Using Stocks or Portfolios in Tests of Factor Models

65 Pages Posted: 17 Mar 2008 Last revised: 11 Aug 2020

See all articles by Andrew Ang

Andrew Ang

BlackRock, Inc

Jun Liu

University of California, San Diego (UCSD) - Rady School of Management

Krista Schwarz

Board of Governors of the Federal Reserve System

Date Written: August 7, 2018

Abstract

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

Ang, Andrew and Liu, Jun and Schwarz, Krista, Using Stocks or Portfolios in Tests of Factor Models (August 7, 2018). AFA 2009 San Francisco Meetings Paper, Jacobs Levy Equity Management Center for Quantitative Financial Research Paper, Available at SSRN: https://ssrn.com/abstract=1106463 or http://dx.doi.org/10.2139/ssrn.1106463

Andrew Ang

BlackRock, Inc ( email )

55 East 52nd Street
New York City, NY 10055
United States

Jun Liu

University of California, San Diego (UCSD) - Rady School of Management ( email )

9500 Gilman Drive
Rady School of Management
La Jolla, CA 92093
United States
858.534.2022 (Phone)
5858.534.0745 (Fax)

Krista Schwarz (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

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