Time-Series Efficient Factors
61 Pages Posted: 1 Apr 2020 Last revised: 2 Sep 2022
Date Written: September 2, 2022
Factors in prominent asset pricing models are unconditionally minimum-variance inefficient: their returns are positively autocorrelated while risks, conditional on past returns, are constant. We derive a transformation that turns an autocorrelated factor into a "time-series efficient" factor. Time-series efficient factors span and earn 40% higher Sharpe ratios than the original factors. Momentum strategies' profits relate to factor inefficiency. Whereas the standard five-factor model does nothing to the momentum factor, the time-series efficient five-factor model subsumes it. We show that the leading macro-finance models generate factors that bear little resemblance to the real-life factors.
Keywords: Factors, Asset Pricing Models, Anomalies, Momentum, Risk-Return Tradeoff
JEL Classification: G11, G12, G40
Suggested Citation: Suggested Citation