Forest Through the Trees: Building Cross-Sections of Stock Returns

We build cross-sections of asset returns for a given set of characteristics, that is, managed portfolios serving as test assets, as well as building blocks for tradable risk factors. We use decision trees to endogenously group similar stocks together by selecting optimal portfolio splits to span the Stochastic Discount Factor, projected on individual stocks. Our portfolios are interpretable and well diversified, reflecting many characteristics and their interactions. Compared to combinations of dozens (even hundreds) of single/double sorts, as well as machine learning prediction-based portfolios, our cross-sections are low-dimensional yet have up to three times higher out-of-sample Sharpe ratios and alphas.

Keywords: Asset Pricing, Sorting, Portfolios, Cross-Section of Expected Returns, Decision Trees, Elastic Net, Stock Characteristics, Machine Learning

JEL Classification: G11, G12, C55, C58

Suggested Citation: Suggested Citation

Bryzgalova, Svetlana and Pelger, Markus and Zhu, Jason, Forest Through the Trees: Building Cross-Sections of Stock Returns (August 25, 2019). Available at SSRN: https://ssrn.com/abstract=3493458 or http://dx.doi.org/10.2139/ssrn.3493458