Elephants and the Cross-section of Expected Returns

Authors: Nora Laurinaityte (Goethe University and SAFE), Christoph Meinerding (Deutsche Bundesbank), Christian Schlag (Goethe University and SAFE), and Julian Thimme (Goethe University)

Title: Elephants and the Cross-section of Expected Returns

Abstract: Standard GMM cross-sectional asset pricing tests can generate spurious explanatory power for factor models when the weight on certain moment conditions is set inappropriately. In fact, by shifting the weights in the GMM, any desired level of cross-sectional fit can be attained at the price of not matching fundamentals. We run placebo tests with factors that by construction do not explain the cross-section of expected returns and obtain a spuriously high cross-sectional R2 for these placebo factors. As an illustrative example, we also provide (spurious) evidence that the global log growth rate of the number of captive Asian elephants in zoos perfectly explains the average returns of the 25 Fama-French portfolios. Finally, we document some examples of factor models proposed in the literature that suffer from this bias.