Columbia Business School
New York, NY 10025
NBER Working Papers and Publications
|December 2017||The Cross-Section of Risk and Return|
with Kent Daniel, Simon Rottke, Tano Santos: w24164
In the finance literature, a common practice is to create factor-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 show that the unpriced risk can be hedged out of these factor portfolios using covariance information estimated from past returns. We apply our methodology to hedge out unpriced risk in the Fama and French (2015) five-factor portfolio. We find that the squared Sharpe ratio of the optimal combination of the resulting hedged factor-portfolios is 2.25, compared with 1.3 for the unhedged portfolios.