Linear Factor Models and the Estimation of Expected Returns

52 Pages Posted: 20 Apr 2016 Last revised: 1 Nov 2017

See all articles by Cisil Sarisoy

Cisil Sarisoy

Board of Governors of the Federal Reserve System

Peter de Goeij

Tilburg University

Bas J. M. Werker

Tilburg University - Center for Economic Research (CentER)

Date Written: March 3, 2016

Abstract

Standard factor models imply a linear relationship between expected returns on assets and their factor exposures. We provide the asymptotic properties of factor-model-based expected return estimators for individual assets and show that exploiting this linear relationship leads to precision gains of up to 31% in the estimates of expected returns compared to using historical averages. Moreover, in the presence of omitted factors, adding an alpha to the model captures mispricing only in case of traded factors, otherwise, the bias caused by misspecifi cation cannot be corrected. Finally, inference about expected returns, unlike inference on factor prices, does not suffer from a small-beta bias. The more precise factor-model-based estimates of expected returns translate into signi cant improvements in out-of-sample performance of optimal portfolios.

Keywords: Factor Pricing, Risk Premium, Small Betas, Omitted Factors

JEL Classification: C13, C38, G11

Suggested Citation

Sarisoy, Cisil and de Goeij, Peter and Werker, Bas J.M., Linear Factor Models and the Estimation of Expected Returns (March 3, 2016). Netspar Discussion Paper No. 03/2016-020, Available at SSRN: https://ssrn.com/abstract=2766515 or http://dx.doi.org/10.2139/ssrn.2766515

Cisil Sarisoy (Contact Author)

Board of Governors of the Federal Reserve System ( email )

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

Peter De Goeij

Tilburg University ( email )

P.O. Box 90153
Room I607
Tilburg, Noord-Brabant 5000 LE
Netherlands
+31134662083 (Phone)

Bas J.M. Werker

Tilburg University - Center for Economic Research (CentER) ( email )

Econometrics and Finance Group
5000 LE Tilburg
Netherlands

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