Time-Series Efficient Factors
71 Pages Posted: 1 Apr 2020
Date Written: March 16, 2020
Factors in prominent asset pricing models are positively serially correlated. We derive the optimal allocation that transforms an auto-correlated factor to a "time-series efficient" factor. The key determinant of the value of factor timing is the ratio of a factor's auto-correlation to its Sharpe ratio. Time-series efficient factors earn significantly higher Sharpe ratios than the original factors and contain all the information found in the original factors. Momentum strategies profit by timing auto-correlated factors; they pick up factor "inefficiencies." We show that, rather than augmenting models with the momentum factor, each factor can instead be made time-series efficient. An asset pricing model with time-series efficient factors, such as an efficient Fama-French five-factor model, prices momentum. Time-series efficient factors also explain more of the co-variance structure of returns; they describe the cross section better than the standard factors and align more closely with the true SDF.
Keywords: Factors, Asset Pricing Models, Anomalies, Momentum
JEL Classification: G11, G12, G40
Suggested Citation: Suggested Citation