Distinguishing Factors and Characteristics with Characteristic-Mimicking Portfolios

49 Pages Posted: 16 Jul 2018

See all articles by Ronald J. Balvers

Ronald J. Balvers

McMaster University - Michael G. DeGroote School of Business

H. Arthur Luo

Government of the United States of America - Office of the Comptroller of the Currency (OCC); McMaster University

Date Written: June 26, 2018

Abstract

We advance a procedure for deriving systematic factors from characteristics based on maximizing each factor’s exposure to a characteristic for given factor variance. The resulting characteristic-mimicking portfolios (CMPs) price assets identically as the original characteristics and have maximum power to identify underlying factors. Performance differences of mimicking factors and characteristics in explaining mean returns are artifacts of arbitrary procedures for generating mimicking factors. CMPs are ideally suited to distinguish factors and characteristics by explanatory power for the time series of returns and are useful for improving risk management and to determine if return explanations are justifiably linked to systematic risk.

Keywords: Characteristics, Factors, Systematic Risk, Mimicking Portfolios

JEL Classification: G12

Suggested Citation

Balvers, Ronald J. and Luo, Hao, Distinguishing Factors and Characteristics with Characteristic-Mimicking Portfolios (June 26, 2018). Available at SSRN: https://ssrn.com/abstract=3203031 or http://dx.doi.org/10.2139/ssrn.3203031

Ronald J. Balvers (Contact Author)

McMaster University - Michael G. DeGroote School of Business ( email )

1280 Main Street West
Hamilton, Ontario L8S 4M4
Canada
(905) 525-9140 x23969 (Phone)

HOME PAGE: http://profs.degroote.mcmaster.ca/business/balvers

Hao Luo

Government of the United States of America - Office of the Comptroller of the Currency (OCC) ( email )

250 E Street, SW
Washington, DC 20219
United States

McMaster University ( email )

1280 Main Street West
Hamilton, Ontario L8S 4M4
Canada

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