The Link Between Fama-French Time-Series Tests and

Fama-MacBeth Cross-Sectional Tests

Ivo Welch∗

September 26, 2008

Abstract

Many papers in the empirical finance literature implement tests of asset pricing
models either via Fama-French time-series regressions or via Fama-Macbeth cross-
sectional regressions. This short paper explains their conceptual relationships. There
is a time-series equivalent method to implementing Fama-Macbeth regressions (in
a stable world). This correspondence also helps to clarify the interpretation of the
estimates from the two methods: The Fama-Macbeth test is better suited for APT tests,
while the plain Fama-French test is better suited for equilibrium tests. (Of course, all
equilibrium model must be arbitrage-free, but not vice-versa.) It is possible to test not
only whether factors can price portfolios in an equilibrium framework, but also the less
restrictive requirement that the factors should not allow for arbitrage. For example,
this short paper shows that the Fama-French 3-factor model fails the weaker arbitrage
pricing restriction for the the 2x3 Fama-French portfolios, and not just the stronger
equilibrium pricing restriction.

First Draft: Comments Very Welcome.

∗
I thank John Cochrane and Eric Jacquier for iterating multiple times on issues raised in this note. For data,
I have to thank Ken French (as usual), whose website provides a great service to the profession. This work
was aided by an NSF grant: understanding the differences between methods turned out to be a prerequisite
to understanding our results. If this work is replicating someone else’s earlier work, please let the author
know.

Electronic copy available at: http://ssrn.com/abstract=1271935

In the asset pricing literature, the common linear factor model assumes that asset rates of
returns above the risk-free rate are generated by

xi,t = αi + β1i · ft1 + β2i · ft2 + · · · + βK K

i · ft + i,t (1)

where superscripts denote the factor (not exponentiation). The normal working assumption
is that all K relevant factors have been correctly identified. Ross’ APT states that

αi = 0 + λ1 · β1i + λ2 · β2i + · · · + λ K · βK
i . (2)
P

Using the notation that overline is averaging over time (x ≡ t xt /T ), this note also
names quantities that are related to demeaned factors with a star: ft? ≡ ft − f . Working
with demeaned factors does not change the exposure coefficients (β? i = βi ), but it does
change the intercept (in general, α?
i ≠ αi ). Similarly, the lambda coefficients in (2) depend
on the means of the factors that are included in (1); in general, λ? ≠ λ. That is, if the
factors are demeaned, the lambda coefficients change,

α?
i = 0 + λ? 1
1 · βi + λ? 2
2 · βi + · · · + λ? K
K · βi . (3)

For example, with one factor, the APT statement can be written in factor-demeaned or
non-factor-demeaned forms:

xi,t = λ1 ·βi + βi · ft = (λ1 + f ) · βi + βi · (ft − f ) = λ? ?

1 ·βi + βi · ft

The APT restriction continues to hold, but with different lambdas and alpha. Moreover, for
one factor, each asset has the same ratio of intercept to slope: αi /βi = λ? ?
1 · αi /βi = λ1 .

Equilibrium models impose further restrictions. For example, the CAPM states that

xi,t = βi · xm,t + i,t (4)

where xm,t is the non-demeaned equity premium in excess of the risk-free rate. In this case,
λ1 = 0 (and, of course, λi = 0 ∀i ≠ 1). If the factor is demeaned, this can be rewritten
?
xi,t = βi · xm + βi · (xm,t − xm ) + i,t = βi · xm + βi · xm,t + i,t (5)

Thus, written in the form of (2), the CAPM states that

APT (necessary): λ0 = λ?
0 = 0
CAPM (additional): λ1 = 0 a λ?
1 = xm and λi = λ?
i = 0 ∀i > 1

It is common for papers to test equilibrium models without first testing the weaker APT
restriction.
The typical empirical test in the investments literature tries to understand not only whether
an asset pricing model holds, but also how factor exposures are priced. In an APT context,
given that lambdas depend also on a constant that would be added to the factor, the same
set of betas can produce different lambdas and alphas. Lambdas and alphas are therefore
meaningful only with respect to factors whose mean properties are clearly defined. In a
sense, an equilibrium model, like the CAPM, helps to do so.

Electronic copy available at: http://ssrn.com/abstract=1271935

Empirical research has largely relied on two different methods to examine asset prices:

Fama and MacBeth (1973), henceforth FM: Each month, the researcher computes factor
exposures, β1i , β2i , ..., for every asset. (Sometimes, characteristics substitute for ex-
posures.) Then, a cross-sectional regression explains one-period-ahead asset rates
of returns, and the (so-called) gamma coefficients for this one-month regression are
recorded. One set of common test statistics is computed from the time-series of
gammas (each on one factor exposure).
The Fama-Macbeth method is often preferred for two perceived advantages: First, it
allows betas to change over time. Second, it is an out-of-sample test.

Fama and French (1993), henceforth FF: After having grouped assets into portfolios, usu-
ally sorted to have good spread in the exposure (or characteristic) of interest, the
researcher computes one time-series regression per portfolio. One set of common
test statistics are based on the properties of the time-series intercept, usually of the
difference of the extreme spread portfolios.
The Fama-French method is often preferred for two reasons: First, it is easier to
implement. Second, it does not require estimating betas, which are known to be noisy
in real-world data. This avoids the error-in-variables issues that plague the FM method.

In common empirical use, the factors ft are typically not mean zero. The most common
factors in empirical tests may well be the market rate of return above the risk-free rate
(as suggested by the CAPM and termed XMKT by Fama and French), the idiosyncratic
volatility (as in the original Fama-Macbeth paper), and the rates of return on Fama-French’s
zero-investment HML and SMB factors.1
The primary goal of this short paper is to relate the Fama-Macbeth and the Fama-French
methods. It seeks to make its points in the easily understandable way, rather than in the
most general way. Therefore, it assumes that there are that there is no noise: i,t ≡ 0, ∀i, t.
This sidesteps all estimation and power issues—the sample is a perfect representation
of the population. With no noise, all factor exposures can be assumed to be known, and
the computed coefficient is all that is important—the T -statistics can be considered to be
infinite or zero. (In the examples below, the carried intercept a can substitute algebraically
for carrying a noise term.) Again, in line with reasonable asset pricing tests, all rates of
return are measured net of the risk-free rate. This note considers only K + 1 assets. In a
noise-free environment, the APT forces any asset to be a linear combinations of the first
non-trivial K base assets, and (for illustration) at least one more asset is included to aid in
the interpretation.
This note does not mean to discount the importance of issues that are explicitly assumed
away (such as estimation concerns and noise). These issues are first-order. The only reason
for ignoring them is to focus on what these tests can ultimately provide. The goal is to focus
on conceptual issues to understand better in principle what each method is estimating.
Relying on the method equivalence, the paper concludes with an interesting observation:
The Fama-French 3-factor model not only fails the strong equilibrium restriction in pricing
the Fama-French 2x3 portfolios, but also the weaker APT restriction.
1
If the factors are sample-demeaned, then the Fama-Macbeth statistic is thought to lose its out-of-sample
property. It is not uncommon to demean factors “as one goes,” based on to-then historical factor means.
This preserves the out-of-sample property.

3
I Equivalence of Methods

A One-Factor Models

It is simplest to start with a one-factor model (K = 1) and two assets i ∈ [A, B]. With our
simplications, the model is

xi,t = αi + βi · ft i ∈ [A, B]

With just two portfolios, all grouping-assets considerations are sidestepped, both in the
Fama-French and the Fama-Macbeth method. The specific APT restriction is that αi =
0 + λ1 · βi , which means that it allows for only one non-trivial base asset. (Other assets
must be scaled.) With only one factor and two base assets, A and B, we can also avoid any
rotation issues pointed out by Stambaugh and Kandel (1995). In this case, the two assets
define exactly their mean-variance frontier.
The Fama-French and Fama-Macbeth tests would now be implemented as follows:

Fama-French: The Fama-French TS method tests the intercept of the difference portfolios.
Define Z as the difference portfolio, B − A.

xZ,t = xB,t − xA,t = (αB + βB · ft ) − (αA + βA · ft )

= (αB − αA ) + (βB − βA ) · ft = αZ + βZ · ft

It is familiar that (expected) time-series regression coefficients, aZ and bZ are not

influenced by the time-series realizations of ft :

aZ = αZ bZ = βZ

It follows that adding more time-series observations would not change aZ or bZ

(provided that the statistical properties of ft remain stable).
If the APT holds (that is, λ0 = λ?
0 = 0), then the return process is xi,t = λ1 · βi + βi · f .
Thus, the ratio of the time-series intercept to the time-series slope is the constant λ
for every asset.
Instead of working with one net difference portfolio Z, we can work with the two input
assets, and solve a second-stage cross-sectional regression, in which each time-series
intercept is regressed on each time-series slope.

Undemeaned Factor: If the APT holds, then xA = λ1 βA + βA · f1 and xB = λ1 βB +

βB · f1 . The second-stage regression is now λ1 βi = l0 + l1 · βi . The estimated
cross-sectional coefficients are coefficients are

l0 = 0 l1 = λ1

Demeaned Factor: If we work with demeaned factors, xi = λ? 1 βA + βA · (f1 − f ),

then the estimated cross-sectional coefficients are coefficients are

l0 = 0 l1 = λ?
1 = λ1 + f

4
Fama-Macbeth: The dependent variable in each monthly regression is always the monthly
rate of return, a vector y = (xA , xB ), and the single independent variable is always the
exposure of A and the exposure of B, i.e., x = (βA , βB ). The FM gamma coefficients
each period are

αB · βA − αA · βB
γ0t =
βA − βB
(6)
(αB + βB · ft ) − (αA + βA · ft ) αB − αA
γ1t = = + ft = αZ /βZ + ft
βB − βA βB − βA

If the APT restriction is followed, then αA = λ1 · βA and αB = λ1 · βB , and this

equation simplifies to

γ0t = 0 (only in the absence of arbitrage; complex otherwise.)

γ1t = λ1 + ft (only in the absence of arbitrage; αZ /βZ + ft otherwise.)

These coefficients are then averaged across time-periods. Thus,

γ0 = 0 (only in the absence of arbitrage; complex otherwise.)

γ1 = λ1 + f (only in the absence of arbitrage; αZ /βZ + f otherwise.)

The FM gamma coefficients are not influenced by whether the factors are demeaned
before exposures are computed. After all, demeaning changes neither the observed
exposures nor the observed rates of return.

This suggests that there are two methods to obtain FM coefficients:

1. The traditional way regresses returns on exposures each month and then aggregates
gamma coefficients over the time-series.

2. An alternative way runs time-series regressions but on demeaned factors and then
runs one cross-sectional regression (to obtain lambdas).

Moreover, please note that the Fama-Macbeth cross-sectional slopes have principal kinship
with the Fama-French time-series intercepts. In the case of one factor, if the APT holds,
then the time-series intercept scaled by the time-series slope (of the difference portfolio) is
the Fama-Macbeth slope. The test whether the Fama-Macbeth slope is equal to zero is the
test whether the factor-demeaned Fama-French intercept is zero.

B Multi-Factor Models

It is straightforward to introduce more factors, e.g., extending the analysis to two factors
and three assets. The return generation model in any period t is now

xi = αi + β1i · f 1 + β2i · f 2 i ∈ [A, B, C]

In FM, we fit xi on known actual β1i and β2i . Each period, the γ1t coefficient is
(αB − αC ) · cA + (αC − αA ) · cB + (αA − αB ) · cC
γ1t = ft1 + (7)
(βB − βC ) · cA + (βC − βA ) · cB + (βA − βB ) · cC

5
Note how in the absence of further restrictions, FM slopes are not just functions of their
respective independent variables (their own underlying betas or equivalent lambdas), but
complex functions of other inputs. However, if we impose the APT no-arbitrage restriction,

αA = βA · λ1 + cA · λ2 αB = βB · λ1 + cB · λ2 αC = βC · λ1 + cC · λ2 ,

we find again, e.g., that γ1t = ft1 + λ1 . Thus

γ0 = 0
γ1 = f 1 + λ1
γ2 = f 2 + λ2

The non-demeaned Fama-French time-series regressions again provide unbiased estimators

of alphas and betas. Moreover, the demeaned-factor FF regressions can again be used to infer
the FM coefficient estimates via a final-stage cross-sectional relation between time-series
intercepts and time-series slopes.
Not surprisingly, extending the two-dimensional case to N-dimensions yields the same
insights.

II Results

The following results are straightforward to prove. Because the goal of this note is to
provide intuition for these methods for empirical use, the next section will illustrate them.
The reader may even prefer to first work through the illustrations before returning to these
results.

Result 1 (FM and Demeaned-factor FF Correspondence) If the APT holds, then there is a
correspondence between K gamma coefficients from a FM regression, and lambdas inferred
from K portfolios’ FF time-series regressions using demeaned factors. (A final-stage inversion
transforms the time-series alphas and betas into equivalent lambdas.)

If and only if demeaned factors are used, from a logical model perspective (as opposed to an
econometric model implementation), it is the same whether one first runs many timeseries
estimations (as in FF) and then solves the cross-section of them to fit the lambdas; or
first many cross-sections and then a time-series over the cross-sectional coefficients (as
in FM). Note that this suggestion is not that “the time-series technique is the same as a
Fama-Macbeth regression, just using one longer time-period.” The time-series approach
comes to the same conclusion as the Fama-Macbeth approach only if the time-series factors
are first demeaned. (Moreover, we cannot use the statistical properties of the time-series
gamma coefficients to ascertain gamma significance.) The equivalence also leans on the
assumption that the no arbitrage pricing restriction holds. (If it does not, all bets are off.)
The tradeoffs of the time-series method to Fama-Macbeth coefficients are slightly different
than they are in the traditional cross-sectional implementation. On the plus side, it is quite
feasible to obtain FM coefficient estimates even if there are only a few months of return data
available, and even if it were therefore impossible to estimate betas in early months. This

6
is a more general point: a time-series approach to Fama-Macbeth coefficients can reduce
EIV problems. One can reduce such an especially severe EIV beta estimation problems by
relying on the long time-series Fama-French regressions in the full sample first, before
running the final cross-sectional regressions second. On the negative side, the disadvantage
is that the time-series-first method assumes beta stability (as do all Fama-French time-
series techniques). Moreover, with unknown properties of the second-stage regression that
extracts the gammas from the estimated full-sample time-series Fama-French regressions,
we must resolve the identification of the gamma parameters via bootstrapping.
When Polk, Thompson, and Vuolteenaho (2006) write that the central idea in our paper
is to measure lambda for each period using purely cross-sectional data, and then use that
measurement to forecast the next period’s equity premium, conceptually, the results are
been equivalent to running a factor-demeaned FF time-series regression, and relying on
the inversion (the estimated time-series intercept divided by the estimated beta as their
predictor of the equity premium) at the end. Econometrically, they are trading off the
assumption of time-varying betas for beta stability.
It would also be possible to alter tests when one wants to hold factors such as XMK, HML,
and SMB constant. Obviously, when demeaned, each α? is the mean of these variables,
and the slopes are a 1 on the own variable and a 0 on the others. Thus, λ? XMKT = XMKT
λ?HML = HML, and λ ?
SMB = SMB. To test whether the intercept is zero (or whether a novel
variable matters) in a set of N assets, one could simply multiply each asset by lambda and
move it to the LHS of the equation. (The LHS is of course immune to the EIV bias problem.)

Result 2 (Intercept-of-zero Tests)

• The Fama-Macbeth test is well suited to a test of the APT restriction. It predicts that the
intercept is zero.

• The Fama-French test on non-demeaned factors is well suited to a test of the CAPM
restriction. With the undemeaned equity premium as a factor, it predicts that the
intercept is zero.
It should also be noted here that, for the intercept of the Fama-French non-demeaned
time-series method to be interesting, the test factors must not just be a linear trans-
formations of some unknown true factors (presumably correlated with consumption).
Instead, the test factors have to be direct one-to-one proxies of the true factors. This
applies to the Fama-French factors XMKT, HML, SMB, and UMD. The fact that these
Fama-French factors are traded portfolios makes this less objectionable.

Before one proceeds with the strict test of an equilibrium model via a Fama-French non-
demeaned time-series regression, it would makes sense to first test the weaker weaker
restriction that the APT restriction holds. If it were to fail, it makes little sense to proceed
to test the equilibrium model. Such failure would be considerably more basic.

7
Result 3 (Interpretation of FM Slopes) Equation 6 shows that

• The FM intercept is zero if and only if the APT restriction holds.

• If the APT arbitrage restriction does not hold, then including exposures to other factors
in the FM regression does not mean that exposures to these factors have been held
constant. The FM gammas on each variable then become complex functions of exposures
to all factors. (Other factors are held constant in FF regressions using non-demeaned
factors.)
Exposures to third factors are irrelevant (held constant) to a Fama-Macbeth coefficient
only if the APT restriction holds.

• Therefore, FM clope coefficients are not easily interpretable unless the FM intercept has
passed an “indistinguishable from zero” test.

Of course, even when the APT holds, the FM slope coefficients are not easy to interpret. They
are the still the sum of the unexpected historical factor realization and a factor exposure.
In an empirical test, one could potentially trust slopes more in periods when the intercept
is closer to zero.

Result 4 (Every Period Implications) Under the APT assumption, it is not just on average
that the FM intercept is zero, and that the FM average slopes are the unexpected overall
mean plus lambda. Instead, they are so each and every period.

Thus, one can run tests not just on the gamma means. For example, the gammas should
also pass auto-correlation (iid) tests, as well as extreme-value tests.

Result 5 (Factor Demeaning Influence) Demeaning factors has no influence on FM coeffi-

cients. It does have influence on FF coefficients.

Result 6 (Relevance of Historical Factor Surprises)

• The non-factor-demeaned FF coefficients are immune to whether a factor has done

better or worse than one could have expected ex-ante.

• The FM coefficients are affected by whether a variable has performed above or below
its historical expected mean. (This cannot be corrected by demeaning the factor.) It
is not possible to hold the factor constant when exploring the marginal influence of
the factor. (This is somewhat equivalent if the OLS estimator b were dependent on
realizations of x.

8
It is often argued that historical equity premia have outperformed what could have been
expected (“the American Century”). This would have increased the observed FM gamma
coefficient on the market. The fact that market-beta is already a weak variable in FM
regressions suggests that its exposure premium is very low or even negative.2
The non-factor-demeaned coefficients are used in the Fama-French model that relies on
XMKT, SMB and HML, for example. Under the assumption that these are the correct factors
(not just linear transforms thereof), the (alpha) test is not affected by whether these factors
were above or below their expectations historically.

Result 7 (If-and-Only-If Relationship) Even though there is a necessary and sufficient re-
lation between mean-variance efficiency and the linear exposure-expected rate of return
relationship, there is no necessary and sufficient relationship between mean-variance effi-
ciency and a linear FM beta relationship.

By choice of factor realizations above or below their expected value, one can construct
gamma coefficients that take on any values one desires.

Result 8 (Interpreting Characteristics in FM Regressions)

When characteristics, such as momentum or book-to-market, are included in Fama-Macbeth

regressions, their gamma coefficients are difficult to interpret.

For example, the original Fama-Macbeth paper considered not only market betas, but also
market betas squared, and idiosyncratic volatility. (Fortunately, the latter coefficients were
insignificantly different from zero.) More recently, characteristics such as firms’ own book-
to-market ratios and firm size are commonly included. If these are interpreted as exposures
to some unknown factor, then the FM gamma coefficients measure both the reward for
holding assets with these characteristics and the average rate of return on whatever factor
these characteristics correlated with.

2
More speculatively, the difference between the FM slope coefficient and the excess rate of return on the
market could conceivably be used to measure the unexpected factor realization. However, this would not be
simple.

9
Result 9 (Data Mining of Factors and Gammas) When one first data-mines for results in
the sense of looking for portfolio factors that had strong historical realizations, then a Fama-
Macbeth regression with exposures to these factors should find good gamma coefficients.

This is a simple consequence of the fact that one would likely uncover factor returns
that had good ex-post results, which would in turn bias the FM regression coefficients
upwards. Analogously, a weak gamma coefficient to exposure to such a factor would hint
at realizations that were ex-post above what one could have expected ex-ante.
Not surprisingly, the market premium—which is the only factor that is truly ex-ante from a
theoretical perspective and thus not “searched”—also displays the lowest FM coefficients.
Given the highly positive factor mean over the American Century, the close-to-zero gamma
coefficient suggests that the exposure premium to beta was negative.

Result 10 (Stability) It is only possible to establish the reward for exposure to a factor [a] if
the factor is prespecified by theory (e.g., like the CAPM beta), or [b] if one stipulates that the
factor historically performed as one would have expected it to perform (and that this will
presumably continue). The first method gives interpretability to FF non-demeaned-factor
coefficients; the latter method gives interpretability to FM coefficients.

We have no other methods to learn how exposure to factors is rewarded (i.e., whether
another variable matters). This applies even to FM regressions, which do not seem to
include the factor mean, but only the factor exposure instead.

III Illustrations

The above results are easiest to bring to life (and easiest to understand intuitively) with
some small numerical examples—even if this is not the standard way to write an academic
paper.

A An Equilibrium Model With One Factor

Start with only one factor, two assets, and two time-periods. Ultimately, everything in
this one-factor world is defined by one lambda (because there is only one factor), by two
factor exposures (one for each asset), and by the realizations for the factors (T of them).
When this note illustrates methods with two time-periods, it is ultimately only five numbers
λ1 , βA , βB , f1 , f2 that define everything that the Fama-French and Fama-Macbeth methods
can work with. This renders the examples easier to follow.

10
The two assets define the mean-variance efficient frontier, so the world must be mean-
variance efficient. This first example is constructed so that the second asset does not violate
the APT restriction:

αi = βi · λ1 = βi · 0 : xA,t = 0 + 0.5 · ft xB,t = 0 + 1.5 · ft

If the factor is the traded market, and ft ≡ xM ≡ rM − rF , then this example is the CAPM
with equal-sized assets A and B.

Fama-French, non-demeaned factor: The difference portfolio Z is xZ,t = 0 + 1 · ft . Re-

gardless of the portfolio realizations, ft = (f1 , f2 , · · · ), the regression on the non-
demeaned factor ft yields FF coefficients of a = 0 and b = 1. The inferred λ1 is
λ1 = a/b = 0/1 = 0.

To proceed further now requires a set of factor realizations. Assume that the raw factor
realizations are ft = (4, 8). Thus, the returns are xA = (2, 4) and xB = (6, 12) in periods
one and two, respectively. The demeaned factor is (−2, 2).

Fama-French, demeaned factor: The portfolio Z continues to be xZ,t = 0 + 1 · ft with

xZ = (4, 8). The FF coefficients when regressing xZ on f ? = (−2, 2) are a? = 6 and
b = 1. The inferred starred lambda-1 is λ? ?
1 = a /b = 6/1 = 6, given that the APT
assures that λ0 = 0.

Fama-Macbeth: The factor realizations define the asset rates of return. As noted, at time 1,
xA,1 = 0 + 0.5 · 4 = 2 and xB,1 = 0 + 1.5 · 4 = 6. These are the dependent variables.
The (known) independent variables are βA = 0.5 and βB = 1.5, respectively. Thus,
the line fit is xi,1 = 0 + 4 · βi,1 . Summarized for both periods,

Observables Statistics
βA = (0.5) βB = (1.5)
ft , ft? ⇒ xA,t xB,t ⇒ γ0 γ1
Time 1 4,−2 +2 +6 0 +4
Time 2 8,+2 +4 +12 0 +8
FM Time-Series Mean: 0 6

The γ1 statistic could have been computed from the historical factor mean f of 6,
and the exposure premium of α = β · λ1 = β · 0. Their sum is always the FM gamma1
coefficient: γ1 = f + λ1 = 6.

With only one factor, and the APT restriction that λ0 = 0, λ1 defines the fixed relationship
between the FF demeaned regression slope and the FM gamma slope:

λ?
1 = a?
i /bi = γ1 = 6 ∀i

11
B An APT Model With One Factor

Now relax the equilibrium model restriction, but retain the APT restriction. Consider

αi = βi · λ = βi · 2 : xA,t = 1 + 0.5 · ft xB,t = 3 + 1.5 · ft

Assume that the factor has a mean of f = 6. In this case, the return structure can be
rewritten as

α? ?
i = βi · λ = βi · 8 : xA,t = 4 + 0.5 · ft? xB,t = 12 + 1.5 · ft?

This factor mean of f = 6 may yield two realizations, say f1 = 4 and f2 = 8. Thus, the
Fama-Macbeth coefficients are

Observables Statistics
βA = (0.5) βB = (1.5)
ft , ft? ⇒ xA,t xB,t ⇒ γ0 γ1
Time 1 4,−2 +3 +9 0 +6
Time 2 8,+2 +5 +15 0 +10
FM Time-Series Mean: 0 8

The Fama-French time-series coefficients are also easily obtained. The different portfolio Z
is (6, 10).
It yields time-series coefficients of a = 2, b = 1 on the undemeaned factors, and a? =
8, b = 1 on the demeaned factors. Equivalently, we can rely on the two assets themselves,
and compute a final-stage cross-sectional regression. If the factors were not demeaned,
then
l0 = 0 l1 = 2 .
If the factors were demeaned, then

l0 = 0 l1? = 8 .

C Adding Observations

Return to the CAPM example in Section A. Now consider the effect of adding another
observation, such as f3 = 12. The relationship between exposures and alphas remains
untouched. The historical factor mean changes from f = 6 to f = 8.

Fama-French, non-demeaned factor: The regression on the non-demeaned factor ft yields

the same FF coefficients of a = 0 and b = 1. The inferred λ remains at 0. In fact, no
new factor realizations ever change the FF non-factor-demeaned coefficients.

Fama-French, demeaned factor: The portfolio Z is xZ,t = 0 + 1 · ft . The FF coefficients

are now changing to a? = 8 and b = 1. The inferred λ?1 is 8.

Fama-Macbeth:

12
 Observables Statistics
βA = (0.5) βB = (1.5)
ft , ft? ⇒ xA,t xB,t ⇒ γ0 γ1
Time 1 4,−4 +2 +6 0 +4
Time 2 8,+0 +4 +12 0 +8
Time 3 12,+4 +6 +18 0 +12
FM Time-Series Mean: 0 8

The non-demeaned factor exposure premium in this example remains at λ = 0, but

the demeaned facto exposure premium changes from f = 6. to λ? = 8. Thus,
α = β · λ = β · 0, and the FM gamma1 coefficient changes to 8.

Intuitively, the reason why f3 = 12 has changed the FM inferences is that it was an
unexpectedly high realization. Although demeaning the factor first before computing FM
coefficients would not have changed the FM coefficients, if f3 had turned out to realize
right at its mean f3 = f = 6, the FM gamma coefficient would not have changed.

D Pitfalls in Interpreting Fama-Macbeth Slopes

The previous example shows how the Fama-Macbeth inference is subject to the realization
of the factor. This has an undesirable flavor, which is best explained by analogy: we would
hope that the expectation of an OLS coefficient does not change when we drew X variables
that are either above or below the mean. This section illustrates this further, and can be
skipped if the reader already finds this intuitive.
Consider three different scenarios, in which the factor loadings of A and B are 1 and 3,
respectively, but the reward for factor exposure differs:

αi = βi · λ xA,t xB,t
Example 1 αi = βi · (+1) : 1 + 1 · ft 3 + 3 · ft
Example 2 αi = βi · 0 : 0 + 1 · ft 0 + 3 · ft
Example 3 αi = βi · (−1) : −1 + 1 · ft −3 + 3 · ft

A naïve interpretation is that factor exposure (β) is rewarded in example 1, unrewarded in

example 2, and punished in example 3. Absent a reference to the factor mean, this is of
course incorrect. For example, consider the first example with λ = 1. If f = −11, then the
first model is observationally equivalent to one xA,t = −10 + 1 · (ft − f ) = −10 + 1 · ft? ,
and λ? = −10. It is the factor mean that defines the lambda.

D.1 The Fama-French Time-Series Method (Non-Demeaned Factors)

The portfolio Z is easy to compute, as are the inferred time-series a and b coefficients:

αi = βi · λ xZ,t a b a?
Example 1 αi = βi · (+1) : 2 + 2 · ft 2 2 TBD

Example 2 αi = βi · 0 : 0 + 2 · ft 0 2 TBD

Example 3 αi = βi · (−1) : −2 + 2 · ft −2 2 TBD

13
Again, the factor realizations have no influence on the time-series coefficients a and b in
the non-demeaned-factor FF regression. The non-starred lambda (exposure premium) can
be recovered from the a and b coefficients, because λ = aZ /bZ . Factor realizations will
have an influence on the time-series intercept a? in the demeaned-factor FF regression, as
we show now.

D.2 Interpreting Fama-Macbeth Coefficients

A typical question of great interest in empirical research is whether a Fama-Macbeth gamma1

coefficient is positive, negative, or zero. Therefore, I begin with examples in which the
Fama-Macbeth γ1 statistic is zero.

Example 1 (xA,t = 1 + 1 · ft , xB,t = 3 + 3 · ft ): With a λ of +1 on the non-demeaned

factors’ exposures, assuming any set of factor realization with a mean of f = −1
induces a γ1 = 0. Although a normally distributed variable with such a mean would
be more realistic, nothing is lost if we assume that f = (−3, 1). The data looks as
follows:

Observables Statistics
βA = (1) βB = (3)
ft , ft? ⇒ xA,t xB,t ⇒ γ0 γ1
Time 1 −3,−2 −2 −6 0 −2
Time 2 +1,+2 +2 +6 0 +2
FM Time-Series Mean: 0 0

As noted, the FM gamma coefficients are not affected if we first demean the factor. In
contrast, the FF method estimates are influenced. As noted, the estimates are b = 2,
and a = 2 if the factor is not demeaned; and b = 2 and a? = 0 if they are demeaned.

Example 2 (xA,t = 0 + 1 · ft , xB,t = 0 + 3 · ft ): If I assume a realized factor mean of

f = 0, such as ft = (−2, 2), the data is

βA = (1) βB = (3)
ft ⇒ xA,t xB,t ⇒ γ0 γ1
Time 1 −2 −2 −6 0 −2
Time 2 +2 +2 +6 0 +2
FM Time-Series Mean: 0 0

Example 3 (xA,t = −1 + 1 · ft , xB,t = −3 + 3 · ft ): Assuming a factor mean of f = +1,

such as ft = (−1, 3), the data is

βA = (1) βB = (3)
ft , ft? ⇒ xA,t xB,t γ0⇒ γ1
Time 1 −1, −2 −2 −6 0 −2
Time 2 +3, +2 +2 +6 0 +2
FM Time-Series Mean: 0 0

As noted, the FF method provides b = 2, and a = −2 if the factor is not demeaned;

and b = 2 and a? = 0 if the factor is demeaned.

14
To repeat, all three factor models obey the APT arbitrage restriction, and the two assets
define the mean-variance frontier.3

D.3 Interpreting Significant Fama-Macbeth Slopes

Now consider (the more reportable) empirical test result that shows that the Fama-Macbeth
statistic γ1 > 0, say γ1 = 1. Revisit example 3, in which xA,t = −1 + 1 · ft , xB,t =
−3 + 3 · ft . With a factor mean of +1, the gamma1 statistic was zero. Assuming a factor
mean of +2, the gamma1 statistic is positive. For example, consider the factor realization
ft = (−1, 4).

βA = (1) βB = (3)
ft ⇒ xA,t xB,t ⇒ γ0 γ1
Time 1 −1 −2 −6 0 −2
Time 2 +4 +3 +9 0 +3
Observed FM Time-Series Mean: 0 +0.5

It does not matter in the FM framework whether the factor was first demeaned. The FF
coefficients are aZ = −2 and bZ = 2. After demeaning the factor, a?
Z = +1 and bZ = 2.

Assuming a factor mean of +1, the gamma1 statistic is negative. Now alter the example,
and consider the same model but with factor realization ft = (−1, 2).

βA = (1) βB = (3)
ft ⇒ xA,t xB,t ⇒ γ0 γ1
Time 1 −1 −2 −6 0 −2
Time 2 +2 +1 +3 0 +1
Observed FM Time-Series Mean: 0 −0.5

The FF coefficients are aZ = −2 and bZ = 2. After demeaning the factor, a?

Z = −1.

Thus, in this example, the FM test of whether the gamma1 coefficient is positive or negative
is equivalent to a test whether the (demeaned or non-demeaned) factor mean did or did
not exceed its historical ex-ante estimate. It is unlikely that a researcher wanted to report
whether the factor premium historically outperformed or underperformed its expectation
when (proudly) reporting T statistics on the slope gamma. The result in this example does
not inform about different lambda rewards for exposure. FM tests intending to illuminate
exposure premia (lambdas) therefore suffer from the same dilemma of requiring knowledge
of the equity premium expectation as application of the CAPM itself.
3
It is not difficult to cook up examples in which the APT and mean variance efficiency are not followed,
and/or examples in which there are more than two securities.

15
E A Two Factor Model, APT Satisfied

Let us now expand the factor space. Our first two-factor example obeys the APT restriction,
λ1 = 2 and λ2 = 3:

xA,t = 2 + 1 · ft1 + 0 · ft2

xB,t = 3 + 0 · ft1 + 1 · ft2
xC,t = 5 + 1 · ft1 + 1 · ft2
xi,t = αi + β1 i · ft1 + β2 i · ft2
= 2·β1 i + 3·β2 i + β1 i · ft1 + β2 i · ft2

Being a two-factor model, this cannot be the CAPM. Now consider some sample factor
realizations, say ft1 = (6, 7, 11) (mean 8) and ft2 = (1, 7, 19) (mean 9). The observables are

β,1 = (1) (0) (1)

β,2 = (0) (1) (1)
ft1 ft2 ⇒ xA,t xB,t xC,t ⇒
γ0 γ1 γ2
Time 1 6 1 8 4 12 0 8 4
Time 2 7 7 9 10 19 0 9 10
Time 3 11 19 13 22 35 0 13 22
Observed FM Time-Series Mean: 0 10 12

Demeaning factors first (before computing exposures) does not change the FM gammas.
The FF time-series regression coefficients depend on which portfolios are chosen:

Portfolio xt=1...3 b1 b2 a a?
A 8, 9, 13 +1 +0 2 10
B 4, 10, 22 +0 +1 3 12
C 12, 19, 35 +1 +1 5 22
C-A 4, 10, 22 0 1 3 12
B-A −4, 1, 9 −1 1 1 2
C-B 8, 9, 13 1 0 2 10

One can infer three lambdas from any set of three assets or their transformation. As noted
earlier, as long as the APT holds, for any given set of factors, we would find the same
lambda. (We could stipulate that the APT holds, which would mean that we would only
have to use two assets to infer two lambdas.) For example, if we regress the first three
assets or the last three portfolios:

• a = (2, 3, 5) on b1 = (1, 0, 1) and b2 = (0, 1, 1), then λ = (0, 2, 3),

• a = (3, 1, 2) on b1 = (0, −1, 1) and b2 = (1, 1, 0), then λ = (0, 2, 3).

The lambda using the demeaned factors, λ? , is more interesting: Regressing either a? =
(10, 12, 28) or a? = (12, 2, 10) on b1 = (1, 0, 1) and b2 = (0, 1, 1) recovers λ? = (0, 10, 12).
This is identical to the FM regression coefficients.4

Naturally, the difference between C and A intercepts (aC − aA = 3 or a?

4 ?
C − aA = 12), which is a common
test statistic in papers employing the FF relation, has no relation to the FM coefficients.

16
F A Two Factor Model, APT Violated

We can also construct a simple example which does not obey the APT restriction,

xA,t = 2 + 1 · ft1 + 0 · ft2

xB,t = 3 + 0 · ft1 + 1 · ft2
xC,t = 11 + 1 · ft1 + 1 · ft2
xi,t = αi + β1i · ft1 + β2i · ft2

Now any consider the same two factor realizations: ft1 = (6, 7, 11) (mean 8) and ft2 =
(1, 7, 19) (mean 9). The observables are

β,1 = (1) (0) (1)

β,2 = (0) (1) (1)
ft1 ft2 ⇒ xA,t xB,t xC,t γ0⇒ γ1 γ2
Time 1 6 1 8 4 18 −6 14 10
Time 2 7 7 9 10 25 −6 15 16
Time 3 11 19 13 22 41 −6 19 28
Observed FM Time-Series Mean: −6 16 18

Demeaning the second factor first (before computing exposures) changes nothing for the
FM coefficients. In the absence of the APT restriction, the FM intercept is not zero. There is
no meaningful lambda now, because alphas and betas do not line up.

The FF time-series regression coefficients depend on which portfolios are chosen:

Portfolio xt=1...3 b1 b2 a a?
A 8, 9, 13 +1 +0 2 10
B 4, 10, 22 +0 +1 3 12
C 18, 25, 41 +1 +1 11 28
C-A 10, 16, 28 0 1 −1 −2
B-A −4, 1, 9 −1 1 1 2
C-B 14, 15, 19 1 0 8 16

Any computed lambdas now depend on which securities are chosen.5

5
For example, if one regresses
• a = (2, 3, 11) on b1 = (1, 0, 1) and b2 = (0, 1, 1), then λ = (−6, 8, 9).
• a? = (10, 12, 28) on b1 = (1, 0, 1) and b2 = (0, 1, 1), then λ? = (−6, 16, 18).
• a = (−1, 1, 8) on b1 = (0, −1, 1) and b2 = (1, 1, 0), then λ = (10, −2, −11).
• a? = (−2, 2, 16) on b1 = (0, −1, 1) and b2 = (1, 1, 0), then λ? = (20, −4, −12).
Moreover, the common test statistic that is the difference between C and A intercepts is aC − aA = −1 or
a? ?
C − aA = −2, still has no relation to the FM coefficients.

17
IV Fama-French Regressions on 2x3 portfolios:
Equilibrium Model or Arbitrage Model Failures?

We can use the “time-series on demeaned factors” approach to determine whether the
familiar Fama-French time-series model fails the equilibrium test or the APT test in pricing
Fama-French portfolios. We can obtain the relevant two data sets from Ken French’s website.
As of September 2008, these files contained daily data from 1963/07/01 to 2008/07/31:

1. F-F_Research_Data_Factors_daily.zip: Daily returns on “Mkt-RF” (which is renamed to

XMK), RF, SMB, and HML.

2. 6_Portfolios_2x3_daily.zip: These are the 6 Portfolios Formed on Size and Book-to-

Market (2x3), equal-weighted. I use S and B to denote the size factor aspect of a
portfolio; and H, M, and L to denote the book-market factor aspect of a portfolio.
Thus, I have LS, MS, HS, LB, MB, and HB portfolios.

Over this particular sample period, the daily summary statistics were

RF XMK SMB HML LS MS HS LB MB HB

Mean 0.022 0.020 0.006 0.020 0.063 0.086 0.111 0.0438 0.0522 0.0599
Sdv 0.011 0.893 0.489 0.452 0.959 0.721 0.636 1.016 0.811 0.835

The familiar Fama-French regressions on these 6 portfolios yield

Portfolio a a? XMK SMB HML σ R2

LS 0.0144 0.0409 0.985 0.990 0.013 0.319 88.9%
s.e. 0.003 0.004 0.004 0.006 0.008
MS 0.0353 0.0641 0.829 0.795 0.343 0.227 90.1%
s.e. 0.002 0.002 0.003 0.005 0.006
HS 0.0605 0.0893 0.730 0.722 0.460 0.258 83.5%
s.e. 0.002 0.002 0.003 0.005 0.007

LB 0.0045 0.0218 1.041 0.244 –0.274 0.244 94.3%

s.e. 0.002 0.002 0.003 0.005 0.006
MB 0.0007 0.0302 0.986 0.210 0.391 0.225 92.3%
s.e. 0.002 0.003 0.003 0.005 0.006
HB –0.0008 0.0379 1.069 0.204 0.759 0.242 91.6%
s.e. 0.002 0.002 0.003 0.005 0.006

The undemeaned-factor intercepts are significantly different from zero among the ’S’
portfolios. This suggests that the 3-factor model fails as an equilibrium model. This is well
known, and Fama-French themselves stress that the three-factor model is indeed only a
model.
The innovation here is the determination of whether this is due to a failure of the more
primitive arbitrage restriction, or due to a failure of the more ambitious equilibrium
restriction. To implement this test, we need to compute gamma coefficients, and especially
γ0 . We can either obtain these by running monthly Fama-Macbeth regressions and then
aggregating; or by treating the above time-series coefficients as our primitive estimates
and then running one final cross-sectional regression. To stay within the current data

18
framework (specifically, to avoid a sudden switch to rolling beta estimation and to monthly
return regressions), this paper follows the second route.
The empirical relationship between the exposures with respect to the (demeaned) factors
and the consequent a? can be obtained by fitting a line between the estimated a? and the
estimated b coefficient vector over these six portfolios. There are only three degrees of
freedom.

a? = γ0? + γ1 · bXMK + γ2 · bSMB + γ3 · bHML

= 0.1769 + (−0.1500) · bXMK + 0.0118 · bSMB + 0.0187 · bHML

(8)
se 0.0430 0.0385 0.0145 0.0116
T (4.11) (−3.89) 0.82 1.62

To consider whether the true gamma intercept is zero requires assessing the statistical
properties of these estimates. It is unlikely that normal distribution theory applies in this
case.
The first concern is the EIV problem that returns via the inversion (the final-stage regression).
By running only one cross-sectional regression at the end, we have traded most of the
EIV estimation error in monthly regressions for the assumption of beta stability (as do all
Fama-French regressions in some sense). A quick look at the time-series return regressions
shows that the standard errors in the exposure estimates are about 1/100 of the spread in
the exposure estimates. This is just too small to make much difference in the final-stage
regression.
Elaborating on this problem, the necessary inversion to obtain gamma estimates is essentially
a division of two normally distributed variables, which can result in a Cauchy distribution.
Although the magnitude of the estimates suggests that this is not a big problem, it is
nevertheless comforting to bootstrap the inference.

• First, we require a clear NULL hypothesis. In this case, the NULL hypothesis is an a?
in which the cross-sectional (stage 2) λ0 = λ? 0 = γ0 regression intercept is exactly
zero. Such a NULL coefficient estimates can be obtained by estimating a regression
with a forced intercept on our 6 portfolios’ exposure estimates:

a? = 0.0 + 0.00575 · bXMK + 0.0561 · bSMB + 0.0398 · bHML

se (forced) 0.0177 0.0244 0.0260 (9)
T (0.32) 2.29 1.53

• Substitute the â? for the observed a? . This is our NULL hypothesis.

Portfolio Observed a? NULL a? bXMK bSMB bHML

LS 0.04095 0.06164 0.985 0.990 0.013
MS 0.06413 0.06298 0.829 0.795 0.343
HS 0.08930 0.06298 0.730 0.722 0.460
LB 0.02181 0.00874 1.041 0.244 –0.274
MB 0.03017 0.03299 0.986 0.210 0.391
HB 0.03789 0.04782 1.069 0.204 0.759
• Compute the in-sample return residuals, using 11,349 daily observations, under our
NULL hypothesis. Naturally, this restriction increases the mistakes in the estimated

19
 portfolio returns. Over the 11,349 observations, the mean-squared error increases to

Portfolio LS MS HS LB MB HB
Pricing Error, Observed Returns, Eq 8 0.102 0.052 0.067 0.059 0.051 0.059
Under NULL Restriction, Eq 9 0.822 0.472 0.343 0.974 0.608 0.640

More importantly for simulation purposes, the residual pricing errors are not uncor-
related. The correlation matrix of the residuals are
Estimated Unrestricted Correlations Estimated NULL Correlations
LS MS HS LB MB HB LS MS HS LB MB HB
LS 1.00 0.60 0.55 0.20 0.18 0.31 1.00 0.98 0.96 0.91 0.88 0.82
MS 0.60 1.00 0.62 0.08 0.25 0.23 0.98 1.00 0.99 0.88 0.90 0.87
HS 0.55 0.61 1.00 0.03 0.09 0.12 0.96 0.99 1.00 0.83 0.88 0.87
LB 0.20 0.08 0.03 1.00 0.42 0.33 0.91 0.88 0.83 1.00 0.96 0.89
MB 0.18 0.25 0.09 0.42 1.00 0.42 0.88 0.90 0.88 0.96 1.00 0.98
HB 0.31 0.23 0.12 0.33 0.42 1.00 0.82 0.87 0.87 0.89 0.98 1.00

We adopt the correlation structure under the NULL hypothesis (on the right) in our
simulations. (It makes little difference to the inference if we use the observed matrix
under the alternative on the left.)

With the NULL regression coefficient estimates for each portfolio, and the residual correlation
matrix determining how portfolio return errors correlate, it is now straightforward to
simulate the world under the NULL hypothesis. Over 10,000 iterations:

• Draw 11,349 correlated daily residuals for six portfolios from this NULL covariance
matrix. The revised ri,t under the NULL is the beta-vector-under-the-NULL multiplied
by the observed X-vector (which remains the same over iterations), plus the new
residuals.
• Compute a set of factor exposures to three factors and the time-series intercepts for
each of the six portfolios
• Now compute one cross-sectional regression explaining the portfolio time-series
intercepts with their own risk exposures, allowing for a gamma intercept. Record
these gamma coefficient estimates.

It remains only to ascertain how often an actual estimated empirical intercept as far as
0.1769 is observed under this NULL hypothesis. The simulation results show that the test
is very powerful as far as the estimated intercept from this NULL model is concerned. In
fact, it is almost always zero to 6 digits after the decimal points.6
We can conclude that we can be very confident that the Fama-French 3-factor model fails
not only the equilibrium pricing test for the 2x3 Fama-French portfolios, but also the more
basic APT restriction.
6
The simulated standard error in (9) for the other gamma estimates are 0.009 (instead of 0.0177 in
eq. 9) for XMK, 0.005 (instead of 0.0244) for SMB, and 0.0043 (instead of 0.00260). Thus, under the NULL
hypothesis, only the inference on the gamma on the market is statistically insignificant under the NULL
restriction (9) that the intercept is zero. In 25% of the simulations, a negative γXMK estimate occurred. In all
simulations under the NULL, the intercept was practically zero, the γSMB estimate was always between 0.038
and 0.074 (mean 0.0056), and the γHML estimate was always between 0.025 and 0.057 (0.0398). Thus, our
simulations on returns did well in replicating the estimated gamma coefficients.

20
V Conclusion

There is a one-to-one conceptual correspondence between Fama-Macbeth (gamma) coeffi-

cients and inverted Fama-French coefficients if the factors are first demeaned. The intercept
in FM regressions tests whether an APT relationship holds, while the intercept in a FF
non-demeaned-factor regression tests whether a CAPM-type relationship holds. If the FM
intercept is not zero, i.e., if the APT relation fails, other FM coefficients are impossible to
interpret: They no longer depend only on exposures to the factor in question, but also on
exposures to other factors. Thus, other factors are no longer “held constant.” Of course,
even when the FM intercept is zero, the gammas are not easy to decompose: they are
the sum of the unexpected historical factor realization and a factor exposure. (Merely
subtracting the mean of the factor before computing exposures does not alter FM inference.)
There is a close kinship between Fama-Macbeth slopes and differences in Fama-French
time-series intercepts, provided that the APT restriction holds. In a one-factor model with
two portfolios, the Fama-French portfolio intercept is zero if and only if the Fama-Macbeth
slope is zero.
There is also no if-and-only-if relationship between FM coefficients and mean-variance
efficiency. One can only expect the if-and-only-if relationship between FM coefficients and
mean-variance efficiency to hold if the factor realizations are presumed to have performed
at their historical average. If the efficient factor portfolio happened to have had a historically
good or historically bad run, research would not find a linear cross-sectional relationship in
individual assets between exposure to this portfolio and their average rates of returns. Note
that performance of the efficient portfolio relative to its historical mean is not a requirement
in the theory, but only in the test.
A sample test that uses the time-series technique to obtain Fama-Macbeth coefficients shows
that the Fama-French 3-factor model fails the simpler APT test when pricing the 2x3 size
and book-to-market portfolios. This explains the failure of the more ambitious equilibrium
factor test. It also suggests that any other Fama-Macbeth gamma coefficient estimates on
the three Fama-French factors in this 2x3 set would not be interpretable. The empirical
gamma coefficient on HML could be caused by underlying exposure to XMK and SMB, for
example, and not necessarily by underlying exposure to HML.

References
Fama, E., and K. French, 1993, “Common Risk Factors in Stock and Bond Returns,” Journal of Financial
Economics, 33(1), 3–56.
Fama, E., and J. MacBeth, 1973, “Risk, Return and Equilibrium: Empirical Tests,” Journal of Political Economy,
71, 607–636.
Polk, C., S. Thompson, and T. Vuolteenaho, 2006, “Cross-sectional forecasts of the equity premium,” Journal
of Financial Economics, 81(1), 101–41.
Stambaugh, R., and S. Kandel, 1995, “Portfolio Inefficiency and the Cross-Section of Expected Returns,”
Journal of Finance, 50(1), 157–184.