NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Lira Mota

Columbia Business School
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NBER Working Papers and Publications

December 2017The 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 (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 appl...
 
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