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Model Comparison with Sharpe Ratios

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  • Barillas, Francisco
  • Kan, Raymond
  • Robotti, Cesare
  • Shanken, Jay

Abstract

We show how to conduct asymptotically valid tests of model comparison when the extent of model mispricing is gauged by the squared Sharpe ratio improvement measure. This is equivalent to ranking models on their maximum Sharpe ratios, effectively extending the Gibbons, Ross, and Shanken (1989) test to accommodate the comparison of nonnested models. Mimicking portfolios can be substituted for any nontraded model factors, and estimation error in the portfolio weights is taken into account in the statistical inference. A variant of the Fama and French (2018) 6-factor model, with a monthly updated version of the usual value spread, emerges as the dominant model.

Suggested Citation

  • Barillas, Francisco & Kan, Raymond & Robotti, Cesare & Shanken, Jay, 2020. "Model Comparison with Sharpe Ratios," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 55(6), pages 1840-1874, September.
    • Handle: RePEc:cup:jfinqa:v:55:y:2020:i:6:p:1840-1874_3
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    Cited by:

    1. Gospodinov, Nikolay & Robotti, Cesare, 2021. "Common pricing across asset classes: Empirical evidence revisited," Journal of Financial Economics, Elsevier, vol. 140(1), pages 292-324.
    2. Shanghui Jia & Xinhui Chen & Liyan Han & Jiayu Jin, 2023. "Global climate change and commodity markets: A hedging perspective," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 43(10), pages 1393-1422, October.
    3. Samane Al-sadat Mousavi & Ali Dolati & Ali Dastbaravarde, 2024. "Some Results on Bivariate Squared Maximum Sharpe Ratio," Risks, MDPI, vol. 12(6), pages 1-17, May.
    4. Dickerson, Alexander & Mueller, Philippe & Robotti, Cesare, 2023. "Priced risk in corporate bonds," Journal of Financial Economics, Elsevier, vol. 150(2).
    5. Ali, Fahad & Ülkü, Numan, 2021. "Quest for a parsimonious factor model in the wake of quality-minus-junk, misvaluation and Fama-French-six factors," Finance Research Letters, Elsevier, vol. 41(C).
    6. Ahmed, Shamim & Bu, Ziwen & Symeonidis, Lazaros & Tsvetanov, Daniel, 2023. "Which factor model? A systematic return covariation perspective," Journal of International Money and Finance, Elsevier, vol. 136(C).
    7. Eleftherios Thalassinos & Naveed Khan & Shakeel Ahmed & Hassan Zada & Anjum Ihsan, 2023. "A Comparison of Competing Asset Pricing Models: Empirical Evidence from Pakistan," Risks, MDPI, vol. 11(4), pages 1-24, March.
    8. Smith, Simon C., 2022. "Time-variation, multiple testing, and the factor zoo," International Review of Financial Analysis, Elsevier, vol. 84(C).
    9. Andrew Detzel & Robert Novy‐Marx & Mihail Velikov, 2023. "Model Comparison with Transaction Costs," Journal of Finance, American Finance Association, vol. 78(3), pages 1743-1775, June.
    10. Cooper, Michael & Gulen, Huseyin & Ion, Mihai, 2024. "The use of asset growth in empirical asset pricing models," Journal of Financial Economics, Elsevier, vol. 151(C).
    11. Thuy Duong Dang & Fabian Hollstein & Marcel Prokopczuk & Zhiguo He, 2023. "Which Factors for Corporate Bond Returns?," The Review of Asset Pricing Studies, Society for Financial Studies, vol. 13(4), pages 615-652.
    12. Fabian Hollstein & Marcel Prokopczuk, 2023. "Managing the Market Portfolio," Management Science, INFORMS, vol. 69(6), pages 3675-3696, June.
    13. Pankaj Agrrawal, 2023. "The Gibbons, Ross, and Shanken Test for Portfolio Efficiency: A Note Based on Its Trigonometric Properties," Mathematics, MDPI, vol. 11(9), pages 1-19, May.
    14. Kan, Raymond & Wang, Xiaolu & Zheng, Xinghua, 2024. "In-sample and out-of-sample Sharpe ratios of multi-factor asset pricing models," Journal of Financial Economics, Elsevier, vol. 155(C).
    15. Massa, Massimo & O'Donovan, James & Zhang, Hong, 2022. "International asset pricing with strategic business groups1," Journal of Financial Economics, Elsevier, vol. 145(2), pages 339-361.
    16. Hanauer, Matthias X. & Kononova, Marina & Rapp, Marc Steffen, 2022. "Boosting agnostic fundamental analysis: Using machine learning to identify mispricing in European stock markets," Finance Research Letters, Elsevier, vol. 48(C).
    17. Hansen, Erwin, 2022. "Economic evaluation of asset pricing models under predictability," Journal of Empirical Finance, Elsevier, vol. 68(C), pages 50-66.
    18. Ume Salma Akbar & Niaz Ahmed Bhutto & Suresh Kumar Oad Rajput, 2021. "Does Five-Factor Model Perform Better Than Three Factor Model? Evidence from Developed Countries of The Asia Pacific Region," iRASD Journal of Economics, International Research Alliance for Sustainable Development (iRASD), vol. 3(2), pages 119-132, September.
    19. Hanauer, Matthias X. & Jansen, Maarten & Swinkels, Laurens & Zhou, Weili, 2024. "Factor models for Chinese A-shares," International Review of Financial Analysis, Elsevier, vol. 91(C).
    20. Ma, Xiuli & Zhang, Xindong & Liu, Weimin, 2021. "Further tests of asset pricing models: Liquidity risk matters," Economic Modelling, Elsevier, vol. 95(C), pages 255-273.
    21. Feng, Frank Yulin & Kang, Wenjin & Zhang, Huiping, 2023. "Liquidity shocks and the negative premium of liquidity volatility around the world," Journal of International Money and Finance, Elsevier, vol. 139(C).
    22. Tan, Xilong & Tao, Yubo, 2023. "Trend-based forecast of cryptocurrency returns," Economic Modelling, Elsevier, vol. 124(C).
    23. Qiao, Zhuo & Wang, Yan & Lam, Keith S.K., 2022. "New evidence on Bayesian tests of global factor pricing models," Journal of Empirical Finance, Elsevier, vol. 68(C), pages 160-172.

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