The closed-end fund evidence shows that the fundamentals-based view of
comovement is at best, incomplete: in that case, the prices of closed-end
funds comove even though their fundamentals do not.^31 Other evidence is
just as puzzling. Froot and Dabora (1999) study “twin stocks,” which are
claims to the same cash-flow stream, but are traded in different locations.
The Royal Dutch/Shell pair, discussed in section 2, is perhaps the best
known example. If return comovement is simply a reflection of comove-
ment in fundamentals, these two stocks should be perfectly correlated. In
fact, as Froot and Dabora show, Royal Dutch comoves strongly with the
S&P 500 index of U.S. stocks, while Shell comoves with the FTSE index of
U.K. stocks.
Fama and French (1993) uncover salient common factors in the returns
of small stocks, as well as in the returns of value stocks. In order to test the
rational view of comovement, Fama and French (1995) investigate whether
these strong common factors can be traced to common factors in news
about the earnings of these stocks. While they do uncover a common factor
in the earnings news of small stocks, as well as in the earnings news of
value stocks, these cash-flow factors are weaker than the factors in returns
and there is little evidence that the return factors are driven by the cash-
flow factors. Once again, there appears to be comovement in returns that
has little to do with fundamentals-based comovement.^32
In response to this evidence, researchers have begun to posit behavioral
theories of comovement. LST is one such theory. To state their argument
more generally, they start by observing that many investors choose to trade
only a subset of all available securities. As these investors’ risk aversion or
sentiment changes, they alter their exposure to the particular securities they
hold, thereby inducing a common factor in the returns of these securities.
Put differently, this “habitat” view of comovement predicts that there will
be a common factor in the returns of securities that are the primary hold-
ings of a specific subset of investors, such as individual investors. This story
A SURVEY OF BEHAVIORAL FINANCE 49(^31) Bodurtha et al. (1993) and Hardouvelis et al. (1994) provide further interesting examples
of a delinking between fundamentals-based comovement and return comovement in the
closed-end fund market. They study closed-end countryfunds, whose assets trade in a differ-
ent location from the funds themselves and find that the funds comove as much with the na-
tional stock market in the country where they are traded as with the national stock market in
the country where their assets are traded. For example, a closed-end fund invested in German
equities but traded in the United States typically comoves as much with the U.S. stock market
as with the German stock market.
(^32) In principle, comovement can also be rationally generated through changes in discount
rates. However, changes in interest rates or risk aversion induce a common factor in the re-
turns on allstocks, and do not explain why a particular group of stocks comoves. A common
factor in news about the risk of certain assets may also be a source of comovement for those
assets, but there is little direct evidence to support such a mechanism in the case of small
stocks or value stocks.