Portfolio Overlapping Bias in Tests of the Fama and French Three-Factor Model

38 Pages Posted: 1 Nov 2012 Last revised: 29 Jan 2014

See all articles by Martin Wallmeier

Martin Wallmeier

University of Fribourg - Faculty of Economics and Social Science

Kathrin Tauscher

University of Fribourg - Faculty of Economics and Social Science

Date Written: January 29, 2014

Abstract

In the three-factor model of Fama and French (1993), portfolio returns are explained by the factors Small Minus Big (SMB) and High Minus Low (HML) which capture returns related to firm capitalization (size) and the book-to-market ratio (B/M). In the standard approach of the model, both the test portfolios and the factor portfolios SMB and HML are formed on the basis of size and B/M. This gives rise to a potential overlapping bias in the time-series regressions. Based on a resampling method and the split sample approach already proposed by Fama and French (1993), we provide an in-depth analysis of the effect of overlapping for a broad sample of European stocks. We find that the overlapping bias is non-negligible, contrary to what seems to be general opinion. The range of slope coefficients for size- and B/M-portfolios in time-series regressions is more than one third larger than in a setup without portfolio overlap. As a consequence, the estimates of SMB and HML factor premiums in cross-sectional regressions are biased downwards, also by about one third compared to the split sample approach without portfolio overlap.

Keywords: Asset pricing, three-factor model, portfolio overlapping, size effect, value premium

JEL Classification: G12, G14

Suggested Citation

Wallmeier, Martin and Tauscher, Kathrin, Portfolio Overlapping Bias in Tests of the Fama and French Three-Factor Model (January 29, 2014). Available at SSRN: https://ssrn.com/abstract=2169398 or http://dx.doi.org/10.2139/ssrn.2169398

Martin Wallmeier (Contact Author)

University of Fribourg - Faculty of Economics and Social Science ( email )

Fribourg, CH 1700
Switzerland
+41 26 300 8294 (Phone)

Kathrin Tauscher

University of Fribourg - Faculty of Economics and Social Science ( email )

Fribourg, CH 1700
Switzerland

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