Working Paper: NBER ID: w1726
Authors: Bruce N. Lehmann; David M. Modest
Abstract: The Arbitrage Pricing Theory (APT) of Ross (1976) presumes that a factor model describes security returns. In this paper, we provide a comprehensive examination of the merits of various strategies for constructing basis portfolios that are, in principle, highly correlated with the common factors affecting security returns. Three main conclusions emerge from our study. First, increasing the number of securities included in the analysis dramatically improves basis portfolio performance. Our results indicate that factor models involving 750 securities provide markedly superior performance to those involving 30 or 250 securities. Second, comparatively efficient estimation procedures such as maximum likelihood and restricted maximum likelihood factor analysis(which imposes the APT mean restriction) significantly outperform the less efficient instrumental variables and principal components procedures that have been proposed in the literature. Third, a variant of the usual Fame-MacBeth portfolio formation procedure, which we call the minimum idiosyncratic risk portfolio formation procedure, outperformed the Fama-MacBeth procedure and proved equal toor better than more expensive quadratic programming procedures.
Keywords: Arbitrage Pricing Theory; Basis Portfolios; Factor Models; Portfolio Construction
JEL Codes: G12; G14
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Number of securities (G12) | Portfolio performance (G11) |
| Estimation method (C51) | Portfolio performance (G11) |
| Portfolio formation technique (G11) | Portfolio performance (G11) |