Abstract
A challenge for modern portfolio managers and security analysts is understanding the variables or factors that drive security returns. Statistical methods such as principal components analysis are useful but lack meaningful interpretations. Real economic factors comport with intuitive understanding but lack explanatory power. This study seeks to bridge the gap between these two approaches by interpreting “statistical factors” using economic factors. The authors examine the factor structure of equity portfolio returns widely used in a sample period from 1963 through 1999. They find there are three major factors for equity returns, which can be associated with 1) the market return; 2) market capitalization; and 3) the investment opportunity set. Higher–order factors can be uniquely identified with macroeconomic variables.
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