Generalized Portfolio Sorts for Factor Validation

Markus Schmid, Daniel Hoechle and Heinz Zimmermann
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Markus Schmid: University of St. Gallen - Swiss Institute of Banking and Finance; University of St. Gallen - School of Finance; Swiss Finance Institute; European Corporate Governance Institute (ECGI)
Daniel Hoechle: FHNW School of Business - Institute for Finance; University of Basel - Department of Finance
Heinz Zimmermann: University of Basel - Faculty of Business and Economics

No 25-32, Swiss Finance Institute Research Paper Series from Swiss Finance Institute

Abstract: Portfolio sorts are widely used in empirical asset pricing to identify firm characteristics that predict stock returns. However, such tests can conflate genuine characteristic-based predictability with persistent, firm-level heterogeneity. To address this limitation, we propose a Generalized Portfolio Sorts (GPS) model, which can exactly replicate results from all variants of conventional portfolio sorts, but can also be specified so that it separates a firm characteristic’s genuine predictive power from stable firm-level factors. We also derive a statistical test to detect whether return predictability arises from the sorting characteristic itself or from persistent, firm-level traits. Applied to a large set of proposed asset pricing predictors, we find that nearly half lose significance once persistent, firm-level heterogeneity is accounted for. The GPS-model thus strengthens factor validation, advances our understanding of the factor zoo, and provides a more robust foundation for empirical asset pricing tests.

Keywords: Portfolio sorts; cross-section of expected returns; tests of asset pricing models; random effects assumption (search for similar items in EconPapers)
JEL-codes: C21 D1 G14 (search for similar items in EconPapers)
Pages: 66 pages
Date: 2025-02
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Persistent link: https://EconPapers.repec.org/RePEc:chf:rpseri:rp2532

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