Columbia Business School
New York, NY 10025
Institutional Affiliation: Columbia University
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 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.