Compensated and Uncompensated Risks In Global Factor Investing

Abstract

Global equity risk factors that are constructed by sorting stocks on firm characteristics associated with expected returns contain embedded region and sector exposures. We show that these positions lead to uncompensated volatility. Hedging out both region and sector exposures simultaneously increases the Sharpe ratio of the typical global factor by 50%. Hedged factors, individually or in a model, always subsume their non-hedged counterparts. Our results have implications for international asset pricing and portfolio management.

Keywords: International Equity Factors, Asset Pricing Models, Portfolio Management, Sector-Neutral factors

JEL Classification: G11, G12, G15