Correcting Alpha Misattribution in Portfolio Sorts

53 Pages Posted: 4 Jun 2018 Last revised: 10 Jan 2019

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: November 15, 2018

Abstract

We show that portfolio sorts, as commonly employed in empirical asset pricing applications, are at risk of accidentally misattributing parts of the risk-adjusted return (or "alpha") to the firm characteristic underlying the sort. Such misattribution occurs if the firm characteristic is correlated with an unobservable yet time-persistent factor. We propose a novel, regression-based methodology for analyzing asset returns. Our technique can reproduce the alpha and factor exposure estimates from all variants of sorting assets into (e.g., decile) portfolios. In addition, and contrary to standard portfolio sorts, our approach handles multivariate and continuous firm characteristics and, if firm-specific (fixed) effects are included in the analysis, is robust to alpha misattribution. In our empirical analysis, we indeed find alpha misattribution to be an issue in conventional portfolio sorts as several well-known characteristics-based factors lose their predictive power when we account for firm fixed effects.

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, Correcting Alpha Misattribution in Portfolio Sorts (November 15, 2018). 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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