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Latent Fundamentals Arbitrage with a Mixed Effects Factor Model

Author

Listed:
  • Andrei Salem Gonçalves

    (Wisconsin School of Business, University of Wisconsin-Madison)

  • Robert Aldo Iquiapaza

    (Universidade Federal de Minas Gerais)

  • Aureliano Angel Bressan

    (Universidade Federal de Minas Gerais)

Abstract

We propose a single-factor mixed effects panel data model to create an arbitrage portfolio that identifies differences in firm-level latent fundamentals. Furthermore, we show that even though the characteristics that affect returns are unknown variables, it is possible to identify the strength of the combination of these latent fundamentals for each stock by following a simple approach using historical data. As a result, a trading strategy that bought the stocks with the best fundamentals (strong fundamentals portfolio) and sold the stocks with the worst ones (weak fundamentals portfolio) realized significant risk-adjusted returns in the U.S. market for the period between July 1986 and June 2008. To ensure robustness, we performed sub period and seasonal analyses and adjusted for trading costs and we found further empirical evidence that using a simple investment rule, that identified these latent fundamentals from the structure of past returns, can lead to profit.

Suggested Citation

  • Andrei Salem Gonçalves & Robert Aldo Iquiapaza & Aureliano Angel Bressan, 2012. "Latent Fundamentals Arbitrage with a Mixed Effects Factor Model," Brazilian Review of Finance, Brazilian Society of Finance, vol. 10(3), pages 317-335.
    • Handle: RePEc:brf:journl:v:10:y:2012:i:3:p:317-335
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    References listed on IDEAS

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    More about this item

    Keywords

    Arbitrage; Factor Models; Mixed Effects.;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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