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Does Unobservable Heterogeneity Matter for Portfolio-Based Asset Pricing Tests?

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  • Hoechle, Daniel
  • Schmid, Markus
  • Zimmermann, Heinz

Abstract

We show that portfolio sorts, as widely used in empirical asset pricing, tend to misattribute cross-sectional return predictability to the firm characteristic underlying the sort. Such misattribution arises if the sorting variable correlates with a firm-specific effect capturing unobservable heterogeneity across firms. We propose a new, firm-level regression approach that can reproduce the results from standard portfolio sorts. Besides, our method handles multivariate firm characteristics and, if firm fixed effects are included, is robust to misattributing cross-sectional return predictability. Our empirical results confirm that portfolio sorts have limited power in detecting abnormal returns: Several characteristics-based factors lose their predictive power when we control for unobservable heterogeneity across firms.

Suggested Citation

  • Hoechle, Daniel & Schmid, Markus & Zimmermann, Heinz, 2017. "Does Unobservable Heterogeneity Matter for Portfolio-Based Asset Pricing Tests?," Working Papers on Finance 1717, University of St. Gallen, School of Finance, revised Mar 2020.
    • Handle: RePEc:usg:sfwpfi:2017:17
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    More about this item

    Keywords

    Portfolio sorts; Cross-section of expected returns; Tests of asset pricing models; Random effects assumption;
    All these keywords.

    JEL classification:

    • C21 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Cross-Sectional Models; Spatial Models; Treatment Effect Models
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • D1 - Microeconomics - - Household Behavior

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