The Journal of Finance

Presidential Address: The Cost of Active Investing

Published: 07/19/2008   |   DOI: 10.1111/j.1540-6261.2008.01368.x

KENNETH R. FRENCH

I compare the fees, expenses, and trading costs society pays to invest in the U.S. stock market with an estimate of what would be paid if everyone invested passively. Averaging over 1980–2006, I find investors spend 0.67% of the aggregate value of the market each year searching for superior returns. Society's capitalized cost of price discovery is at least 10% of the current market cap. Under reasonable assumptions, the typical investor would increase his average annual return by 67 basis points over the 1980–2006 period if he switched to a passive market portfolio.

Presidential Address: The Cost of Active Investing

Published: 07/19/2008   |   DOI: 10.1111/j.1540-6261.2008.01368.x

KENNETH R. FRENCH

I compare the fees, expenses, and trading costs society pays to invest in the U.S. stock market with an estimate of what would be paid if everyone invested passively. Averaging over 1980–2006, I find investors spend 0.67% of the aggregate value of the market each year searching for superior returns. Society's capitalized cost of price discovery is at least 10% of the current market cap. Under reasonable assumptions, the typical investor would increase his average annual return by 67 basis points over the 1980–2006 period if he switched to a passive market portfolio.

Taxes and the Pricing of Stock Index Futures

Published: 06/01/1983   |   DOI: 10.1111/j.1540-6261.1983.tb02496.x

BRADFORD CORNELL, KENNETH R. FRENCH

Stock index futures prices are generally below the level predicted by simple arbitrage models. This paper suggests that the discrepancy between the actual and predicted prices is caused by taxes. Capital gains and losses are not taxed until they are realized. As Constantinides demonstrates in a recent paper, this gives stockholders a valuable timing option. If the stock price drops, the investor can pass part of the loss on to the government by selling the stock. On the other hand, if the stock price rises, the investor can postpone the tax by not realizing the gain. Since this option is not available to stock index futures traders, the futures prices will be lower than standard no‐tax models predict.

Multifactor Explanations of Asset Pricing Anomalies

Published: 03/01/1996   |   DOI: 10.1111/j.1540-6261.1996.tb05202.x

EUGENE F. FAMA, KENNETH R. FRENCH

Previous work shows that average returns on common stocks are related to firm characteristics like size, earnings/price, cash flow/price, book‐to‐market equity, past sales growth, long‐term past return, and short‐term past return. Because these patterns in average returns apparently are not explained by the CAPM, they are called anomalies. We find that, except for the continuation of short‐term returns, the anomalies largely disappear in a three‐factor model. Our results are consistent with rational ICAPM or APT asset pricing, but we also consider irrational pricing and data problems as possible explanations.

The Cross‐Section of Expected Stock Returns

Published: 06/01/1992   |   DOI: 10.1111/j.1540-6261.1992.tb04398.x

EUGENE F. FAMA, KENNETH R. FRENCH

Two easily measured variables, size and book‐to‐market equity, combine to capture the cross‐sectional variation in average stock returns associated with market β, size, leverage, book‐to‐market equity, and earnings‐price ratios. Moreover, when the tests allow for variation in β that is unrelated to size, the relation between market β and average return is flat, even when β is the only explanatory variable.

Size and Book‐to‐Market Factors in Earnings and Returns

Published: 03/01/1995   |   DOI: 10.1111/j.1540-6261.1995.tb05169.x

EUGENE F. FAMA, KENNETH R. FRENCH

We study whether the behavior of stock prices, in relation to size and book‐to‐market‐equity (BE/ME), reflects the behavior of earnings. Consistent with rational pricing, high BE/ME signals persistent poor earnings and low BE/ME signals strong earnings. Moreover, stock prices forecast the reversion of earnings growth observed after firms are ranked on size and BE/ME. Finally, there are market, size, and BE/ME factors in earnings like those in returns. The market and size factors in earnings help explain those in returns, but we find no link between BE/ME factors in earnings and returns.

Taxes, Financing Decisions, and Firm Value

Published: 12/17/2002   |   DOI: 10.1111/0022-1082.00036

Eugene F. Fama, Kenneth R. French

We use cross‐sectional regressions to study how a firm's value is related to dividends and debt. With a good control for profitability, the regressions can measure how the taxation of dividends and debt affects firm value. Simple tax hypotheses say that value is negatively related to dividends and positively related to debt. We find the opposite. We infer that dividends and debt convey information about profitability (expected net cash flows) missed by a wide range of control variables. This information about profitability obscures any tax effects of financing decisions.

The Corporate Cost of Capital and the Return on Corporate Investment

Published: 12/17/2002   |   DOI: 10.1111/0022-1082.00178

Eugene F. Fama, Kenneth R. French

We estimate the internal rates of return earned by nonfinancial firms on (i) the initial market values of their securities and (ii) the cost of their investments. The return on value is an estimate of the overall corporate cost of capital. The estimate of the real cost of capital for 1950–96 is 5.95 percent. The real return on cost is larger, 7.38 percent, so on average corporate investment seems to be profitable. A by‐product of calculating these returns is information about the history of corporate earnings, investment, and financing decisions that is perhaps more interesting than the returns.

Value versus Growth: The International Evidence

Published: 12/17/2002   |   DOI: 10.1111/0022-1082.00080

Eugene F. Fama, Kenneth R. French

Value stocks have higher returns than growth stocks in markets around the world. For the period 1975 through 1995, the difference between the average returns on global portfolios of high and low book‐to‐market stocks is 7.68 percent per year, and value stocks outperform growth stocks in twelve of thirteen major markets. An international capital asset pricing model cannot explain the value premium, but a two‐factor model that includes a risk factor for relative distress captures the value premium in international returns.

The Value Premium and the CAPM

Published: 09/19/2006   |   DOI: 10.1111/j.1540-6261.2006.01054.x

EUGENE F. FAMA, KENNETH R. FRENCH

We examine (1) how value premiums vary with firm size, (2) whether the CAPM explains value premiums, and (3) whether, in general, average returns compensate β in the way predicted by the CAPM. Loughran's (1997) evidence for a weak value premium among large firms is special to 1963 to 1995, U.S. stocks, and the book‐to‐market value‐growth indicator. Ang and Chen's (2005) evidence that the CAPM can explain U.S. value premiums is special to 1926 to 1963. The CAPM's more general problem is that variation in β unrelated to size and the value‐growth characteristic goes unrewarded throughout 1926 to 2004.

Business Cycles and the Behavior of Metals Prices

Published: 12/01/1988   |   DOI: 10.1111/j.1540-6261.1988.tb03957.x

EUGENE F. FAMA, KENNETH R. FRENCH

The theory of storage says that the marginal convenience yield on inventory falls at a decreasing rate as inventory increases. The authors test this hypothesis by examining the relative variation of spot and futures prices for metals. As the hypothesis implies, futures prices are less variable than spot prices when inventory is low, but spot and futures prices have similar variability when inventory is high. The theory of storage also explains inversions of “normal” futures‐spot price relations around business‐cycle peaks. Positive demand shocks around peaks reduce metal inventories and, as the theory predicts, generate large convenience yields and price inversions.

The Equity Premium

Published: 12/17/2002   |   DOI: 10.1111/1540-6261.00437

Eugene F. Fama, Kenneth R. French

We estimate the equity premium using dividend and earnings growth rates to measure the expected rate of capital gain. Our estimates for 1951 to 2000, 2.55 percent and 4.32 percent, are much lower than the equity premium produced by the average stock return, 7.43 percent. Our evidence suggests that the high average return for 1951 to 2000 is due to a decline in discount rates that produces a large unexpected capital gain. Our main conclusion is that the average stock return of the last half‐century is a lot higher than expected.

The CAPM is Wanted, Dead or Alive

Published: 12/01/1996   |   DOI: 10.1111/j.1540-6261.1996.tb05233.x

EUGENE F. FAMA, KENNETH R. FRENCH

Kothari, Shanken, and Sloan (1995) claim that βs from annual returns produce a stronger positive relation between β and average return than βs from monthly returns. They also contend that the relation between average return and book‐to‐market equity (BE/ME) is seriously exaggerated by survivor bias. We argue that survivor bias does not explain the relation between BE/ME and average return. We also show that annual and monthly βs produce the same inferences about the β premium. Our main point on the β premium is, however, more basic. It cannot save the Capital asset pricing model (CAPM), given the evidence that β alone cannot explain expected return.

Average Returns, B/M, and Share Issues

Published: 11/11/2008   |   DOI: 10.1111/j.1540-6261.2008.01418.x

EUGENE F. FAMA, KENNETH R. FRENCH

The book‐to‐market ratio (B/M) is a noisy measure of expected stock returns because it also varies with expected cashflows. Our hypothesis is that the evolution of B/M, in terms of past changes in book equity and price, contains independent information about expected cashflows that can be used to improve estimates of expected returns. The tests support this hypothesis, with results that are largely but not entirely similar for Microcap stocks (below the 20th NYSE market capitalization percentile) and All but Micro stocks (ABM).

Luck versus Skill in the Cross‐Section of Mutual Fund Returns

Published: 09/21/2010   |   DOI: 10.1111/j.1540-6261.2010.01598.x

EUGENE F. FAMA, KENNETH R. FRENCH

The aggregate portfolio of actively managed U.S. equity mutual funds is close to the market portfolio, but the high costs of active management show up intact as lower returns to investors. Bootstrap simulations suggest that few funds produce benchmark‐adjusted expected returns sufficient to cover their costs. If we add back the costs in fund expense ratios, there is evidence of inferior and superior performance (nonzero true α) in the extreme tails of the cross‐section of mutual fund α estimates.

Dissecting Anomalies

Published: 07/19/2008   |   DOI: 10.1111/j.1540-6261.2008.01371.x

EUGENE F. FAMA, KENNETH R. FRENCH

The anomalous returns associated with net stock issues, accruals, and momentum are pervasive; they show up in all size groups (micro, small, and big) in cross‐section regressions, and they are also strong in sorts, at least in the extremes. The asset growth and profitability anomalies are less robust. There is an asset growth anomaly in average returns on microcaps and small stocks, but it is absent for big stocks. Among profitable firms, higher profitability tends to be associated with abnormally high returns, but there is little evidence that unprofitable firms have unusually low returns.

Characteristics, Covariances, and Average Returns: 1929 to 1997

Published: 03/31/2007   |   DOI: 10.1111/0022-1082.00209

James L. Davis, Eugene F. Fama, Kenneth R. French

The value premium in U.S. stock returns is robust. The positive relation between average return and book‐to‐market equity is as strong for 1929 to 1963 as for the subsequent period studied in previous papers. A three‐factor risk model explains the value premium better than the hypothesis that the book‐to‐market characteristic is compensated irrespective of risk loadings.