Linear Factor Models and the Estimation of Expected Returns
58 Pages Posted: 20 Apr 2016 Last revised: 24 May 2021
Date Written: May 24, 2021
This paper analyzes the properties of expected return estimators on individual assets implied by the linear factor models of asset pricing, i.e., the product of factor exposures and prices of risk. We provide the asymptotic properties of factor-model-based expected return estimators, which yield the standard errors for individual assets. We show that using factor-model-based risk premium estimates leads to sizable precision gains compared to the historical averages. 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 misspecification 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 sizable improvements in out-of- sample performance of optimal portfolios.
Keywords: Cross Section of Expected Returns, Risk Premium, Small Betas, Omitted Factors.
JEL Classification: C13, C38, G11
Suggested Citation: Suggested Citation