The Cross-Section of Risk and Return
68 Pages Posted: 6 Dec 2017 Last revised: 6 Nov 2019
Date Written: November 04, 2019
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.
Keywords: Factor Models, Unpriced Risk, Characteristics, Covariances
JEL Classification: G12, G1
Suggested Citation: Suggested Citation