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A top-down approach to factor models
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I propose choosing factors based on the maximum squared Sharpe ratio (Sh2) of the
model. The model then provides a description of anomalies, but anomalies do not drive
the choice of factors. I introduce a five-factor model of market, size, value, momentum,
and profitability factors with a Sh2 of 0.316. The Sh2 is higher than competing models and
mispricing is reduced for common anomalies. Value and momentum subsume the popular
investment factor through their ability to forecast changes in book equity. The model struggles
to price sorts on momentum and volatility. The model’s description of these anomalies,
small, unprofitable stocks with poor recent returns, point to problems with firm size beyond
illiquidity. In particular, I find that problems arise from the interaction of size, volatility,
and value.
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Palavras-chave
Asset-pricing Factors Size Momentum Volatility