Identifying the factor structure of equity returns

A challenge for modern portfolio managers and security analysts is understa nding the variables or factors that drive security returns. Statistical met hods such as principal components analysis are useful but lack meaningful i nterpretations. Peal economic factors comport with intuitive understanding but lack explanatory power. This study seeks to bridge the gap between thes e two approaches by interpreting "statistical factors" using economic facto rs. The authors examine the factor structure of equity portfolio returns wi dely used in a sample period from 1963 through 1999. They find there are th ree major factors for equity returns, which can be associated with 1) the m arket return; 2) market capitalization; and 3) the investment opportunity s et. Higher-order factors can be uniquely identified with macroeconomic vari ables.