Microfounding the Fama-MacBeth Regression

Since Fama and French (1993), 502 papers that attempt to identify factors that determine equilibrium asset prices have been published in major finance journals. None of these papers, however, ask the question whether these factors matter to fund managers investment decisions. Our paper attempts to answer this question studying the industry allocation decisions of active US mutual funds and by recovering their implied expected returns. In particular, we take 7 major published asset pricing models and estimate the implied expected factor risk premiums in order to fit fund managers observed asset allocation. Existing models are then compared in terms of their implied mean-variance efficiency (Sharpe ratio) of the observed market portfolio. We find that the traditional macroeconomic risk factor model proposed by Chen et al. (1986) is the only one that can produce a risk-return trade-off that is internally consistent with fund managers risk preferences, as well as, that has explanatory power of the equity risk premium across the business cycle