Factor Returns and Out-of-Sample Alphas: Factor Construction Matters

35 Pages Posted: 22 Nov 2022

See all articles by Hendrik Bessembinder

Hendrik Bessembinder

W.P. Carey School of Business

Aaron Burt

University of Oklahoma - Division of Finance

Christopher M. Hrdlicka

University of Washington - Michael G. Foster School of Business

Date Written: November 19, 2022

Abstract

Portfolios formed on a time-varying basis from the principal components of the factors compiled by Chen and Zimmerman (CZ) and Jensen, Kelly, and Pedersen (JKP) display large and robust out-of-sample Sharpe ratios, implying that the factors strongly forecast the cross-section of stock returns. However, average Sharpe ratios obtained based on the CZ factors are notably larger than when using the JKP factors. We investigate this divergence, documenting the roles of the weighting methods used to construct factor returns, the number of quantile portfolios employed to construct factor returns, and divergences in the numbers and composition of the factors contained across databases. We also show that factor principal components beyond the first few contribute substantially to the factors’ ability to forecast the cross-section of returns.

Keywords: Asset Pricing, Factors, Data Mining, Replication, Sharpe Ratios, Anomalies

JEL Classification: G10, G11, G12

Suggested Citation

Bessembinder, Hendrik (Hank) and Burt, Aaron Paul and Hrdlicka, Christopher M., Factor Returns and Out-of-Sample Alphas: Factor Construction Matters (November 19, 2022). Available at SSRN: https://ssrn.com/abstract=4281769 or http://dx.doi.org/10.2139/ssrn.4281769

Hendrik (Hank) Bessembinder (Contact Author)

W.P. Carey School of Business ( email )

W. P. Carey School of Business
PO Box 873906
Tempe, AZ 85287-3906
United States

HOME PAGE: http://isearch.asu.edu/profile/2717225

Aaron Paul Burt

University of Oklahoma - Division of Finance ( email )

Norman, OK 73019
United States

HOME PAGE: http://sites.google.com/sites/aaronburt

Christopher M. Hrdlicka

University of Washington - Michael G. Foster School of Business ( email )

Box 353200
Seattle, WA 98195
United States
206.616.0332 (Phone)
206.542.7472 (Fax)

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