A Note on the Impact of Portfolio Overlapping in Tests of the Fama and French Three-Factor Model

Martin Wallmeier and Kathrin Tauscher

No 433, FSES Working Papers from Faculty of Economics and Social Sciences, University of Freiburg/Fribourg Switzerland

Abstract: In the three-factor model of Fama and French (1993), portfolio returns are explained by the factors Small Minus Big (SMB) and High Minus Low (HML) which capture returns related to firm capitalization (size) and the book-to-market ratio (B/M). In the standard approach of the model, both the test portfolios and the factor portfolios SMB and HML are formed on the basis of size and B/M. This gives rise to a potential overlapping bias in the time-series regressions. Based on a resampling method and the split sample approach already proposed by Fama and French (1993), we provide an in-depth analysis of the effect of overlapping for a broad sample of European stocks. We find that the overlapping bias is non-negligible, contrary to what seems to be general opinion. As a consequence, the standard approach of applying the three-factor model tends to overestimate the ability of the model to explain the cross-section of stock returns.

Keywords: Asset pricing; three-factor model; portfolio overlapping; size effect; value premium (search for similar items in EconPapers)
JEL-codes: G12 G14 (search for similar items in EconPapers)
Pages: 33 pages
Date: 2012-11-16
New Economics Papers: this item is included in nep-ecm
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Citations: View citations in EconPapers (1)

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