Hostname: page-component-78c5997874-94fs2 Total loading time: 0 Render date: 2024-11-15T09:45:23.324Z Has data issue: false hasContentIssue false
  • English
  • Français

When Factors Do Not Span Their Basis Portfolios

Published online by Cambridge University Press:  12 October 2018

Mark Grinblatt  and
Konark Saxena
Get access Rights & Permissions [Opens in a new window]

Abstract

To price assets with a parsimonious set of factor-mimicking portfolios, one typically identifies and weights well-diversified basis portfolios. Traditional weightings lead to factor-mimicking portfolios that are unlikely to price even the basis portfolios from which they are formed. We offer a method to combine basis portfolios into a single factor-mimicking portfolio that is closely linked to the optimal portfolio. In practice, this method improves the pricing accuracy of parsimonious factor models, even for anomaly portfolios formed from characteristics that are distinct from those underlying the basis portfolios.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 53 , Issue 6 , December 2018 , pp. 2335 - 2354
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2018 

Access options

Get access to the full version of this content by using one of the access options below. (Log in options will check for institutional or personal access. Content may require purchase if you do not have access.)

Footnotes

1

We thank Kenneth French for making the data available, as well as an anonymous referee, Hendrik Bessembinder (the editor), Tarun Chordia, Bhagwan Chowdhry, Robert Faff, David Feldman, Olivier Ledoit, Richard Roll, Avanidhar Subrahmanyam, Terry Walter, Chu Zhang, and seminar participants at Hong Kong Polytechnic University, University of South Australia, and the University of New South Wales for helpful comments on earlier drafts.

References

Barillas, F., and Shanken, J.. “Which Alpha?” Review of Financial Studies, 30 (2017), 1316–1338.Google Scholar
Barillas, F., and Shanken, J.. “Comparing Asset Pricing Models.” Journal of Finance, 73 (2018), 715–754.Google Scholar
Basak, G. K.; Jagannathan, R.; and Ma, T.. “Jackknife Estimator for Tracking Error Variance of Optimal Portfolios.” Management Science, 55 (2009), 990–1002.Google Scholar
Black, F.; Jensen, M.; and Scholes, M.. “The Capital Asset Pricing Model: Some Empirical Tests.” In Studies in the Theory of Capital Markets, Jensen, M. C., ed. New York, NY: Praeger (1972), 79–121.Google Scholar
Carhart, M. M.“On Persistence in Mutual Fund Performance.” Journal of Finance, 52 (1997), 57–82.Google Scholar
Connor, G.“A Unified Beta Pricing Theory.” Journal of Economic Theory, 34 (1984), 13–31.Google Scholar
Cremers, M.; Petajisto, A.; and Zitzewitz, E.. “Should Benchmark Indices Have Alpha? Revisiting Performance Evaluation.” Critical Finance Review, 2 (2013), 1–48.Google Scholar
Engle, R. F.; Ledoit, O.; and Wolf, M.. “Large Dynamic Covariance Matrices.” Journal of Business & Economic Statistics, forthcoming (2018).Google Scholar
Fama, E. F., and French, K. R.. “Common Risk Factors in the Returns on Stocks and Bonds.” Journal of Financial Economics, 33 (1993), 3–56.Google Scholar
Fama, E. F., and French, K. R.. “A Five-Factor Asset Pricing Model.” Journal of Financial Economics, 116 (2015), 1–22.Google Scholar
Fama, E. F., and MacBeth, J. D.. “Risk, Return, and Equilibrium: Empirical Tests.” Journal of Political Economy, 81 (1973), 607–636.Google Scholar
Gerakos, J., and Linnainmaa, J. T.. “Dissecting Factors.” Working Paper, University of Chicago Booth School of Business (2014).Google Scholar
Gibbons, M. R.; Ross, S. A.; and Shanken, J.. “A Test of the Efficiency of a Given Portfolio.” Econometrica, 57 (1989), 1121–1152.Google Scholar
Huberman, G., and Kandel, S.. “A Size Based Stock Returns Model.” Working Paper, University of Chicago (1985).Google Scholar
Kan, R., and Smith, D. R.. “The Distribution of the Sample Minimum-Variance Frontier.” Management Science, 54 (2008), 1364–1380.Google Scholar
Lahiri, S. N.“Second Order Optimality of Stationary Bootstrap.” Statistics and Probability Letters, 11 (1991), 335–341.Google Scholar
Ledoit, O., and Wolf, M.. “Robust Performance Hypothesis Testing with the Sharpe Ratio.” Journal of Empirical Finance, 15 (2008), 850–859.Google Scholar
Lintner, J.“The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets.” Review of Economics and Statistics, 47 (1965), 13–37.Google Scholar
Newey, W. K., and West, K. D.. “A Simple, Positive Semi-Definite, Heteroskedasticity and Autocorrelation Consistent Covariance Matrix.” Econometrica, 55 (1987), 703–708.Google Scholar
Novy-Marx, R.“The Other Side of Value: The Gross Profitability Premium.” Journal of Financial Economics, 108 (2013), 1–28.Google Scholar
Politis, D. N., and Romano, J. P.. “A Circular Block-Resampling Procedure for Stationary Data.” In Exploring the Limits of Bootstrap, LePage, R. and Billard, L., eds. New York, NY: Wiley (1992), 263–270.Google Scholar
Ross, S. A.“The Arbitrage Theory of Capital Asset Pricing.” Journal of Economic Theory, 13 (1976), 341–360.Google Scholar
Sharpe, W. F.“Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk.” Journal of Finance, 19 (1964), 425–442.Google Scholar
Welch, I.“The Link between Fama-French Time-Series Tests and Fama-MacBeth Cross-Sectional Tests.” Working Paper, University of California, Los Angeles (2008).Google Scholar