Generalized Portfolio Sorts for Factor Validation*
Series
School of Finance Working Paper Series
Type
working paper
Date Issued
2025-03
Author(s)
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.
Language
English
Keywords
Portfolio sorts
Cross-section of expected returns
Tests of asset pricing models
Random effects assumption
HSG Classification
contribution to scientific community
HSG Profile Area
SOF - System-wide Risk in the Financial System
Publisher
SoF-HSG
Publisher place
St. Gallen
Volume
2017/17
Number
17
Pages
64
Subject(s)
Division(s)
Contact Email Address
markus.schmid@unisg.ch
Eprints ID
254085
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Name
GeneralizedPortfolioSorts_11March2025.pdf
Size
3.95 MB
Format
Adobe PDF
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