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portfolio1

portfolio1

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02/01/2013

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is necessary to group stocks into
portfolios. The theoretical implication of
using an attribute correlated with a
stocks\u2019 return has been examined by
Berk (2000) and Lo and MacKinlay
(1990). Lo and MacKinlay (1990) point
out that sorting without regard to the
data-generating process may lead to
spurious correlation between the
attributes and the estimated pricing
errors. They advocate using data from
different sampling periods to avoid
data-snooping bias. Berk (2000) shows
that sorting assets into portfolios using an
attribute can lead to bias toward rejecting
the model when asset pricing tests are
implemented within the portfolio. Since
grouping of stocks is unavoidable in an

Introduction

One universal practice in any asset
pricing test is to sort stocks into
portfolios based on a particular attribute
of the stocks. Size, estimated beta and
book-to-market ratio are some of the
most common attributes used in sorting
stocks (see eg Fama and French, 1992,
1993; Gibbonset al., 1989; Jagannathan
and Wang, 1996). There are two reasons
for sorting stocks into portfolios to
implement asset pricing tests: \ufb01rst,
grouping stocks into portfolios diversi\ufb01es
away idiosyncratic risks of individual
stocks. Secondly, the cross-section of
individual stocks is very often larger than
the number of time series observations
available. To make estimation feasible, it

\ue000Henry Stewart Publications 1470-8272 (2004)Vol. 5, 3, 203\u2013216Journal of Asset Management
203
Portfolio formation can affect
asset pricing tests
Received: 19th November, 2003
Ingrid Lo
received her PhD (economics) from the University of Western Ontario and is presently a senior lecturer in \ufb01nance at the
University of Waikato. Her research interests are concentrated on asset pricing and market microstructure.
Department of Finance, Waikato Management School, University of Waikato, Hamilton, New Zealand
E-mail: ingridlo@mngt.waikato.ac.nz
AbstractThis paper investigates the issues of portfolio formation and asset pricing

tests. Since much empirical work in \ufb01nance starts with grouping individual stocks into
portfolios based on a particular attribute of the stocks, this paper examines the effect of
this practice and whether using individual stocks solves the problem of grouping.
Canadian stock return data are used. Three asset pricing tests, the multivariateF test,
the averageF test and a robust speci\ufb01cation test by Hansen and Jagannathan (Journal

of Finance, 52(2), 557\u201390, 1997) are considered. It is found that (i) grouping of stocks

based on different attributes can give different asset pricing inference using the same pool of stocks, (ii) using individual assets introduces survivorship problems and (iii) the three asset pricing tests can give different inference on the same model speci\ufb01cation.

Keywords:portfolio formation, asset pricing test, multivariate F test, average F test,
robust speci\ufb01cation test

empirical context, this paper studies
whether different attributes used in
sorting the same pool of stocks would
lead to different asset pricing inference.1
This issue is important because, if
different attributes used in sorting leads
to different asset pricing inference, there
is no way of judging whether a set of
factors statistically prices a pool of stocks.
Another issue examined concerns the
asset pricing test used. As the asset
pricing inference depends on the test
used, this paper also examines whether
different asset pricing tests would lead to
the same inference.

The paper examines empirically, using
Canadian stock return data, the following
three related questions:

1. Does sorting stocks into portfolios
based on different attributes yield
different asset pricing inference?

2. If sorting stocks does have an effect on
inference, does using individual stocks
(if possible) solve the problems
associated with sorting?

3. Do different asset pricing tests give the
same inference?

Two attributes, size and estimated betas,
are used in grouping stocks into
portfolios. It is found that portfolios
formed by stocks sorted by different
attributes pick up different risks, and they
can give different asset pricing inference.
One special feature of this study is that
the pricing of individual assets\u2019 returns is
examined through the averageF test
proposed by Hwang and Satchell (1997).
It is found that, although using individual
stocks avoids issues associated with
sorting, it introduces survivorship bias
problems. Regarding the third question,
three asset pricing tests are considered.
The three tests are the multivariateF
test, the averageF test and a robust
speci\ufb01cation test developed by Hansen
and Jagannathan (1997). The\ufb01rst two

tests are based on the regression
framework. The robust speci\ufb01cation test
is based on the stochastic discount factor
framework. It is found that the three
tests can lead to different inferences
owing to the different de\ufb01nition of
pricing errors and the weighting of
pricing errors in the three tests.

Canadian stock return data are used to
create a modi\ufb01ed version of the three
factors (excess market return, SMB and
HML) used in Fama and French (1996).
Canadian stock return data are used
because there is relatively little work
examining Canadian stock return with
Fama and French factors. Elfakhaniet al.
(1998) examine the pricing of Canadian
stocks using Fama and French\u2019s three
factors. Their study, however, uses a
two-stage cross-section regression
method, which is prone to
error-in-variables problems. Grif\ufb01n
(2001) compares the performance of
country speci\ufb01c and the global version of
Fama and French\u2019s three factor model,
with Canada as one of the domestic
models examined.

The rest of the paper is organised as
follows: the next section presents the
model speci\ufb01cation. The third section
examines the implementation of the
multivariateF test, the averageF test and
the robust speci\ufb01cation test. The fourth
section explains the construction of the
variables and the data sources. The\ufb01fth
section presents the empirical results and
the sixth section concludes.

Models
Asset pricing frameworks

This paper focuses on linear pricing
relationships and examines asset pricing
in both the traditional regression
framework and the stochastic discount
factor framework using GMM. For asset
pricing posed in the traditional regression

204
Journal of Asset ManagementVol. 5,3, 203\u2013216\ue000 Henry Stewart Publications 1470-8272 (2004)
Lo

in whicha is normalised to 1.
Substituting Equation (4) into Equation
(3), all parameters can be estimated, and
inference can be drawn in the GMM
framework withn moment conditions.

Speci\ufb01cations to be tested

Excess market return, size factor return
and book-to-market factor return are
constructed from Canadian securities.
The last two factors, the size factor and
the book-to-market factor, are modi\ufb01ed
versions of SMB and HML from Fama
and French (1993). The reasons for the
modi\ufb01cations will be explained in the
fourth section. Three models are
examined: the\ufb01rst model is a standard
CAPM model with the excess market
return as the only factor

re
it\ue000\ue000i \ue001\ue001m,ire
mt\ue001\ue002it, i \ue0001, . . .,n (5)
in whichre
itis excess of market return at
timet, and\ue001m,iis the factor loading of
asseti.\ue000iis interpreted as the pricing
error of asseti: if excess market return is
the only source of risk in pricingre
it, then
\ue000ishould be equal to zero. In the
stochastic discount factor framework, the
linear discount factor is given by
mt\ue000a \ue001bmre
mt
(6)
bmis the change in the intertemporal
marginal rate of substitution with respect
to unit change in excess market return.

The second model contains two
factors: excess market return and size
factor return. The excess return of asseti
is generated by the following equation,

re
it\ue000\ue000i \ue001\ue001m,ire
mt\ue001\ue001s,irst \ue001\ue002it,
i\ue0001, . . ., n
(7)

in whichrstis the return of size factor at
timet, and\ue001s,iis its associated factor
loading of asseti. In the stochastic

framework, assets\u2019 excess returns are
linear functions ofk factors\u2019 return.
rit\ue002rf t\ue000\ue000 \ue001\ue0011,if1t\ue001\ue0012,if2t\ue001...
\ue001\ue001k,ifkt\ue001 \ue002it, i\ue0001,...n,
t\ue0001, . . ., T
(1)

wheren is the number of assets, andT is
the number of time series observations.rit
is the asset return, andrft is the risk-free
rate, so thatrit\u2013r f tis the excess return at
timet, hereafter denoted asre

it.fit is the

factor return of factorj at timet.\ue001j,iis
factorj\u2019s loading of asseti. The
assumptions behind Equation (1) are: (1)

ritandfitare stationary and spherically

distributed; (2)\ue002itis i.i.d. with zero
mean; (3) each\ue001j,iis constant through
time. If a linear combination of thek
factors is ef\ufb01cient, the expected return
linear beta relation holds, ie

E(rit\ue002rf t)\ue000\ue0011,iE( f1t)\ue001\ue0012,iE( f2t)\ue001 ...
\ue001\ue001k,iE( fkt),i\ue000 1, . . .,n
(2)

Equation (2) implies that\ue000\ue0000 for all
assets in Equation (1). This forms the
null hypothesis in testing. Equation (1)
and linear regression will be used to
implement the multivariateF test and
the averageF test.

Asset pricing in the stochastic discount
factor framework is based on the Euler
equation, which is the\ufb01rst-order
condition of the investor\u2019s utility
maximisation problem. For the simple
excess return, the Euler equation

becomes
E(mtrit|\ue003it)\ue000 0
(3)

in which\ue003itis the investor\u2019s information
set at timet\ue002 1. This representation is
unfortunately too general to estimate,
thus the linear discount factor model will
be examined, ie

mt\ue000a \ue001b1 f1t\ue001b2 f2t\ue001... \ue001bkfkt
(4)
\ue000Henry Stewart Publications 1470-8272 (2004)Vol. 5, 3, 203\u2013216Journal of Asset Management
205
Portfolio formation can affect asset pricing tests

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