Hedging Risk Factors

Abstract

Standard risk factors can be hedged with minimal reduction in average returns. Stocks with low factor-exposure have similar performance relative to stocks with high factor-exposure, hence a long-short portfolio hedges factor risk with little reduction in expected returns. This is true for both “macro” factors relating to the business cycle, and “reduced-form” factors such as value and momentum. Hedging macro factors also hedges business cycle risk (e.g. NBER recessions) and hedges many other macro factors argued to be priced in the literature, and hedging “reduced-form: factors generates large alphas. Our results have implications for portfolio formation and for understanding the economic origins of equity risk premiums.

Keywords: Risk and Return, Equity Premium, Hedging, Asset Pricing Models, Factor Models