The role of sorting portfolios in asset-pricing models

Abstract

This article investigates the role of sorting portfolios in evaluating asset-pricing models. With the rising number of empirical studies about asset-pricing models, the comparability of these effects suffers from (1) different aggregational levels of firm returns, (2) different models, i.e. Capital Asset-Pricing Model (CAPM) versus the Fama and French model and (3) time-varying factor risk loadings. We find that β-sorting improves the performance of the CAPM, while portfolios built according to size and book-to-market equity (BE/ME) enhance the Fama and French model. However, the success of the three-factor model is not restricted to its factor-mimicking portfolios. For all analysed types of portfolios the Fama and French three-factor model turns out to be superior to the CAPM, both statistically and economically. Applying a quantile regression-based analysis, we also find support that the ‘independent and identically distributed’ (i.i.d.)-assumption empirically holds in these asset-pricing models, but the role of the unspecified part (α) changes when looking at the tails of the return distribution. The validity of our empirical results is supported by careful specification tests.