Article2018

When Factors Do Not Span Their Basis Portfolios

23 citations0/0 files storedJournal of Financial and Quantitative Analysis

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Financial Markets and Investment Strategies Financial Analysis and Corporate Governance Financial Risk and Volatility Modeling

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.

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1993Common risk factors in the returns on stocks and bonds 1964CAPITAL ASSET PRICES: A THEORY OF MARKET EQUILIBRIUM UNDER CONDITIONS OF RISK*1997On Persistence in Mutual Fund Performance 1973Risk, Return, and Equilibrium: Empirical Tests 2014A five-factor asset pricing model 1965The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets 1976The arbitrage theory of capital asset pricing 1975THE VALUATION OF RISK ASSETS AND THE SELECTION OF RISKY INVESTMENTS IN STOCK PORTFOLIOS AND CAPITAL BUDGETS**This paper is another in a series of interrelated theoretical and statistical studies of corporate financial and investment policies being made under grants from the Rockefeller Foundation, and more recently the Ford Foundation, to the Harvard Business School. The generous support for this work is most gratefully acknowledged. The author is also much indebted to his colleagues Professors Bishop, Christenson, Kahr, Raiffa, and (especially) Schlaifer, for extensive discussion and commentary on an earlier draft of this paper; but responsibility for any errors or imperfections remains strictly his own.[Professor Sharpe's paper, “Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk” (Journal of Finance, September 1964) appeared after this paper was in final form and on its way to the printers. My first section, which parallels the first half of his paper (with corresponding conclusions), sets the algebraic framework for sections II, III and VI, (which have no counterpart in his paper) and for section IV on the equilibrium prices of risk assets, concerning which our results differ significantly for reasons which will be explored elsewhere. Sharpe does not take up the capital budgeting problem developed in section V below.]

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