NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

The Cross-Section of Risk and Return

Kent Daniel, Lira Mota, Simon Rottke, Tano Santos

NBER Working Paper No. 24164
Issued in December 2017
NBER Program(s):Asset Pricing

In the finance literature, a common practice is to create factor-portfolios by sorting on characteristics (such as book-to-market, profitability or investment) associated with average returns. The goal of this exercise is to create a parsimonious set of factor-portfolios that explain the cross-section of average returns, in the sense that the returns of these factor-portfolios span the mean-variance efficient portfolio. We argue that this is unlikely to be the case, as factor-portfolios constructed in this way fail to incorporate information about the covariance structure of returns. By using a high statistical power methodology to forecast future covariances, we are able to construct a set of portfolios which maintains the expected return, but hedges out much of the unpriced risk. We apply our methodology to hedge out unpriced risk in the Fama and French (2015) five-factors. We find that the squared Sharpe ratio of the optimal combination of the resulting hedged factor-portfolios is 2.29, compared with 1.31 for the unhedged portfolios, and is highly statistically significant.

You may purchase this paper on-line in .pdf format from SSRN.com ($5) for electronic delivery.

Access to NBER Papers

You are eligible for a free download if you are a subscriber, a corporate associate of the NBER, a journalist, an employee of the U.S. federal government with a ".GOV" domain name, or a resident of nearly any developing country or transition economy.

If you usually get free papers at work/university but do not at home, you can either connect to your work VPN or proxy (if any) or elect to have a link to the paper emailed to your work email address below. The email address must be connected to a subscribing college, university, or other subscribing institution. Gmail and other free email addresses will not have access.

E-mail:

Machine-readable bibliographic record - MARC, RIS, BibTeX

Document Object Identifier (DOI): 10.3386/w24164

Users who downloaded this paper also downloaded* these:
Jordà, Knoll, Kuvshinov, Schularick, and Taylor w24112 The Rate of Return on Everything, 1870–2015
Daniel, Hirshleifer, and Sun w24163 Short and Long Horizon Behavioral Factors
Kozak, Nagel, and Santosh w24070 Shrinking the Cross Section
Haddad, Kozak, and Santosh w23886 Predicting Relative Returns
Chu, Hirshleifer, and Ma w24144 The Causal Effect of Limits to Arbitrage on Asset Pricing Anomalies
 
Publications
Activities
Meetings
NBER Videos
Themes
Data
People
About

National Bureau of Economic Research, 1050 Massachusetts Ave., Cambridge, MA 02138; 617-868-3900; email: info@nber.org

Contact Us