Time-Series Efficient Factors

Abstract

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