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I am studying idiosyncratic volatility. After applying the Fama Frech 3 Factor model with its Marktet, SMB and HML factors I want to build a factor based on idiosyncratic volatility.

Can I just build a portfolio including the highest idiosyncratic volatility assets and one with the lowest idiosyncratic volatility and subtract those from each other ?

My factor would then be:

IVOL factor = excess return of highest IVOL portfolios - excess returns of lowest IVOL portfolios

I could either used the 20% highest/lowest or just build the median and then assign them to one of the portfolios.

I am not sure if this approach is correct.

Best wishes

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Are you doing this in an academic context? If so, the standard factor portfolio procedure is the Fama-French construct, which involves building 6 portfolios (split by size into 3/4/3 buckets and high/low based on your score) then average of the small and big. If you're doing this in an industry/work context, calculating average quintile/decile excess returns will suffice.

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  • $\begingroup$ Thanks a lot! It is for an academic paper. What do you mean with "split by size into 3/4/3 buckets"? From my understanding I would construct the portfolio just like the Fama-French HML factor which would give me instead of: HML = 1/2 (Small Value + Big Value) - 1/2 (Small Growth + Big Growth) the following: HML_idiosyncratic = 1/2 (Small_high idiosyncratic volatility + Big_idiosyncratic volatilty) - 1/2 (Small_low idiosyncratic volatility + Big_low idiosyncratic volatility) Does that sound correct to you?Sorry for the formatting this is my first post here $\endgroup$
    – John
    Jan 3, 2021 at 9:25
  • $\begingroup$ Here is an example for B/M [mba.tuck.dartmouth.edu/pages/faculty/ken.french/Data_Library/…. The 30%/40%/30% split is what I'm referring to. When Ken French says "Portfolios are formed on BE/ME at the end of each June using NYSE breakpoints", he meant the size bucket "breakpoints" should be based on NYSE-listed stocks, then applied to NASDAQ and Amex stocks. The reason you do this is that NYSE tends to be larger than NASDAQ and Amex. If you calculate small/big buckets using all stocks then the small bucket will contain all the NASDAQ/Amex stocks $\endgroup$
    – stevew
    Jan 4, 2021 at 8:39
  • $\begingroup$ Thank you so much! $\endgroup$
    – John
    Jan 13, 2021 at 14:45

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