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

53 Pages Posted: 4 Jun 2018 Last revised: 2 Feb 2020

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

Heinz Zimmermann

University of Basel - Center for Economic Science (WWZ) - Department of Finance

Date Written: January 31, 2020

Abstract

We show that portfolio sorts, as widely used in empirical asset pricing, tend to misattribute cross-sectional return predictability to the firm characteristic underlying the sort. Such misattribution arises if the sorting variable correlates with a firm-specific effect capturing unobservable heterogeneity across firms. We propose a new, firm-level regression approach that can reproduce the results from standard portfolio sorts. Besides, our method handles multivariate firm characteristics and, if firm fixed effects are included, is robust to misattributing cross-sectional return predictability. Our empirical results confirm that portfolio sorts have limited power in detecting abnormal returns: Several characteristics-based factors lose their predictive power when we control for unobservable heterogeneity across firms.

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? (January 31, 2020). 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 )

Rosenbergstrasse 52
St. Gallen, 9000
Switzerland

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

Unterer Graben 21
St.Gallen, CH-9000
Switzerland

Heinz Zimmermann

University of Basel - Center for Economic Science (WWZ) - Department of Finance ( email )

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

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