Title: Linear factor models and the estimation of expected returns
Authors: Cisil Sarisoy - Federal Reserve Board (United States) [presenting]
Peter de Goeij - Tilburg University (Netherlands)
Bas Werker - Tilburg University (Netherlands)
Abstract: The focus is on analyzing the properties of expected return estimators on individual assets implied by the linear factor models of asset pricing, i.e., the product of beta and lambda. We show that using factor-model-based risk premium estimates leads to precision gains of up to 31\% when compared to the historical averages. In the presence of omitted factors, adding an alpha to the model captures mispricing only in case of traded factors, otherwise the bias caused by misspecification can not be corrected. Finally, inference about expected returns, unlike inference on factor prices, does not suffer from a small-beta bias. The more precise factor-model-based estimates of expected returns translate into significant improvements in out-of-sample performance of optimal portfolios.