The Cross-Section of Risk and Return

69 Pages Posted: 3 Jan 2018

See all articles by Kent D. Daniel

Kent D. Daniel

Columbia Business School - Finance and Economics; National Bureau of Economic Research (NBER)

Lira Mota

Columbia University - Columbia Business School, Finance

Simon Rottke

University of Amsterdam - Finance Group

Tano Santos

Columbia Business School; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: December 2017

Abstract

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.

Suggested Citation

Daniel, Kent D. and Mota, Lira and Rottke, Simon and Santos, Tano, The Cross-Section of Risk and Return (December 2017). NBER Working Paper No. w24164. Available at SSRN: https://ssrn.com/abstract=3095125

Kent D. Daniel (Contact Author)

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Lira Mota

Columbia University - Columbia Business School, Finance ( email )

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Simon Rottke

University of Amsterdam - Finance Group ( email )

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Tano Santos

Columbia Business School ( email )

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National Bureau of Economic Research (NBER)

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