Asset Pricing Tests with Mimicking Portfolios

Abstract

Mimicking portfolios for factors are often used in asset pricing studies. Current practice has generally ignored the impact of estimation errors on the weights of the mimicking portfolios. We show that such a practice can lead to gross understatement of the standard errors of the estimated risk premia associated with the mimicking portfolios, especially when the factors are not highly correlated with the returns on the test assets. In this paper, we present a methodology that properly takes into account the impact of the estimation errors of the mimicking portfolios on the standard error of estimated risk premia. In empirical applications, we report that the outcome of asset pricing tests can vary significantly, depending on whether the estimation errors on the weights of the mimicking portfolios are accounted for. Our findings thus cast doubt on existing empirical studies that use mimicking portfolios but ignore the estimation error problem.