The Cross-Section of Risk and Return
52 Pages Posted: 6 Dec 2017 Last revised: 1 Nov 2018
Date Written: October 31, 2018
In the finance literature, a common practice is to create factor-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 show that the unpriced risk can be hedged out of these factor-portfolios using covariance information estimated from past returns. We apply our methodology to hedge out unpriced risk in the Fama and French (2015) five factor-portfolios. We find that the squared Sharpe-ratio of the optimal combination of the resulting hedged factor-portfolios is 2.26, compared with 1.21 for the unhedged portfolios.
Keywords: Factor Models, Unpriced Risk, Characteristics, Covariances
JEL Classification: G12, G1
Suggested Citation: Suggested Citation