Working Paper: NBER ID: w24164
Authors: Kent Daniel; Lira Mota; Simon Rottke; Tano Santos
Abstract: In the finance literature, a common practice is to create characteristic portfolios by sorting on characteristics associated with average returns. We show that the resulting portfolios are likely to capture not only the priced risk associated with the characteristic, but also unpriced risk. We develop a procedure to remove this unpriced risk using covariance information estimated from past returns. We apply our methodology to the five Fama and French (2015) characteristic portfolios. The squared Sharpe ratio of the optimal combination of the resulting characteristic efficient portfolios is 2.16, compared with 1.16 for the original characteristic portfolios.
Keywords: characteristic portfolios; risk; return; Sharpe ratio; asset pricing
JEL Codes: G00; G1; G12; G14
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| standard characteristic portfolio construction procedure (G11) | mean-variance efficient portfolios (G11) |
| characteristic portfolios load on both priced and unpriced risks (G19) | standard characteristic portfolio construction procedure unlikely to yield mean-variance efficient portfolios (G11) |
| constructing hedge portfolios (G11) | increase Sharpe ratio of characteristic efficient portfolios (CEPs) (G11) |
| characteristic efficient portfolios (CEPs) provide better benchmarks for portfolio performance evaluation (G14) | standard characteristic portfolios may not effectively capture underlying risk factors driving returns (G11) |
| standard characteristic portfolios load on industry returns (G11) | unpriced sources do not fully span the mean-variance efficient frontier (G19) |