Analysing Portfolios of Financial and Nonfinancial Stocks Using a Single Factor Model

Abstract

We develop an alternative factor model to determine the required rate of return by replacing the HML factor with a dividend-based alternative. Traditional factor models cannot be applied to portfolios diversified across the financial and nonfinancial sectors. We offer a resolution to this problem. Our empirical analysis of UK-listed stocks shows that even though the new model is estimated using only nonfinancial firms it can explain returns on portfolios of both nonfinancial and financial firms. As financials constitute a substantial proportion of an investor’s opportunity set, this represents a more practical model for factor-based investing.

Keywords: asset pricing, dividends, multifactor models, CAPM, Fama-French model, performance evaluation