Common Stock Returns Are Not Equity Returns
Posted: 23 Apr 2019
Date Written: March 24, 2019
U.S. companies hold cash on their balance sheets, and the share of assets held in cash varies across companies and over time. A firm’s cash holdings is an implicit holding in a low-return asset, which pushes down a firm’s common stock return, and investors should thus hedge out the cash on the balance sheets when calculating equity returns. Failing to do so has implications for portfolio formation and optimization, asset pricing models, and trading strategy performance. We show that neglecting to consider cash holdings results in biases in portfolio optimization, factor creation, and the cross-sectional asset pricing. We decompose common stock market betas into components, which depend on the portfolio’s cash holding, the return on cash, and the portfolio’s cash-hedged equity return. We create a cash-hedged market factor and show this better explains the cross-sectional variation in portfolio returns than the standard market factor. Finally, we show the implications of creating and using cash-hedged factors and test assets. Cash-hedged factors and portfolios increase Sharpe ratios of factors across the board, and motivate the creation of new factor based on cash-holdings of firms.
Keywords: stock returns, cross-section of expected returns, asset pricing, cash, balance sheet, CAPM, beta
JEL Classification: G12
Suggested Citation: Suggested Citation