Semiparametric Conditional Factor Models in Asset Pricing

Abstract

We introduce a simple and tractable methodology for estimating semiparametric conditional latent factor models. Our approach disentangles the roles of characteristics in capturing factor betas of asset returns from ``alpha.''  We construct factors by extracting principal components from Fama-MacBeth managed portfolios. Applying this methodology to the cross-section of U.S. individual stock returns, we find compelling evidence of substantial nonzero pricing errors, even though our factors demonstrate superior performance in standard asset pricing tests. Unexplained ``arbitrage'' portfolios earn high Sharpe ratios, which decline over time. Combining factors with these orthogonal portfolios produces out-of-sample Sharpe ratios exceeding 4.

Keywords: Characteristics, Managed portfolios, Factor models, PCA, Sieve estimation, Fama-MacBeth regression, Nonlinearity