A new empirical version of the Fama and French model based on the Hausman specification test: An application to hedge funds

Abstract

In this article, we propose a new empirical version of the Fama and French (FF) model based on a new version of the Hausman (1978) specification test. This empirical model incorporates correction factors for risk exposure. These factors take into account the problem of errors-in-variables. Our model also features another innovation. It uses higher moments of the four factors of the augmented FF model as instruments to tackle the problem of errors-in-variables. This new method reflects the nonlinear character of risk. We highlight the link between our new version of the Hausman artificial regression and the standard two-stage least-squares method. Our results suggest that it is preferable to account for errors-in-variables and more generally specification errors when estimating the FF model because it might cause serious biases of important parameters like alpha and beta. © 2011 Macmillan Publishers Ltd.