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When Factors Do Not Span Their Basis Portfolios

Published online by Cambridge University Press:  12 October 2018

Mark Grinblatt  and
Konark Saxena
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Abstract

To price assets with a parsimonious set of factor-mimicking portfolios, one typically identifies and weights well-diversified basis portfolios. Traditional weightings lead to factor-mimicking portfolios that are unlikely to price even the basis portfolios from which they are formed. We offer a method to combine basis portfolios into a single factor-mimicking portfolio that is closely linked to the optimal portfolio. In practice, this method improves the pricing accuracy of parsimonious factor models, even for anomaly portfolios formed from characteristics that are distinct from those underlying the basis portfolios.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 53 , Issue 6 , December 2018 , pp. 2335 - 2354
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2018 

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Footnotes

1

We thank Kenneth French for making the data available, as well as an anonymous referee, Hendrik Bessembinder (the editor), Tarun Chordia, Bhagwan Chowdhry, Robert Faff, David Feldman, Olivier Ledoit, Richard Roll, Avanidhar Subrahmanyam, Terry Walter, Chu Zhang, and seminar participants at Hong Kong Polytechnic University, University of South Australia, and the University of New South Wales for helpful comments on earlier drafts.

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