Diversification and the Optimal Construction of Basis Portfolios

Bruce N. Lehmann () and David M. Modest ()
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Bruce N. Lehmann: Graduate School of International Relations and Pacific Studies, 9500 Gilman Drive, University of California at San Diego, La Jolla, California 92092-0519
David M. Modest: Azimuth Trust, 162 Fifth Street, 8th Floor, New York, New York 10010

Management Science, 2005, vol. 51, issue 4, 581-598

Abstract: Nontrivial diversification possibilities arise when a factor model describes security returns. This paper catalogs the merits of alternative strategies for constructing basis portfolios to mimic the common factors. We show how to use the \chi 2 statistic for the joint significance of mean basis portfolio returns to rank alternative procedures and the bootstrap to perform inferences on the disparity between \chi 2 statistics across portfolio formation procedure, estimation method, cross-section size, and number of factors. Our main conclusion is that maximum likelihood factor analysis coupled with minimum idiosyncratic risk portfolio formation yields economically and statistically superior basis portfolios compared with those derived from asymptotic principal components.

Keywords: basis; Fama-MacBeth; mimicking; minimum idiosyncratic risk portfolios; principal components; maximum likelihood factor analysis; approximate factor structure; arbitrage pricing theory (APT); diversification; cross-sectional regression; ordinary and weighted least squares; large cross-sections; bootstrapping (search for similar items in EconPapers)
Date: 2005
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Citations: View citations in EconPapers (9)

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Persistent link: https://EconPapers.repec.org/RePEc:inm:ormnsc:v:51:y:2005:i:4:p:581-598

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