Time-Series Efficient Factors

Abstract

We show that factors in prominent asset pricing models are unconditionally minimum-variance inefficient. Factor returns are positively autocorrelated while risk, conditional on past returns, is constant. We derive a transformation that turns an autocorrelated factor into a “time-series efficient” factor. Time-series efficient factors earn 40% higher Sharpe ratios than the original factors and contain all the information found in the original factors. Momentum strategies profit from the inefficiencies in factor returns. An asset pricing model with time-series efficient factors, such as an efficient Fama-French five-factor model, prices momentum. Our results impose novel restrictions on theoretical models of asset returns.

Keywords: Factors, Asset Pricing Models, Anomalies, Momentum, Dynamics of the Risk-Return Tradeoff

JEL Classification: G11, G12, G40