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
Date Written: March 7, 2020
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: Suggested Citation