Principal Portfolios

98 Pages Posted: 6 Aug 2020 Last revised: 26 May 2021

See all articles by Bryan T. Kelly

Bryan T. Kelly

Yale SOM; AQR Capital Management, LLC; National Bureau of Economic Research (NBER)

Semyon Malamud

Ecole Polytechnique Federale de Lausanne; Centre for Economic Policy Research (CEPR); Swiss Finance Institute

Lasse Heje Pedersen

AQR Capital Management, LLC; Copenhagen Business School - Department of Finance; New York University (NYU); Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 2 versions of this paper

Date Written: June 8, 2020

Abstract

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.

Keywords: Portfolio choice, asset pricing tests, optimization, expected returns, predictability

JEL Classification: C3, C58, C61, G11, G12, G14

Suggested Citation

Kelly, Bryan T. and Malamud, Semyon and Pedersen, Lasse Heje, Principal Portfolios (June 8, 2020). Swiss Finance Institute Research Paper No. 20-67, NYU Stern School of Business, Available at SSRN: https://ssrn.com/abstract=3623983 or http://dx.doi.org/10.2139/ssrn.3623983

Bryan T. Kelly (Contact Author)

Yale SOM ( email )

135 Prospect Street
P.O. Box 208200
New Haven, CT 06520-8200
United States

AQR Capital Management, LLC ( email )

Greenwich, CT
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Semyon Malamud

Ecole Polytechnique Federale de Lausanne ( email )

Lausanne, 1015
Switzerland

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Swiss Finance Institute

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

Lasse Heje Pedersen

AQR Capital Management, LLC ( email )

Greenwich, CT
United States

Copenhagen Business School - Department of Finance ( email )

Solbjerg Plads 3
Frederiksberg, DK-2000
Denmark

New York University (NYU) ( email )

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

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