The Low-Minus-High Portfolio and the Factor Zoo
47 Pages Posted: 7 May 2019 Last revised: 19 Nov 2019
Date Written: March 31, 2019
Regardless of whether the CAPM is rejected for valid reasons or by mistake, a single long-short portfolio will always explain, together with the market, 100% of the cross- sectional variation in returns. Yet, this portfolio, which we coin the “Low-Minus-High (LMH) portfolio,” need not proxy for fundamental risk. We show theoretically how factors based on valuation ratios (e.g, book-to-market), or on investment rates, can be proxies for the LMH portfolio. More generally, the empiricist can uncover an infinity of proxies for the LMH portfolio, thus unleashing the factor zoo.
Keywords: CAPM, factor zoo, anomalies
JEL Classification: G12
Suggested Citation: Suggested Citation