In Search of the Economic Meaning and Role of the Fama-French Factors in Japan: Implications for Investment Management

ABSTRACT

This paper explores and clarifies the economic meaning and role of Fama and French’s (FF) size return premia, small-minus-big (SMB) factor, and value premia, high-minus-low (HML) factor, in Japan. In contrast to FF’s suggestion, our analysis reveals that SMB but not HML has meaning as a proxy for distress risk. Moreover, by using a multivariate Generalized Autoregressive Conditional Heteroskedasticity (GARCH) model, our analysis confirms that both SMB and HML are well-priced state variables in Merton’s Intertemporal Capital Asset Pricing Model (ICAPM). Furthermore, even after controlling for macroeconomic variables, when adjusting the lag orders we find that both lagged HML and SMB demonstrate clear predictability for future real GDP growth. Hence, we empirically support FF’s argument that HML and SMB are state variables that predict future changes in the investment opportunity set in the context of Merton’s ICAPM. This finding has the practical implication that SMB and HML can be used for predicting the future investment environment. As an ancillary finding, we also conclude that lagged credit and term spread are strongly priced factors in the ICAPM in Japan. One implication for investment management is that bearing the risks included in the credit spread and the term spread is rewarded with future return in the Japanese stock market.

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