if the benchmark model is the true asset pricing model that is able to correctly
price the cross-section of asset returns.
5
However the Jensen measure can be
viewed as the abnormal returns of the strategy compared to an alternative
passive strategy that invests in the risk-free asset and the market index that have
the same risk characteristics as the strategy (see Elton & Gruber, 1995). We
refer to performance from Eq. (7) as the Jensen measure.
We estimate the Ferson and Schadt (1996) performance measure by the
following regression:
r
it
=
i
+
i
r
mt
+
L
l=1
il
r
mt
z
lt 1
+
it
(8)
z
lt 1
is the de-meaned lth information variable (l = 1,...,L) realization at time
t 1 and
i
is the average conditional beta of strategy i with respect to each of
the benchmark portfolios. The
ilk
coefficients are the estimated coefficients of
strategy i in the conditional beta function with respect to each of the L
information variables. The intercept
i
is the Ferson and Schadt (1996) measure
which equals zero under the null hypothesis of the strategy exhibiting no
abnormal performance. The conditional performance measure allows the
strategy betas and factor risk premia to vary through time. Ferson and Schadt
(1996) use the approximation that the portfolio beta in period t is a linear
function of common information variables that are known at that time. The
additional terms, r
k
t
z
lt 1
(l=1,...,L), captures the covariance between the
conditional betas and the market risk premium. We refer to performance from
Eq. (8) as the FS performance measure.
We correct the test statistics of the performance measures for the effects of
heteroskedasticity using White (1980).
DATA
Investment Universe
We explore the impact of the different models on domestic U.K. asset
allocation strategies. We follow Fletcher (1997) and Grauer (2000) and use
industry portfolios as our investment universe. An alternative approach is to use
large portfolios of individual securities as in Chou, Li and Zhou (2001).
However, the focus on this study is on asset allocation strategies rather than
stock selection strategies. We leave the issue of stock selection strategies to
future research.
We use 10 U.K. industry portfolios and the domestic risk-free asset as the
investment universe. We collect the data from Datastream unless otherwise
257Characteristics Versus Covariances

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