been little controversy over the source of the size premium—it’s accepted that small stocks are riskier than large stocks—there has been a great debate as to the source of the value premium.
Read the rest of the article at ETF.com.