Better Factor Portfolios and Pricing Book-to-Market Characteristics with the Fama-French Factor Model

Abstract:     
This paper suggests forming portfolios by optimizing an objective function instead of by sorting. This is more parsimonious and flexible, and makes better use of the data. Empirically, our paper confirms the Davis, Fama, and French (2000) conjecture that the Daniel and Titman (1997) result was unique to their 1973–1993 sample period. The latter’s evidence is obsolete: From 1973–2008, the Fama-French model can price their sort-based incongruence portfolio (spreading HML exposures vs. book-to-market characteristics) almost perfectly. However, we show that it could never price optimized incongruence portfolios.

Moreover, one can also construct optimized benchmark factors in lieu of the original Fama-French benchmark factors. These alternatives have higher Sharpe ratios, and some models based on them can price their own incongruence portfolios.

Keywords: book-to-market, HML, characteristics, factors

JEL Classifications: G1

Working Paper Series