Principal Portfolios
We propose a new asset-pricing framework in which all securities’ signals are used to predict each individual return. While the literature focuses on each security’s own-signal predictability, assuming an equal strength across securities, our framework is flexible and includes cross-predictability—leading to three main results. First, we derive the optimal strategy in closed form. It consists of eigenvectors of a “prediction matrix,” which we call “principal portfolios.” Second, we decompose the problem into alpha and beta, yielding optimal strategies with, respectively, zero and positive factor exposure. Third, we provide a new test of asset pricing models. Empirically, principal portfolios deliver significant out-of-sample alphas to standard factors in several data sets.
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Copy CitationBryan T. Kelly, Semyon Malamud, and Lasse H. Pedersen, "Principal Portfolios," NBER Working Paper 27388 (2020), https://doi.org/10.3386/w27388.Download Citation
Published Versions
BRYAN KELLY & SEMYON MALAMUD & LASSE HEJE PEDERSEN, 2023. "Principal Portfolios," The Journal of Finance, vol 78(1), pages 347-387.
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