Multifactor efficiency and Bayesian inference

This article reinvestigates the performance of risk-based multifactor models. We generalize the Bayesian methodology of Shanken and Kandel, McCulloch, and Stambaugh from mean-variance to multifactor efficiency. Using informative priors, our flexible framework handles severe small-sample problems. We introduce a new inefficiency metric that measures the maximum correlation between the market portfolio and any multifactor-efficient portfolio. Finally, we present new empirical evidence that neither the two additional Fama-French factors nor the momentum factor move the market portfolio robustly closer to being multifactor efficient or robustly decrease pricing errors relative to the Capital Asset Pricing Model.