Hostname: page-component-6898cfcb55-th4rj Total loading time: 0 Render date: 2026-11-11T12:13:22.288Z Has data issue: false hasContentIssue false
  • English
  • Français

Factor Model Comparisons with Conditioning Information

Published online by Cambridge University Press:  29 January 2024

Wayne E. FersonOpen the ORCID record for Wayne E. Ferson[Opens in a new window],
Andrew F. SiegelOpen the ORCID record for Andrew F. Siegel[Opens in a new window] and
Junbo L. WangOpen the ORCID record for Junbo L. Wang[Opens in a new window]
Wayne E. Ferson*
Affiliation:
Finance at the Marshall School, University of Southern California, and a Research Associate at the National Bureau of Economic Research
Andrew F. Siegel
Affiliation:
University of Washington Foster School of Business Finance and Business Economics and Information Systems and Operations Management aasiegel@u.washington.edu
Junbo L. Wang
Affiliation:
Ourso College of Business, Louisiana State University junbowang@lsu.edu
*
ferson@usc.edu (corresponding author)
Rights & Permissions [Opens in a new window]

Abstract

Core share and HTML view are not available for this content. However, as you have access to this content, a full PDF is available via the 'Save PDF' action button.

We develop methods for testing factor models when the weights in portfolios of factors and test assets can vary with lagged information. We derive and evaluate consistent standard errors and finite sample bias adjustments for unconditional maximum squared Sharpe ratios and their differences. Bias adjustment using a second-order approximation performs well. We derive optimal zero-beta rates for models with dynamically trading portfolios. Factor models’ Sharpe ratios are larger but standard test asset portfolios’ maximum Sharpe ratios are larger still when there is dynamic trading. As a result, most of the popular factor models are rejected.

Information

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 60 , Issue 3 , May 2025, pp. 1401 - 1426
Copyright
© The Author(s), 2024. Published by Cambridge University Press on behalf of the Michael G. Foster School of Business, University of Washington

Footnotes

We are grateful to an anonymous referee, Andrew Detzel, Thierry Foucault (the editor), Raymond Kan, Xiaolu Wang, Baozhong Yang, Paolo Zaffaroni, Guofu Zhou, the editor for comments, and to seminar participants at the 2019 Financial Management Conference, the 2021 China International Finance Conference, the 2022 Southwestern Finance Association, the 2022 Southern Finance Association, the 2022 World Symposium on Investment Research, the University of Texas at Austin, the University of New Orleans, the Louisiana State University, and the University of Washington.

References

Abhyankar, A.; Basu, D.; and Stremme, A.. “The Optimal Use of Return Predictability: An Empirical Study.” Journal of Financial and Quantitative Analysis, 47 (2012), 973–1001.CrossRefGoogle Scholar
Adrian, T.; Etula, E.; and Muir, T.. “Financial Intermediaries and the Cross‐Section of Asset Returns.” Journal of Finance, 69 (2014), 2557–2596.CrossRefGoogle Scholar
Barillas, F.; Kan, R.; Robotti, C.; and Shanken, J.. “Model Comparison with Sharpe Ratios.” Journal of Financial and Quantitative Analysis, 55 (2020), 1840–1874.CrossRefGoogle Scholar
Barillas, F., and Shanken, J.. “Which Alpha?” Review of Financial Studies, 30 (2017), 1316–1338.CrossRefGoogle Scholar
Bekaert, G., and Liu, J.. “Conditioning Information and Variance Bounds on Pricing Kernels.” Review of Financial Studies, 17 (2004), 339–378.CrossRefGoogle Scholar
Black, F. “Capital Market Equilibrium with Restricted Borrowing.” Journal of Business, 45 (1972), 444–455.CrossRefGoogle Scholar
Black, F.; Jensen, M. C.; and Scholes, M.. “The Capital Asset Pricing Model: Some Empirical Tests.” In Studies in the Theory of Capital Markets, Jensen, M. C., ed. New York, NY: Praeger Publishers (1972).Google Scholar
Boudoukh, J.; Michaely, R.; Richardson, M.; and Roberts, M. R.. “On the Importance of Measuring Payout Yield: Implications for Empirical Asset Pricing.” Journal of Finance, 62 (2007), 877–915.CrossRefGoogle Scholar
Breeden, D. “An Intertemporal Asset Pricing Model with Stochastic Consumption and Investment Opportunities.” Journal of Financial Economics, 7 (1979), 265–296.CrossRefGoogle Scholar
Campbell, J. Y. “Understanding Risk and Return.” Journal of Political Economy, 104(2) (1996), 298–345.CrossRefGoogle Scholar
Chamberlain, G. “Funds, Factors, and Diversification in Arbitrage Pricing Models.” Econometrica, 11 (1983), 1305–1323.CrossRefGoogle Scholar
Chen, N. F.; Roll, R.; and Ross, S. A.. “Economic Forces and the Stock Market.” Journal of Business, 59 (1986), 383–403.CrossRefGoogle Scholar
Chiang, I. H. E. “Modern Portfolio Management with Conditioning Information.” Journal of Empirical Finance, 33 (2015), 114–134.CrossRefGoogle Scholar
Cochrane, J. H. “A Cross-Sectional Test of an Investment-Based Asset Pricing Model.” Journal of Political Economy, 104 (1996), 572–621.CrossRefGoogle Scholar
Cochrane, J. H. “Production-Based Asset Pricing and the Link Between Stock Returns and Economic Fluctuations.” Journal of Finance, 46 (1991), 209–237.Google Scholar
Cohen, R. B.; Polk, C.; and Vuolteenaho, T.. “The Value Spread.” Journal of Finance, 58 (2003), 609–641.CrossRefGoogle Scholar
Cooper, I., and Maio, P.. “New Evidence on Conditional Factor Models.” Journal of Financial and Quantitative Analysis, 54 (2019), 1975–2016.CrossRefGoogle Scholar
Ehsani, S., and Linnainmaa, J.. “Time-Series Efficient Factors.” Working Paper, Dartmouth College (2020).CrossRefGoogle Scholar
Fama, E. F. “A Note on the Market Model and the Two-Parameter Model.” Journal of Finance, 28 (1973), 1181–1185.Google Scholar
Fama, E. F., and French, K. R.. “Business Conditions and Expected Returns on Stocks and Bonds.” Journal of Financial Economics, 25 (1989), 23–49.CrossRefGoogle Scholar
Fama, E. F., and French, K. R.. “Multifactor Explanations of Asset Pricing Anomalies.” Journal of Finance, 51 (1996), 55–87.CrossRefGoogle Scholar
Fama, E. F., and French, K. R.. “A Five-Factor Asset Pricing Model.” Journal of Financial Economics, 116 (2015), 1–22.CrossRefGoogle Scholar
Fama, E. F., and French, K. R.. “Dissecting Anomalies with a Five-Factor Model.” Review of Financial Studies, 29 (2016), 69–103.CrossRefGoogle Scholar
Fama, E. F., and French, K. R.. “Choosing Factors.” Journal of Financial Economics, 128 (2018), 234–252.CrossRefGoogle Scholar
Ferson, W. E. “Theory and Empirical Testing of Asset Pricing Models.” In Handbook in Operations Research and Management Science-Finance, Vol. 9, Jarrow, R. A., Maksimovic, V., and Ziemba, W. T., eds. Amsterdam, The Netherlands: North Holland (1995), 145–200.Google Scholar
Ferson, W. E. Empirical Asset Pricing: Models and Methods. Cambridge, MA: MIT Press (2019).Google Scholar
Ferson, W. E.; Sarkissian, S.; and Simin, T.. “Spurious Regressions in Financial Economics?” Journal of Finance, 58 (2003), 1393–1413.CrossRefGoogle Scholar
Ferson, W. E., and Siegel, A. F.. “The Efficient Use of Conditioning Information in Portfolios.” Journal of Finance, 56 (2001), 967–982.CrossRefGoogle Scholar
Ferson, W. E., and Siegel, A. F.. “Stochastic Discount Factor Bounds with Conditioning Information.” Review of Financial Studies, 16 (2003), 567–595.CrossRefGoogle Scholar
Ferson, W. E., and Siegel, A. F.. “Testing Portfolio Efficiency with Conditioning Information.” Review of Financial Studies, 22 (2009), 2735–2758.CrossRefGoogle Scholar
Ferson, W. E., and Siegel, A. F.. “Optimal Orthogonal Portfolios with Conditioning Information.” In Handbook of Financial Econometrics and Statistics, Lee, C.-F. and Lee, J. C., eds. New York, NY: Springer (2015), 977–1002.CrossRefGoogle Scholar
Ferson, W. E.; Siegel, A. F.; and Xu, P.. “Mimicking Portfolios with Conditioning Information.” Journal of Financial and Quantitative Analysis, 41 (2006), 607–635.CrossRefGoogle Scholar
Frazzini, A., and Pedersen, L. H.. “Betting Against Beta.” Journal of Financial Economics, 111 (2014), 1–25.CrossRefGoogle Scholar
Gibbons, M. R. “Multivariate Tests of Financial Models.” Journal of Financial Economics, 10 (1982), 3–27.CrossRefGoogle Scholar
Gibbons, M. R., and Ferson, W. E.. “Testing Asset Pricing Models with Changing Expectations and an Unobservable Market Portfolio.” Journal of Financial Economics, 14 (1985), 217–236.CrossRefGoogle Scholar
Gibbons, M. R.; Ross, S. A.; and Shanken, J.. “A Test of the Efficiency of a Given Portfolio.” Econometrica, 57 (1989), 1121–1152.CrossRefGoogle Scholar
Goyal, A.; Welch, I.; and Zafirov, A.. “A Comprehensive Look at Equity Premium Prediction, Part II.” Working Paper 21–8, Swiss Finance Institute (2021).Google Scholar
Grinblatt, M., and Titman, S.. “The Relation Between Mean-Variance Efficiency and Arbitrage Pricing.” Journal of Business, 60 (1987), 97–112.CrossRefGoogle Scholar
Hansen, L. P. “Large Sample Properties of the Generalized Method of Moments Estimators.” Econometrica, 50 (1982), 1029–1054.CrossRefGoogle Scholar
Hansen, L. P., and Hodrick, R. J.. “Risk Averse Speculation in the Forward Foreign Exchange Market: An Econometric Analysis of Linear Models.” Exchange Rates and International Macroeconomics, Frenkel, J. A., ed. Chicago, IL: University of Chicago Press (1983), 113–152.Google Scholar
Hansen, L. P., and Richard, S. F.. “The Role of Conditioning Information in Deducing Testable Restrictions Implied by Dynamic Asset Pricing Models.” Econometrica, 55 (1987), 587–613.CrossRefGoogle Scholar
Harvey, C. R. “Time-Varying Conditional Covariances in Tests of Asset Pricing Models.” Journal of Financial Economics, 24 (1989), 289–317.CrossRefGoogle Scholar
Hou, K.; Mo, H.; Xue, C.; and Zhang, L.. “An Augmented q-Factor Model with Expected Growth.” Review of Finance, 25 (2021), 1–41.CrossRefGoogle Scholar
Hou, K.; Xue, C.; and Zhang, L.. “Digesting Anomalies: An Investment Approach.” Review of Financial Studies, 28 (2015), 650–705.CrossRefGoogle Scholar
Jegadeesh, N.; Noh, J.; Pukthuanthong, K.; Roll, R.; and Wang, J.. “Empirical Tests of Asset Pricing Models with Individual Assets: Resolving the Errors-in-Variables Bias in Risk Premium Estimation.” Journal of Financial Economics, 133 (2019), 273–298.CrossRefGoogle Scholar
Jobson, J. D., and Korkie, B.. “Estimation of Markowitz Efficient Portfolios.” Journal of the American Statistical Association, 75 (1980), 544–554.CrossRefGoogle Scholar
Kan, R.; Wang, X.; and Zheng, X.. “In-Sample and Out-of-Sample Sharpe Ratios of Multi-Factor Asset Pricing Models.” Working Paper, University of Toronto (2019).CrossRefGoogle Scholar
Kandel, S. “The Geometry of the Maximum Likelihood Estimator of the Zero‐Beta Return.” Journal of Finance, 41 (1986), 339–346.Google Scholar
MacKinlay, A. C. “On Multivariate Tests of the CAPM.” Journal of Financial Economics, 18 (1987), 341–371.CrossRefGoogle Scholar
Merton, R. “An Intertemporal Capital Asset Pricing Model.” Econometrica, 41 (1973), 867–887.CrossRefGoogle Scholar
Penaranda, F. “Understanding Portfolio Efficiency with Conditioning Information.” Journal of Financial and Quantitative Analysis, 51 (2016), 985–1011.CrossRefGoogle Scholar
Phillips, P. C. B. “On Confidence Intervals for Autoregressive Roots and Predictive Regression.” Econometrica, 82 (2014), 1177–1195.Google Scholar
Roll, R. “A Critique of the Asset Pricing Theory’s Tests—Part 1: On Past and Potential Testability of the Theory.” Journal of Financial Economics, 4 (1977), 129–176.CrossRefGoogle Scholar
Sharpe, W. F. “Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk.” Journal of Finance, 19 (1964), 425–442.Google Scholar
Sharpe, W. F. “The Sharpe Ratio.” Streetwise–the Best of the Journal of Portfolio Management, 3 (1988), 169–185.Google Scholar
Siegel, A. “Geometry of Unconditionally Efficient Portfolios Formed with Conditioning Information: The Efficient Semicircle.” Quantitative Finance, 21 (2021), 881–889.CrossRefGoogle Scholar
Siegel, A., and Woodgate, A.. “Performance of Portfolios Optimized with Estimation Error.” Management Science, 53 (2007a), 1005–1015.CrossRefGoogle Scholar
Siegel, A., and Woodgate, A.. “Online Appendix to Performance of Portfolios Optimized with Estimation Error.” Management Science, 53(6) (2007b), 1005–1015. http://faculty.washington.edu/asiegel/OnlineAppendixSiegelWoodgate.pdf.CrossRefGoogle Scholar
Stambaugh, R. F. “On the Exclusion of Assets from Tests of the Two-Parameter Model.” Journal of Financial Economics, 10 (1982), 235–268.CrossRefGoogle Scholar
Stivers, C., and Sun, L.. “Cross-Sectional Return Dispersion and Time Variation in Value and Momentum Premiums.” Journal of Financial and Quantitative Analysis, 45 (2010), 987–1014.CrossRefGoogle Scholar
Supplementary material: File

Ferson et al. supplementary material

Ferson et al. supplementary material
Download Ferson et al. supplementary material(File)
File 1.3 MB