Template-type: ReDIF-Paper 1.0
Author-Name: David E. Allen
Author-Email: profallen2007@gmail.com
Author-Workplace-Name: School of Mathematics and Statistics, University of Sydney, Department of Finance, Asia University, Taiwan, and School of Business and 
	Law, Edith Cowan University, Australia.
Author-Name:
 Michael McAleer
Author-Workplace-Name:
 Department of Quantitative Finance National Tsing Hua University, Taiwan and Econometric Institute Erasmus School of 
	Economics Erasmus University Rotterdam, The Netherlands and Department of Quantitative Economics Complutense University of 
	Madrid, Spain And Institute of Advanced Sciences Yokohama National University, Japan.
Title: Drawbacks in the 3-factor approach of Fama and French
Abstract: This paper features a statistical analysis of the monthly three factor Fama/French return series. We apply rolling OLS regressions to explore the 
	relationship between the 3 factors, using monthly and weekly data from July 1926 to June 2018, that are freely available on French's website. The 
	results suggest there are significant and time-varying relationships between the factors. This is confirmed by non-parametric tests. We then switch to 
	a sub-sample from July 1990 to July 2018, also taken from French's website. The three series and their interrelationships are analysed using two stage 
	least squares and the Hausman test to check for issues related to endogeneity, the Sargan overidentification test and the Cragg-Donald weak instrument 
	test. The relationship between factors is also examined using OLS, incorporating Ramsey's RESET tests of functional form misspecification, plus	
	Naradaya-Watson kernel regression techniques. The empirical results suggest that the factors, when combined in OLS regression analysis, as suggested 
	by Fama and French (2018), are likely to suffer from endogeneity. OLS regression analysis and the application of Ramsey's RESET tests suggest a 
	non-linear relationship exists between the three series, in which cubed terms are significant. This non-linearity is also confirmed by the kernel 
	regression analysis. We use two instruments to estimate the market betas, and then use the factor estimates in a second set of panel data tests using 
	a small sample of monthly returns for US firms that are drawn from the online data source “tingo”. These issues are analysed using methods suggested 
	by Petersen (2009) to permit clustering in the panels by date and firm. The empirical results suggest that using an instrument to capture endogeneity 
	reducesthe standard error of market beta in subsequent crosssectional tests, but thatclustering effects, as suggested by Petersen (2009), will also 
	impact on the estimated standard errors. The empirical results suggest that using these factorsin linear regression analysis, such as suggested by Fama 
	and French (2018), as a method of screening factor relevance, is problematic in that the estimated standard errors are highly sensitive to the correct 
	model specification.
Classification-JEL: C13, C14, G12.
Keywords: Fama-French Factors, Correct specification, Ramsey's RESET, Hausman tests, Endogeneity, Consistent standard errors.
Length: 37 pages 
Creation-Date: 2019-01
Number: 2019-02
X-File-Ref: http://america.sim.ucm.es/repec/ucm/ref/doicae1902.txt
File-URL: https://eprints.ucm.es/id/eprint/54661/1/1902.pdf
File-Format: Application/pdf
Handle: RePEc:ucm:doicae:1902