Identification-robust inference on risk premia of mimicking portfolios of non-traded factors

Mimicking portfolios of economic (non-traded) factors are commonly constructed by projecting the factors on a set of base assets. When these factors are associated with small betas, the beta-estimator using their mimicking portfolios has nonstandard limit behavior. This jeopardizes inference on risk premia in the commonly used Fama and MacBeth (1973) two-pass procedure. Using sorting or the average excess returns on the mimicking portfolios to estimate the risk premia leads to similar non-standard behavior. We therefore propose a novel test for the risk premia on mimicking portfolios. Its validity does not depend on the magnitude of the betas. Simulation evidence suggests that it performs well in terms of size and power. We use it to analyze the risk premium on the leverage factor of Adrian, Etula, and Muir (2014). Our results indicate that the leverage factor is a weak factor which leads to substantially different results for its risk premium