Does Unobservable Heterogeneity Matter for Portfolio-Based Asset Pricing Tests?

146 Pages Posted: 4 Jun 2018 Last revised: 20 Feb 2024

See all articles by Daniel Hoechle

Daniel Hoechle

FHNW School of Business - Institute for Finance; University of Basel - Department of Finance

Markus Schmid

University of St. Gallen - Swiss Institute of Banking and Finance; University of St. Gallen - School of Finance; Swiss Finance Institute; European Corporate Governance Institute (ECGI)

Heinz Zimmermann

University of Basel - Faculty of Business and Economics

Multiple version iconThere are 2 versions of this paper

Date Written: February 16, 2024

Abstract

We show that portfolio sorts often misattribute cross-sectional return predictability to the firm characteristic underlying the sort. This misattribution occurs when the sorting variable correlates with a firm-specific effect that captures unobservable heterogeneity across firms. We propose a new, firm-level regression approach that reproduces the results from portfolio sorts as a special case, handles multivariate firm characteristics, and can control for unobservable heterogeneity across firms. Empirical tests show that nearly half of the firm characteristics in Gu et al. (2020, 2021), that predict the cross-section of stock returns in portfolio sorts, lose their predictive power when unobservable heterogeneity is considered.

Keywords: : Portfolio sorts, Cross-section of expected returns, Tests of asset pricing models, Random effects assumption

JEL Classification: C21, G14, D1

Suggested Citation

Hoechle, Daniel and Schmid, Markus and Zimmermann, Heinz, Does Unobservable Heterogeneity Matter for Portfolio-Based Asset Pricing Tests? (February 16, 2024). Paris December 2018 Finance Meeting EUROFIDAI - AFFI, Available at SSRN: https://ssrn.com/abstract=3190310 or http://dx.doi.org/10.2139/ssrn.3190310

Daniel Hoechle (Contact Author)

FHNW School of Business - Institute for Finance ( email )

Peter Merian-Strasse 86
Basel, CH-4002
Switzerland
+41 61 279 17 73 (Phone)

University of Basel - Department of Finance ( email )

Peter Merian-Weg 6
Basel, CH-4002
Switzerland

Markus Schmid

University of St. Gallen - Swiss Institute of Banking and Finance ( email )

Unterer Graben 21
St. Gallen, 9000
Switzerland

University of St. Gallen - School of Finance ( email )

Unterer Graben 21
St.Gallen, CH-9000
Switzerland

Swiss Finance Institute

c/o University of St. Gallen
Dufourstrassse 50
St. Gallen, SG 9000
Switzerland

European Corporate Governance Institute (ECGI) ( email )

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

Heinz Zimmermann

University of Basel - Faculty of Business and Economics ( email )

Peter Merian Weg 6
Basel, 4002
Switzerland
+41 61 267 33 16 (Phone)
+41 61 267 08 98 (Fax)

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