How Robust are Empirical Factor Models to the Choice of Breakpoints?

Abstract

We comprehensively investigate the robustness of well-known factor models to altered factor formation breakpoints. Deviating from the standard 30th and 70th percentile selection, we use an extensive set of anomaly test portfolios to uncover two main findings: First, there is a trade-off between specification and diversification. More centered breakpoints tend to result in less (idiosyncratic) risk. More extreme sorts lead to greater exposure to the underlying anomalies and thus to higher average returns. Second, the models are robust to varying degrees. The Hou, Xue, and Zhang (2015) model is much more sensitive to changes in breakpoints than the Fama–French models.

Keywords: Asset Pricing, Factors, Replication, Breakpoint Analysis, Robustness

JEL Classification: G12, C58, G10