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A Note on the Impact of Portfolio Overlapping in Tests of the Fama and French Three-Factor Model

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  • Wallmeier, Martin
  • Tauscher, Kathrin
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    Abstract

    In the three-factor model of Fama and French (1993), portfolio returns are explained by the factors Small Minus Big (SMB) and High Minus Low (HML) which capture returns related to firm capitalization (size) and the book-to-market ratio (B/M). In the standard approach of the model, both the test portfolios and the factor portfolios SMB and HML are formed on the basis of size and B/M. This gives rise to a potential overlapping bias in the time-series regressions. Based on a resampling method and the split sample approach already proposed by Fama and French (1993), we provide an in-depth analysis of the effect of overlapping for a broad sample of European stocks. We find that the overlapping bias is non-negligible, contrary to what seems to be general opinion. As a consequence, the standard approach of applying the three-factor model tends to overestimate the ability of the model to explain the cross-section of stock returns.

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    Bibliographic Info

    Paper provided by Faculty of Economics and Social Sciences, University of Freiburg/Fribourg Switzerland in its series FSES Working Papers with number 433.

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    Length: 33 pages
    Date of creation: 16 Nov 2012
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    Handle: RePEc:fri:fribow:fribow00433

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    Related research

    Keywords: Asset pricing; three-factor model; portfolio overlapping; size effect; value premium;

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