Persistent and Transitory Components of Characteristics: Implications for Asset Pricing

Abstract

We study the horizon-dimension of cross-sectional return predictability through the lens of a model where characteristics contain persistent and transitory components. We test the implications of this model for the average returns of popular characteristic-based trading strategies at short versus long horizons after portfolio formation. Our evidence supports the claim that the relative compensation for persistent and transitory components varies across characteristics, in magnitude and sign. Benchmark factor models cannot explain the returns of portfolios sorted on characteristics where either the persistent or transitory component is dominant. Finally, we model and test implications for firms' long-term discount rates.

Keywords: Characteristics, Persistent-Transitory Decomposition, Cross-Sectional Return Predictability, Discount Rates, Asset Pricing Tests

JEL Classification: G11, G12