Do firm fixed effects matter in empirical asset pricing?

Abstract

In empirical asset pricing, it is standard to sort assets into portfolios based on a characteristic, and then compare the top (e.g., decile) portfolio’s risk-adjusted return with that of the bottom portfolio. We show that such an analysis assumes the random effects assumption to hold. Therefore, results from portfolio sorts are valid if and only if firm-specific effects are uncorrelated with the characteristic underlying the portfolio sort. We propose a novel, regression-based approach to analyzing asset returns. Relying on standard econometrics, our technique handles multiple dimensions and continuous firm characteristics. Moreover, it nests all variants of sorting assets into portfolios as a special case, provides a means for testing the random effects assumption, and allows for the inclusion of firm-fixed effects in the analysis. Our empirical results demonstrate that the random effects assumption underlying portfolio sorts is often violated, and that certain characteristics-based factors that are well-known from empirical asset pricing studies do not withstand tests accounting for firm fixed effects.