Distinguishing Factors and Characteristics with Characteristic-Mimicking Portfolios
49 Pages Posted: 16 Jul 2018
Date Written: June 26, 2018
We advance a procedure for deriving systematic factors from characteristics based on maximizing each factor’s exposure to a characteristic for given factor variance. The resulting characteristic-mimicking portfolios (CMPs) price assets identically as the original characteristics and have maximum power to identify underlying factors. Performance differences of mimicking factors and characteristics in explaining mean returns are artifacts of arbitrary procedures for generating mimicking factors. CMPs are ideally suited to distinguish factors and characteristics by explanatory power for the time series of returns and are useful for improving risk management and to determine if return explanations are justifiably linked to systematic risk.
Keywords: Characteristics, Factors, Systematic Risk, Mimicking Portfolios
JEL Classification: G12
Suggested Citation: Suggested Citation