Working Paper: NBER ID: w26708
Authors: Valentin Haddad; Serhiy Kozak; Shrihari Santosh
Abstract: The optimal factor timing portfolio is equivalent to the stochastic discount factor. We propose and implement a method to characterize both empirically. Our approach imposes restrictions on the dynamics of expected returns which lead to an economically plausible SDF. Market-neutral equity factors are strongly and robustly predictable. Exploiting this predictability leads to substantial improvement in portfolio performance relative to static factor investing. The variance of the corresponding SDF is larger, more variable over time, and exhibits different cyclical behavior than estimates ignoring this fact. These results pose new challenges for theories that aim to match the cross-section of stock returns.
Keywords: Factor Timing; Stochastic Discount Factor; Predictability; Portfolio Performance
JEL Codes: G00; G11; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| factor timing (C41) | stochastic discount factor (SDF) (D15) |
| predictability of factors (C53) | stochastic discount factor (SDF) (D15) |
| stochastic discount factor (SDF) variance (D15) | portfolio performance (G11) |
| predictability of largest principal components (C38) | robust forecasts of factor returns (G17) |
| dynamics of SDF variance (C69) | market risk premiums (G19) |
| size and value loadings (D46) | procyclicality (E32) |
| momentum (C69) | countercyclicality (E32) |