Factoring Characteristics into Returns: A Clinical Study on the SMB and HML Portfolio Construction Methods

66 Pages Posted: 29 May 2018 Last revised: 12 Mar 2020

See all articles by Marie Lambert

Marie Lambert

University of Liège - HEC Management School

Boris Fays

University of Liege, HEC Management School

Georges Hübner

HEC Liège

Date Written: March 7, 2020

Abstract

Factor performance is highly sensitive to the number of stocks composing its long and short basis portfolios. We examine three methodological choices that have an impact on portfolio diversification: the (in)dependence and the (a)symmetry of the stock sorting procedure and the sorting breakpoints. We show that these methodological choices have to be considered jointly and that a dependent (D) sort that starts with the control variables with whole sample or “name” (N) breakpoints and that performs a symmetric (S) sort on characteristics minimizes the biases from unpriced risks. This paper also demonstrates that the biases introduced by currently popular sorting methodologies can become very severe under specific market conditions and are not driven by small capitalizations. This alternative framework generates much stronger “turn-of-the- year” size and “through-the-year” book-to-market effects than what is conventionally documented.

Keywords: Portfolio sorting; Factor performance; Factor construction methods

JEL Classification: G10, G11, G12

Suggested Citation

Lambert, Marie and Fays, Boris and Hübner, Georges, Factoring Characteristics into Returns: A Clinical Study on the SMB and HML Portfolio Construction Methods (March 7, 2020). Journal of Banking and Finance, Forthcoming, Available at SSRN: https://ssrn.com/abstract=3179655 or http://dx.doi.org/10.2139/ssrn.3179655

Marie Lambert (Contact Author)

University of Liège - HEC Management School ( email )

HEC-Liège
rue Louvrex 14
LIEGE, Liege 4000
Belgium

Boris Fays

University of Liege, HEC Management School ( email )

Liège
Belgium

Georges Hübner

HEC Liège ( email )

Rue Louvrex 14, Bldg. N1
Liege, 4000
Belgium
+32 42327428 (Phone)

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