Latent Fundamentals Arbitrage with a Mixed Effects Factor Model

We propose a single-factor mixed effects panel data model to create an arbitrage portfolio that identifies differences in firm-level latent fundamentals. Furthermore, we show that even though the characteristics that affect returns are unknown variables, it is possible to identify the strength of the combination of these latent fundamentals for each stock by following a simple approach using historical data. As a result, a trading strategy that bought the stocks with the best fundamentals (strong fundamentals portfolio) and sold the stocks with the worst ones (weak fundamentals portfolio) realized significant risk-adjusted returns in the U.S. market for the period between July 1986 and June 2008. To ensure robustness, we performed sub period and seasonal analyses and adjusted for trading costs and we found further empirical evidence that using a simple investment rule, that identified these latent fundamentals from the structure of past returns, can lead to profit