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Factoring characteristics into returns: A clinical study on the SMB and HML portfolio construction methods

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  • Lambert, Marie
  • Fays, Boris
  • Hübner, Georges

Abstract

Factor performance is highly sensitive to the number of stocks composing its long and short basis portfolios. We examine three methodological choices that have an impact on portfolio diversification: the (in)dependence and the (a)symmetry of the stock sorting procedure and the sorting breakpoints. We show that these methodological choices have to be considered jointly and that a dependent (D) sort that starts with the control variables with whole sample or “name” (N) breakpoints and that performs a symmetric (S) sort on characteristics minimizes the biases from unpriced risks. This paper also demonstrates that the biases introduced by currently popular sorting methodologies can become very severe under specific market conditions and are not driven by small capitalizations. This alternative framework generates much stronger “turn-of-the-year” size and “through-the-year” book-to-market effects than what is conventionally documented.

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  • Lambert, Marie & Fays, Boris & Hübner, Georges, 2020. "Factoring characteristics into returns: A clinical study on the SMB and HML portfolio construction methods," Journal of Banking & Finance, Elsevier, vol. 114(C).
    • Handle: RePEc:eee:jbfina:v:114:y:2020:i:c:s0378426620300789
    DOI: 10.1016/j.jbankfin.2020.105811
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    Cited by:

    1. Fays, Boris & Papageorgiou, Nicolas & Lambert, Marie, 2021. "Risk optimizations on basis portfolios: The role of sorting," Journal of Empirical Finance, Elsevier, vol. 63(C), pages 136-163.
    2. Pätäri, Eero & Ahmed, Sheraz & Luukka, Pasi & Yeomans, Julian Scott, 2023. "Can monthly-return rank order reveal a hidden dimension of momentum? The post-cost evidence from the U.S. stock markets," The North American Journal of Economics and Finance, Elsevier, vol. 65(C).
    3. Boris Fays & Georges Hübner & Marie Lambert, 2022. "Harvesting the seasons of the size anomaly," Journal of Asset Management, Palgrave Macmillan, vol. 23(4), pages 337-349, July.

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    More about this item

    Keywords

    Portfolio sorting; Factor performance; Factor construction methods;
    All these keywords.

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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