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Multifactor Efficiency and Bayesian Inference

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  • K. J. Martijn Cremers

    (Yale School of Management)

Abstract

This article reinvestigates the performance of risk-based multifactor models. We generalize the Bayesian methodology of Shanken and Kandel, McCulloch, and Stambaugh from mean-variance to multifactor efficiency. Using informative priors, our flexible framework handles severe small-sample problems. We introduce a new inefficiency metric that measures the maximum correlation between the market portfolio and any multifactor-efficient portfolio. Finally, we present new empirical evidence that neither the two additional Fama-French factors nor the momentum factor move the market portfolio robustly closer to being multifactor efficient or robustly decrease pricing errors relative to the Capital Asset Pricing Model.

Suggested Citation

  • K. J. Martijn Cremers, 2006. "Multifactor Efficiency and Bayesian Inference," The Journal of Business, University of Chicago Press, vol. 79(6), pages 2951-2998, November.
    • Handle: RePEc:ucp:jnlbus:v:79:y:2006:i:6:p:2951-2998
    DOI: 10.1086/508005
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    Cited by:

    1. Enrique Sentana, 2009. "The econometrics of mean-variance efficiency tests: a survey," Econometrics Journal, Royal Economic Society, vol. 12(3), pages 65-101, November.
    2. Cederburg, Scott & O’Doherty, Michael S., 2015. "Asset-pricing anomalies at the firm level," Journal of Econometrics, Elsevier, vol. 186(1), pages 113-128.
    3. Erik Kole & Reza Brink, "undated". "Constructing and Using Double-adjusted Alphas to Analyze Mutual Fund Performance," Tinbergen Institute Discussion Papers 19-029/IV, Tinbergen Institute.
    4. Ouysse, Rachida & Kohn, Robert, 2010. "Bayesian variable selection and model averaging in the arbitrage pricing theory model," Computational Statistics & Data Analysis, Elsevier, vol. 54(12), pages 3249-3268, December.
    5. Cosemans, M. & Frehen, R.G.P. & Schotman, P.C. & Bauer, R.M.M.J., 2009. "Efficient Estimation of Firm-Specific Betas and its Benefits for Asset Pricing Tests and Portfolio Choice," MPRA Paper 23557, University Library of Munich, Germany.

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