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When do characteristics-sorted factors mechanically explain returns?

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  • Murtazashvili, Irina
  • Vozlyublennaia, Nadia

Abstract

This paper demonstrates that the factors based on typical procedures that employ sorting by characteristics (including size and book-to-market, among others) can create a good mechanical fit in the regressions of portfolio returns. Such factors are approximately linear functions of the sorted portfolios, and including them into regressions adds linear restrictions on the intercepts. These restrictions mechanically reduce significance of the time-series regression intercepts, increase the regression R2, and lead to a good fit in the cross-sectional regressions. Our simulation evidence confirms these propositions. Moreover, we show that popular size and value factors do not “work” in the sets of asset portfolios, which they are not mechanically related to. These results cast doubt on the interpretation of characteristics-sorted factors as the true risk factors.

Suggested Citation

  • Murtazashvili, Irina & Vozlyublennaia, Nadia, 2013. "When do characteristics-sorted factors mechanically explain returns?," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 25(C), pages 119-143.
    • Handle: RePEc:eee:intfin:v:25:y:2013:i:c:p:119-143
    DOI: 10.1016/j.intfin.2013.01.006
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    Cited by:

    1. Sudipta Das, 2019. "Asset Pricing Test Using Alternative Sets of Portfolios: Evidence from India," Asia-Pacific Financial Markets, Springer;Japanese Association of Financial Economics and Engineering, vol. 26(3), pages 339-354, September.
    2. Doukakis, Leonidas C. & Papanastasopoulos, Georgios A., 2014. "The accrual anomaly in the U.K. stock market: Implications of growth and accounting distortions," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 32(C), pages 256-277.
    3. Ahmed Al Samman & Mahmoud Moustafa Otaify, 2017. "How Does Volatility of Characteristics-sorted Portfolios Respond to Macroeconomic Volatility?," International Journal of Economics and Financial Issues, Econjournals, vol. 7(4), pages 300-315.

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    More about this item

    Keywords

    Risk factors; Security returns; Size and value factors; Characteristics sorting;
    All these keywords.

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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