Improving Factor Models

Abstract

Factor-mimicking portfolios typically identify and weight well-diversified basis portfolios. Improving weightings of the basis portfolios so that they are more closely related to the optimal portfolio’s weights enhances the pricing accuracy of parsimonious factor models. In this article, the authors—one of whom was a student of Professor Stephen Ross at the Yale School of Management and later a Ross coauthor—show that this can be achieved with known ex post efficiency criteria, applied with common sense that recognizes when statistical biases are minimal. These alternatives to traditional weightings, such as equal long–short portfolios, help explain the returns of popular anomaly portfolios.

TOPICS: Factor-based models, portfolio construction