Multifactor Models and the APT: Evidence from a Broad Cross-Section of Stock Returns

Abstract

We seek to describe the broad cross-section of average stock returns. We follow the APT literature and estimate the common factor structure among a large cross-section containing 278 decile portfolios associated with 28 market anomalies. Our statistical model contains seven common factors (with an economic meaning) and prices well both the original portfolio returns and an efficient combination of these portfolios. This model clearly outperforms the empirical workhorses in the literature when it comes to pricing this broad cross-section. Augmenting the empirical models with new factor-mimicking portfolios, based on APT principles, significantly improves their performance. Our results shed light on the number of factors necessary to describe expected stock returns. Moreover, we show that there is significant room for improving the existing multifactor models in terms of explaining the large cross-section of stock returns (and in a way that is consistent with the APT).