Using Stocks or Portfolios in Tests of Factor Models
Jacobs Levy Equity Management Center for Quantitative Financial Research Working Paper
65 Pages Posted: 17 Mar 2008 Last revised: 10 Aug 2018
Date Written: August 7, 2018
We examine the efficiency of using individual stocks or portfolios as base assets to test asset pricing models using cross-sectional data. The literature has argued that creating portfolios reduces idiosyncratic volatility and allows more precise estimates of factor loadings, and consequently risk premia. We show analytically and empirically that smaller standard errors of portfolio beta estimates do not lead to smaller standard errors of cross-sectional coefficient estimates. Factor risk premia standard errors are determined by the cross-sectional distributions of factor loadings and residual risk. Portfolios destroy information by shrinking the dispersion of betas, leading to larger standard errors.
Keywords: Specifying Base Assets, Cross-Sectional Regression, Estimating Risk Premia, APT, Efficiency Loss
JEL Classification: G12, C13
Suggested Citation: Suggested Citation