Semiparametric Conditional Factor Models in Asset Pricing (2112.07121v5)

Abstract: We introduce a simple and tractable methodology for estimating semiparametric conditional latent factor models. Our approach disentangles the roles of characteristics in capturing factor betas of asset returns from alpha.'' We construct factors by extracting principal components from Fama-MacBeth managed portfolios. Applying this methodology to the cross-section of U.S. individual stock returns, we find compelling evidence of substantial nonzero pricing errors, even though our factors demonstrate superior performance in standard asset pricing tests. Unexplainedarbitrage'' portfolios earn high Sharpe ratios, which decline over time. Combining factors with these orthogonal portfolios produces out-of-sample Sharpe ratios exceeding 4.