A Critical Investigation of the Explanatory Role of Factor Mimicking Portfolios

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Abstract

The common approach for constructing factor mimicking portfolios is to go long in assets with high loadings and to short-sell those with low loadings on some background factors. As a result portfolios containing stocks with low loading on the background factor receive negative betas against the corresponding mimicking portfolio. Thus, such portfolios appear as hedges against the background risk and may in tests of asset pricing models receive significant positive intercepts. The final result regarding acceptance or rejection of an asset pricing model may therefore to some extent be understood as a random outcome.

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  • Economics
Original languageEnglish
Pages (from-to)835-47
JournalApplied Financial Economics
Volume15
Issue number12
StatePublished - 2005
Peer-reviewedYes